The developing Madoff scandal reminds us of some basic tenets of investing, which have more to do with common sense than with financial sophistication.
 

Don’t Buy What You Don’t Understand
 

In 2000, Enron Corp. was a Wall Street darling. The company stood 18th on Fortune’s list of the 535 “Most Admired Companies in America”. That same magazine named it “Most Innovative Company in America” for the sixth year in a row. In an environment where the technology bubble was menacing to burst, but natural resources were becoming desirable, their global involvement in energy and commodities seemed irresistible for investors.
 
Not surprisingly, many of our clients were putting pressure on us to include this winner in their portfolios. But we resisted.
 

A couple of years earlier, as the publicity around Enron was building up, the stock still had not seemed overly expensive for value investors like us, because “reported” earnings growth had kept pace with the stock price. So, Robert Kleinschmidt and John Hathaway, our two senior partners with extensive knowledge of energy and natural resources, had decided to go visit the company. In fact, they had gone not once but twice.
 
Both times, they had come back reporting that they did not understand how the company could be so profitable. As it became known in 2001, Enron’s celebrated “innovation” had mostly been in the fields of accounting and financial reporting. The company had used a global web of secret offshore entities to hide its losses and boost reported profits.
 
This episode vindicated one of the basic tenets of our investment discipline: we won’t buy an investment that we do not understand. Of course, it takes a mature analyst (and a self-confident one) to admit that he does not understand something. The others, as Jeffrey Skilling (then Enron’s C.E.O.) once reportedly said, are merely “highly paid stenographers”.
 

There Is No Investment Reward Without Some Risk
 

In 1999, in a paper entitled “Genius vs. Common Sense in Investments”, I related the following episode: 
“A number of years ago, an inspector from the French Police Judiciaire showed up at our office in New York, asking to see me. I had no obligation to talk to him, he said, but there were a few questions he would like to ask. Knowing the "PJ" only through Inspector Clouseau, of the Pink Panther movies, I was in fact rather eager to meet him.
 
After some small talk, the inspector informed me that my name had been found in the correspondence files of Chaumet, a renowned Paris jeweler that was then in the midst of a fraudulent bankruptcy. At first, I was puzzled: not only had I never set foot in that store but I didn’t know anybody working at that company either.
 
And then it all came back. A few summers earlier, in the south of France, a volleyball buddy of mine had mentioned over lunch on the beach "a deal that would interest me". A leading Paris jeweler was offering to sell prime-quality diamonds to selected investors, with a guarantee — backed by a letter of credit from a leading bank — to buy them back at cost within five years, if the investor so desired. I could not lose, but stood to make a nice profit if the price of diamonds went up.
 
The name of the jeweler had not been mentioned, which explains why I did not immediately make the mental connection. But I soon remembered, and related my answer to the inspector: I would gladly look at the proposal out of curiosity but would not invest, because I have an unbreakable rule: "I never invest in a situation in which I cannot lose."
 
My "friend" nevertheless suggested to Chaumet that they send me their offering literature. Although they never sent it, this explained the presence of my name in their files. My story was consistent with the inspector’s information and he left after a further nice chat, never to be heard from again.”
 

Find Out How The Other Guy Makes His Money
 

The reason why I do not invest when I cannot lose is that win-win situations simply do not exist in the investment world. Regardless of the markets’ periodic infatuation with "portfolio insurance", risk hedging and other intellectual constructions, plain common sense tells us that if the buyer of an investment is guaranteed not to lose, the seller must be guaranteed not to win. Since the seller is often quite sophisticated, the odds should make investors cautious: maybe there’s something in this dream offer that they don’t understand.
 
In recent years, European investors, in particular, have become enamored with products where the amount invested is guaranteed but the upside can be much higher than other, riskless investments. When they ask my advice, my answer usually is: “Have the bank send me a memo explaining how they make money on this deal”. It may be a legitimate offer from the investor’s point of view but a gamble for the bank. I don’t like to invest with institutions that take this type of gamble. In 2008, some of the more “racy” near-money-market-funds failed to pay back dollar for dollar to investors who thought that they had invested in a deposit-like instrument – only one paying much more interest than other such funds. These investors share the guilt for not asking: “How?”
 

Where Were The Sophisticates While Madoff Was Ponziing?
 

I recently read a letter which purports to have been submitted to the Securities and Exchange Commission on November 7, 2005. I tend to find it credible, if only because no one could have accumulated so much detail in the short period since the scandal erupted.
 

The author claims to have first presented his rationale to the SEC’s Boston office as early as 1999.  He seems to have accumulated more facts ever since, through interviews with hedge fund and funds-of-fund investors in a hedge fund run by Madoff Securities LLC, as well as the heads of various Wall Street equity derivatives trading desks. The author himself claims to be an experienced derivative expert, having traded or assisted in the trading of several billion dollars in option strategies for hedge funds and institutional clients.
 
Listing no less than 29 red flags documenting his letter’s title (“The World’s Largest Hedge Fund is a Fraud”), the author concludes that there are two possibilities: either the broker-dealers involved are front-running the customers’ order flow, which he deems unlikely, or Madoff Securities is “the world’s largest Ponzi scheme”, which he deems highly likely. The latter, of course, is what the newspaper and media reports have been chronicling extensively in recent days.
 
What lends further credence to this letter is that several other potential investors (one of whom I know) decided not to invest with Madoff because, after doing some due diligence, they concluded that the returns reported could not be achieved with the strategies described or alluded to. Then, of course, there was the now-famous 2001 article in Barron’s, which essentially claimed the same.
 
