Charles Ellis - The Characteristics of Successful Firms

8/6/2019 Charles Ellis - The Characteristics of Successful Firms

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The Characteristics ofSuccessful Investment FirmsDr. Charles D. Ellis, CFA

THE RECIPE FOR INVESTMENTSUCCESSIt should, in theory, really be quite easyto develop a first-rate professional firm.We all know the recipe. Get top people.Have a clear purpose. Have high professional standards. Take a long-termview. Always remember tha t clientscome ahead of the firm. Always remember that the firm comes ahead of theindividual. And always remember, asan individual, that professional commitments come ahead of the financialrewards. Maintain discipline at alltimes, and you shall succeed. As Mr.Morgan put it, "Run a first class business in a first class way."The recipe is the same one for successfulmanagement thatMarvin Bowers ofMcKinsey & Co. wrote about in his book,The Will to Manage. The title says it all.There wasn't anything unusual aboutwhat the management of any reallygood company was doing. They had thesame rec ipe every other managementhad, but they were doing it. That made allthe difference.David Ogilvy has writ ten a third book,Ogilvy on Advertising. It's fun to read,has lots of pictures-and a good deal ofreal insight. He discusses five great advertising agencies, and comes to the conclusion that the principal factor requiredfor success was-and is-persistence.One of the probl ems with identifyinggreat and successful investmentmanagement firms is that most organizations doing very well now will no t bedoing very well 10 years from now.Most of the organizat ions we admiredmost 10 years ago are no t those wewould pu t on our shortest list of thegreat successful firms today . I have noanswer for you as to why that should bethe case-except that we are a veryhumane and human business. There isnothing quite so temporary as successin an intense, dynamic, "people" business like ours.The Professional Dimension/BusinessGoals ConflictMany observers believe there is a basicconflict between the professional goals

and the business goals of an investmentmanagement organization, and thatthese two spheres work against eachother.This can certainly be true. There's nodoubt that they will be in direct conflictif either is mediocre. Any semi-goodprofessional commitment or semi-goodbusiness goal will sooner or later corrode any organization.But there is no conflict between reallygood business goals and really good professional goals- if each strives for excellence and if the respect for both issuff icien t. For example , it is only business st reng th t hat gives professionalsthe independence of mind and surenessof purpose that allows them to do firstrate professional work. Only professional independence is l ikely to result in thereally good work tha t is needed to makea rea lly good business. There is no conflict as long as each is truly strong. Mostorganizat ions, however, find it veryhard to achieve and sustain excellencein both areas. It is a matter that requiresmuch attention. The cul tu re or the climate of the organization must alwaysfavor the professional dimension. Whenin doubt, lean toward the professionalside. There must be that kind offavoritism.The Importance Of StrategicConsiderationsIt's my belief that fees are one of themost powerful forces in the success orfailure of an investment managementorganization. The fee level you set determines the market you will serve. Onceyou have chosen the market you willserve-which you do when setting yourfees-you can then identify th e key factors for success, the rules of the game inthat market. Then you can organize tobe successful in tha t par ti cu lar k ind ofmarket. For example, if you choose tocharge high fees, you mus t intend to bea high-value-adding organization.In strategy, clarity and simplicity areclearly critical. Most organizations areuncomfortable identifying what theywill not do. It is no t what you are willingto do, but what you will not do thatmost clearly defineswhat you really are.


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Peter Drucker has a good deal to say onthi s. I t can be easily summarized. Focusyour attention on areas of excellence; asprofessionals, do those things t ha t youdo quite well and try not to waste timedoing the other things in which you areonly moderately good. The internalfocus should be on the things a t whichyou are really good; the external focusshould be on the major opportunities ,the truly extraordinary opportunities.With regard to the formation of businesss trategy, i t is my belief t ha t many or ganizations fail to recognize that it is acompletely different l ine of work fromtheir investment management activityor their routine business administration. I would urge going to a different environment-in a different timeframe- taking two or three or four daysaway from your offices, an d clearlyseparated from your regular work.Otherwise, you're almost sure to havethe time-urgent decisions d ra in awaywhat time you have for those thingsthat might be more important.Identifying Th e Big DecisionsWe never take too much, or evensufficient, time for th e big dec is ions . Idon't mean those big decisions that areabundantly evident and show themselves with great force an d drama. Werecognize these decisions-whether tremendous problems or great opportunities - an d they do get ou r time. InsteadI mean those soft, delicate, subtl e,avoidable, easily postponed decisionson bas ic pol icy and strategy that canand will lead to very hard decisionslater on if they are no t attended to when"soft." The "soft" decisions are not easy.They are very difficult because they arethe things of basic value: the selectionof young people an d the training,coaching, hope an d t rust that you put inthem; decisions on which areas of development to give special emphasis; onthe quality of the commitment you willmake to your clients. It is in these areasof "softness" that all the really important decisions wil l be made, an d theycannot be made wisely and well in thepress of our daily activity.Strategy formation is not planning. It ismy strong belief that planning is a nega-tive function. P lan ning can be veryuseful, but it is negative in th e sensethat its whole intention is to eliminate

errors, reduce uncertainty, an d avoidmistakes. If we were so good that wecould p lan the ri ght things ahead twoor three years, wouldn' t we simply dothem now? Firms tha t a re successful dounderstand the value of a planningdiscipline, bu t it's a discipline againstnegatives.Our People And Our CommunicationsIt was said earlier today , it wi ll be saidtomorrow, it will be said every t ime wege t together: the mos t important part ofa very successful organization is f irstrate, high-caliber people. However,most of us do no t give enough time andattention to th e truly first-rate youngpeop le in ou r organizations. It is difficult to give them the environment theyneed; and difficult to give them the atten tion they want. First-rate people areso wonderfully rare that if we find themand br ing them into ou r organizations,we should give them everything theyneed to flourish.Successful f irms have a tremendousconsistency on basic values. The really"interesting" di scus sions seldom takeplace-because they are no t needed.The organization that has deep agreement on the most important philosophical matters does no t have "interesting,"crisis discussions. The best firms willenrich that consistent set of core valueswith a wonderful diversity of experienceand orientation, ways of thinking an darticulating, and personalities-all withdeep mutual respect. It is out of thatkind of common weal that an aristocracy of talent is likely to come forth.I think that the matter of size andmarket liquidity is a false i ssue for mostinvestment management organizations.There are some for which it would beright to say that market considerationswould put constraints on their ability tomanage money. Bu t most investmentmanagement organizations are not constrained ex ternal ly . They are constrained, instead, by their internaldifficulties, largely their difficulties ofcommunication.Consider, for a moment, t he GermanU-boat fleet, which in the early par t o fthe Second World War was dread ful lysuccessful. Much as the AmericanBritish navies would like to say thatthey defeated the U-boats, the reality is


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that the V-boats defeated themselves.The reason is that the V-boat commandwas in Berlin. The original concept wasthat al l V-boats would look for cargoships, and if they found a shi p theywould radio back to Berlin, and Berlinwould decide where every V-boatshould go. When Germany had only 50or 60 V-boats, that system worked verywell. When they go t to 400 or 500 V-boats, the deluge of data piling intoBerlin so exceeded Berlin's capacity toprocess and organize the data that headquarters' decision making could no tkeep up with the demand.This same problem of data over-load ischaracteristic of investment management firms that are in trouble. The enormous volume of data can overwhelmdecision making an d make it seem impossible to f ind t ime to think. It is a curious reality of ou r profession that th e investment management communi ty inthe Vni ted Sta tes is now spending $2billion a year induc ing a group ofhighly-motivated, very competent individuals largely located in Wall Street tosupply investment managers with further excesses of data. Two billion dollarsis a very large amount of money. Successful fi rms protect their decisionmakers from the tyranny of data an dfind ways to control the flow of information coming into their organizations.They make sure that the research isworking for them-not the o ther wayaround. I t does no good to play thehorse to someone else's Lady Godiva.For interna l communica tion , the greatproblem is adding people. As you addpeople ari thmetically, their relationships go up geometrically. There is arapid progression toward decisions thatare social or political, rather than objective and fact-founded; decisions that aremade with inadequate reflection becauseso much time is spent talking; anddecisions without clear-cut accountabil ity . Di rec t, s imple, short lines ofcommunica tion are wonderful ly powerful. One of the great organizations inthe history of the world, the CatholicChurch, has only four levels of communication between God and the average parishioner. That's a model communication system. Most of us can't saywe're very close to it. The closer we getto simple, clear , direct communication,the greater ou r chances to succeed.

Getting Bigger vs. Getting BetterGrowth and expansion are entirely different from one another-even thoughin the investment field, we tend to talkabout growth as though it were expansion an d about expansion as though itwere growth. Expansion is gettingbigger. Growth is getting better.Getting bigger almost necessarily meansthat you will have fewer wonderfulpeople join ing your organization inlarger numbers. It almost necessarilymeans that you will be doing morethings for more cus tomers . As youexpand the volume of work, there is agrim tendency to enter lines of workthat are less value-adding and to servesmaller clients. As the margin of valueadded decl ines, so does the margin ofprofit-but both are h idden in the shortru n by expansion's increase in totalprofits. Expansion is almost always a decline in quality offset by a rise inquantity.Growth is getting better. Doing moredifficult, more valuable things-oftenfor more substantial an d demandingclients. I'm for getting bet te r - forg rowth. The g reat enemy of growth isexpansion . Peter Drucker , once again,says that the easiest way to get hold offirst-rate resources that can be pu t towork on first-rate opportunities is tostop doing things that aren't worthdoing. Stop doing things you don't dowell and devote the liberated resourcesto things with which you could succeedgreatly.Tenure, Turnover And StructureOptimizing the balance betweencommon commi tmen t and diversityrecommends average t enure of professionals between four and six years. Tocalculate average tenure, take all theyears of everyone in your organizationand divide it by the total number ofpeople. Ideally , i t wil l to be somewherebetween four an d six years. I f it is lessthan that, people don't know each otherwell enough to really work togethereffectively. Beyond six years, they knoweach other too well and stop listeningand stop thinking.This leads naturally to a desire for lowturnover. All th e real ly success fu l


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organizations, other than those tha t a revery new, have low turnover. In somecases it c an mean reaching out to findextraordinarily talented new faces thatwill help bring your average tenuredown into that four to six year zone.The great silent enemy of a vibrant, effective strategy is its structure. Thereason is that strategy, created to meet amarket's requirement, needs a structurefor implementat ion. As soon as thestructure is in place, however, it strivesto wrest cont ro l of the organizationaway from strategy. Structure almostalways wins. Structure resists change. Itholds onto the familiar past and keepsus from advancing toward our futurewith a bold contemporary strategy, if itcan.Beware the normal tendency toward the"Peter Principle". Don't take your bestinvestment manager and make him anot-very-good organization manager.Keep th e best investment achievers, ifyou are lucky enough to have them, freeto invest . Try to make it possible forthem to invest 100% of th e time. Thereare many more good general managersthan there are good investment managers in this nation. I don't think it's possible to be a good business manager and agood investment manager simultaneous ly , because the basic talents thatlead to great success in an investmentmanager are no t l ikely to lead to greatsuccess in an organization manager.CompensationNow-And LaterCompensation is th e great driving forcein any organization's s trategy. I t i s no tjust the financial compensation that'simportant; and most particularly, it'sno t the current-dollar compensation.Do you have dis tr ibut ive justice? Ifeverybody knew exactly what everybody was being paid , would it makegood sense to them? The best test of thatis, I think, one every organization oughtseriously to consider: total disclosure ofcompensation policy. It will cause thosewho make the decisions to make themwith great care. Fair play is the essentialfactor in compensation. Without fairplay, no organization will be successfulfor long.Beyond current compensation, there is alooming problem for the most successful

of the independent investment management firms. In many o f th ese firms, agreat confrontation will come betweenthree generational groups. One groupwill say, "We started this firm. We werehere when there was no one here. Wed id the first pieces of business. We tookall the risks. It's ours. " The next groupwill say, "The first arr ivals may havesta rted this company, but it wasn'tmuch when we got here. We are theones who brought in the really bigaccounts. We are th e ones tha t made thereally important strategy moves. We arethe ones that made i t a really successfulbusiness. It is ours." And the third generation will say, "We are the future. Wea re doing al l the really good researchand we are moving into more and moreclient relationships. I f you lose us, th efuture will be rough. The firm should beours." Those generations will not bemore than ten years apart.Investment organizations that are partof a large organizat ion all too oftenhave their pay patterns set by the pattern designed for the parent company'sother-usually larger and moreimportant- business. This can cause adistressing mismatch between the firm'sinternal compensation and the norm inthe market. In one form or another,most inv estment organ izations arestruggling with success. Many are sosuccessful that their major problem willbe living with that success.In some cases, very successful firmshave a benevolent major owner who isi ncr easing ly d ist ri bu ti ng the ownership-and matching the rising expectations of the young. Other firms have acomplete disclosure policy or equitablesharing - equal pay to all partners. Mostfirms do not enjoy such blessedconditions.Stature, respect, acceptance and recognized importance are vital aspects ofcompensation. There certainly ought tobe no one i n the inves tmen t management business inadequately compensated today. The pay is, frankly,spectacular. The prospects ar e evenmore charming. But there ar e peoplewho will be unhappy because t hey a reno t treated with th e respect as professionals that they are entit led to. In successful organizations there is a highlevel, even a surplus, of respect,recognition, and admiration among the


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professionals. There is, also, quite a lo tof pride-that same kind o f p ride thatgoes with being a good athlete. There isa total dedication an d desire to be verygood.The Power Of Good Ideas And GoodClientsMost of usgo to work every day. We pu tin ten or more hours reading an d talkingabout routine and making un important, perhaps even useless, decisions day after day. Only once or twicea year is there something really worthdoing. Most of us are too busy to notice.Great organizations must have the ability to recognize a great idea, grab hold ofit an d embrace it in a powerful way.Knowledge is not a constant. Insight iscertainly no t a constant. Big ideas of realvalue seldom come along. The best investment management organizationsseem to be reasonably good a t pausingreverently before those good ideas andexploiting them.An impor tant dimension of successfulinvestment management organizations-true of great organizations inmany fields-is having great clients. Ifyou have clients you do not enjoy oradmire, or clients that do not expectmuch of you, you should seriously consider terminating the relationship withthem. They wil l hold you back. I f youhave gr eat clients, wonderful clients,reach out to them and ask them todemand even more of you. The g reatrole of the client is to challenge you tobe the very best you can be.Appraising "Success"What makes for successful f irms? Business success in investment managementis not hard to come by. Fees are high.Costs are relatively modest. Technological risks are minimal. Foreign competition is no t consequential. Growth comeseasily. Customer s ar e often docile.Competition is benign. Demand exceedssupply. It's a wonderful, easy place tohave a business success.In terms of profess ional success, however, I would ask some questions.First, how many of the really importantdevelopments in investment management have come f rom within - from

wit hin you r own organization or fromwithin our profession-as opposed tocoming from outside?Have we, as a profession, truly contributed to our national society? Havewe added ne t value? I confess to havingsome genuine doubts. If you took allthe fees paid to all the inves tmentmanagers, added up all the transactioncosts incurred by these managers, an dthen compared the total to the riskadjusted returns on th e portfolios,which would be larger?Have we t ruly advanced young peoplein their professional development?Have we succeeded in educating ou rclients, particularly with regard to theimportance of setting long term policieson asset mix an d risk levels? Have wetaught them how to avoid odd-lotting?I suspect that, on those dimensions ofprofessional success, we're no t yet verysuccessful. In th e long run, however,satisfying the real an d legitimate needsof clients will be the best part of ou r professional success.Leadership is the final characteristic ofsuccessful f irms. To become excel lent afirm needs strong leadership-not anindividual, necessarily, bu t ideally agroup of leaders-committed to an ideaof real value and able to take the timeneeded to pursue tha t idea. Venturecapitalists say they don't want to investin small companies. They want to investin small companies in big businesses. Itis my belief that the successful investment management organizations of thefuture will be those whose people wantto invest their careers in relatively smallenterprises that engage in impor tantwork on challenging problems for greatclients.It's a wonderfully difficult field inwhich we are engaged. Fortunately, it isan easy place to make a business successand, therefore, we will be well paid. Thereally interesting questions ar e how tomake a professional success. On that, Idon 't t hink we have the answers . I'mnot even sure we have the questions. Itis ou r largest challenge.

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A brief discussion period immediatelyfollowed this presentation.


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Mr. Ellis: One thing that I know is verymuch on your minds concerns"TheLoser's Game". Do I still believe in it?The answer is affirmative.Let me tell you why. The reason is you.The tal ent i n this business is too great .There is no reasonable hope that such awonderful group of talen ts could leavesufficiently large errors in plain viewfor me o r anyone I know to find themand exploit them, if they manage consequential amounts of money.Question: Would you be more explicitabout th e details of the conflict you findbetween business and professionalsuccess?Mr. Ellis: For investment managers theeasy, quick business profi ts are so greatthat it is difficult to justify striving to bereally good at the professionaldimension.Those organizations that ar e most successful at the professional dimens ion-the development of really clearlya rt icul ated, matur e, supported an dachievable concepts of investmentmanagement-typically ar e not financially motivated in th at work. The attitude that is brought to bear is one seek-in g fulfillment in t he p ro fe ssionaldimension, rather than seeking to makea business success of it. That gets into adangerous conflict when the bus inesssuccess starts to roll. It is easier for us tocount the jelly beans than achieve themore subtle things that have to do withprofessional excellence.It's easy to accep t bus iness that wereally ought to let pass by. I t' s easy toaccept th e growth in business or the ex-pansion in business that requires us toadd people to undertake more of whatwe ar e doing successfully. I watch outside ou r field. Look at the great management consulting firms. There are so fewthat have done first-rate work for verylong. The greatest failure i n the consulting field is certainly Booz, Allen &Hamilton, which at the beginning of theSecond Wor ld War was t he largest, bestregarded and probably the most capableconsulting firm in th e country. Sometime in the 1950s it was controlled by agroup of people who cared more aboutrunning it as a business. They ultimatelyto ok it pub lic an d it failed badly as apublic company. It was bought back by

people who had been there asprofessionals. They are still in the process of rebuilding that organization.During that same time, McKinsey &Company went from being a fairlysmall, inconsequential managementconsulting firm to being clearly the consistently best f irm. I believe the reason isthat the people at McKinsey haveclosed down a ser ies of their activities.They've really backed away from businesses t ha t do not lend luster to the professional integrity of the firm. It has tobe a bus iness they are proud to do, orthey won't do it.Ogilvy & Mather has an interestingrequirement: to take on any new client,first the new client has to be in a dif-ferent field than present clients. Sometimes a lo t o f imagination is required toget differences between kinds ofconsumer goods companies! Then italso has to look l ike it would be interesting and challenging work. It must bestrongly sponsored by a senior memberin the organization who wants to do thework. I think that's one of the reasonsthey're so successful in the ir bus iness.The clients they add ar e added from aprofessional point of view.Am I being helpful? Let me just identifywhat I think is the most professional decision I have ever heard. Peter Drucker'sbook, The Concept of the Corp-oration- written in the middle 1940sabout General Motors Corporation andvery unpopular with the company- ex-plains how in the late 1930s their seniormanagement came to t he judgementthat th e world was moving towards agreat and difficult war. And if therewould be a war, there would be a shortage of talented, skil led labor. So theybegan to search in 1938 for areas inwhich there were large populations ofskilled labor. They deliberately put theirplant locations, to the extent they could,in those centers of talent. In late 1939 orearly 1940 the executive committee ofthat corporation proposed to the boardof directors-and th e proposal wasaccepted-that if there was a war theywould take no contracts of any kind,including mil itary work, if some othercompany could do that work. Theywould only take, as manufacturingassignments , those things that no on eelse could do. Tha t was one of the reasons that this nation was so enormous-


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mously successful at staffing itsmilitarycapability. General Motors was ableto do things that we really needed tohave done.Lis ten to Vladimir Horowitz talk abouthis musical performances. Every yearhe eliminates two or three pieces he hasmastered because they are starting tobecome almost easy. He takes on somet hing he th inks might be very difficult.For a wonderfully long per iod he hasbeen first-rate by keeping himself testedand challenged.The great professional of ou r field isc lear ly Ben Graham. I didn't ge t toknow Ben until he was an older man.He was 77 when I f irst met him. What athrilling experience i t was to watch himsit in a room with the lions and tigers ofthe performance period. Twenty investment geniuses and old Ben Graham.Ben was th e one that had th e largestnumber of new ideas, was th e most i nterested in th e ideas of others, and wasth e least sure about th e ones he had.In his last two years he was involvedwith a slide rule and an ancienttypewriter. With his delightful Spanish

companion talking with him and encouraging him, he was t ryi ng to reinvent inves tment management. TheRenaissance of Value, published byThe Financial Analysts ResearchFoundation, was a preliminary reporton the work that he'd been doing. Hethought that he had found another wayto outperform the market.That, I think, is where great professionalism comes from. It' s an innerdrive; when you f ind it, support it andnurture it i nany way you can.Jack Hogge asked today, "What shouldyou do i f you can only do one thing?" Agood answer is one that was given , "Ihope to tel l each person working for meexactly how I think they are doing,always." My own answer would havebeen, "I hope to f ind wonderful talent,"because there's so little more we can doafter we've done that. The wonderfultalents are the geniuses behind all thereally successful f irms. The extremelysuccessful firms are the ones who don'tmess this up. They give talent the roomto do first-rate work and encourage it.That's a very delicate process.

Charles Ellis - The Characteristics of Successful Firms

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