So, the question arises: Why did so many supposedly sophisticated investors invest in the Madoff web of funds?
 
I leave aside all the show-business personalities, and even the successful business people who, I am sure, do not do most of their investing or due diligence themselves. But what about the large sophisticated banks and other fund-of-fund type of investors whose job it is supposed to be?
 
The author of the letter discussed above has a simple answer: “As far as I know, none of the hedge funds, fund of funds mentioned in my report are engaged in a conspiracy to commit fraud. I believe they are naïve men and women with a notable lack of derivative expertise and possessing little or no quantitative finance ability.” I will add one failing: they lack the common sense to realize that if a record is too good to be true, it probably is not true. Or, because they are too caught up in the performance game that is at the heart of the investment management industry and its profits these days, maybe they prefer not to ask themselves too many questions.
 

Even Great Investors Have Bad Years
 

What was most suspicious in Madoff’s claimed performance was not that he outperformed the S&P 500 Index for many years, as reported in the press. It is that his published record was incredibly smooth, with only a few months marginally down here and there – presumably to add a touch of reality, since these records apparently were fabricated.
 
Great investors outperform “the market” over the long term but, because they are human, they have some dry spells. Best Minds Inc., in the April 2006 issue of The Investor’s Mind offers the following example:
 
“Think back, if you will, to 1974. The Dow has lost 45 percent, falling from 1051, in January of 1973, to 577, in December of 1974. Fund managers, who had been eager to buy just a few years earlier, have now taken a “batten down the hatches” approach to the markets…In the midst of all this, imagine that you’re shopping for money managers. You’re excited about one in particular, because you’ve heard he’s really good, but he’s lost 23 percent in 1973 and he’s down 50 percent by 1974. Incredibly, as the losses have mounted, he’s actually getting more confident! If we’re like most people, we’re thinking to ourselves, “If I invested $1 million with this guy at the beginning of 1973, I’d have had $500,000 left by late 1974” …. “At this rate, I’ll be broke in 2 years! I don’t care how brilliant he thinks he is; I’m going pass on this one.”
 
“This one” was Warren Buffet and those who stayed with him and endured the losses over those two years were handsomely rewarded: though the chart below does not go back all the way to 1974, it tells the story well enough.
 

Berkshire Hathaway A Shares -- Source: BigCharts, Inc.
 

Berkshire Hathaway also lost about 50% from top to bottom in 1999-2001 and again this year, between December 2007 and November 2008, it lost about 50%. Yet, the long-term record still stands out.
 
Berkshire is not a mutual fund, so its share price reflects more what investors think the company is worth than its net asset value, which arguably moves somewhat more smoothly. Yet, in the past year, a number of mutual funds with superior long-term records also saw their winning streaks interrupted. Among them:
 
Marty Whitman's Third Avenue Value Fund, which had returned more than 14% a year since 1990, declined almost 60% between November 2007 and November 2008.
 

Third Avenue Funds -- Source: BigCharts, Inc.
 

Ron Muhlenkamp, whose fund outpaced the S&P 500 for the past 15 years, declined about 65% between July 2007 and November 2008.
 

Muhlenkemp Fund -- Source: BigCharts, Inc.
 

Bill Miller, whose Legg Mason Value Trust built quite a following while beating the S&P 500 every year from 1990 to 2005, declined more than 70% between mid-2007 and November 2008.
 

Legg Mason Value Trust -- Source: BigCharts, Inc.
 

The moral of these stories is that superior long-term investment records do not happen smoothly, month by month. This alone should have made Bernie Madoff’s published record suspect to “sophisticated” investors.
 

The Lure of Easy Money
 

In 1989, Michael Lewis, a former bond trader at Salomon Brothers, wrote a best seller entitled “Liar’s Poker”. A semi-biographical book, it was also meant to be a post mortem on a decade of greed and deteriorating ethics on Wall Street – spurred in part by the deregulation of the mortgage market (allowing Savings & Loans to sell mortgages as bonds) and the emergence of “junk bonds” and leverage buy-outs (LBOs).
 
Twenty years later, Lewis just authored an article in Portfolio.com, revisiting the sequels of an era which he believed had died when he resigned from Wall Street. Here are a couple of quotes:
 
“I thought I was writing a period piece about the 1980s in America. Not for a moment did I suspect that the financial 1980s would last two full decades longer or that the difference in degree between Wall Street and ordinary life would swell into a difference in kind.…  What I didn't expect was that any future reader would look on my experience and say, ’How quaint’."
 
“I might have said something like, "I hope that college students trying to figure out what to do with their lives will read it and decide that it's silly to phony it up and abandon their passions to become financiers… Somehow that message failed to come across. Six months after Liar's Poker was published, I was knee-deep in letters from students …who wanted to know if I had any other secrets to share about Wall Street. They'd read my book as a how-to manual.”
 
In the last two decades, the deteriorating ethics of the financial industry became increasingly visible as the banks’ primary focus shifted from their fiduciary duties to maximizing profit margins and achieving market share gains through the aggressive sale of new “products” with large fees.
 
At the same time, the products that banks were selling were becoming so complex that the people selling them – and even the banks’ CEOs – did not really understand them. The investing public obviously did not understand them either: faced with promises that black-box techniques would reduce or eliminate risk while producing superior results, they preferred to close their eyes than to ask difficult questions, for fear of missing out on money-making opportunities.
 
Greed, in one form or another, had become pervasive.
 
In a wsj.com blog, The Intelligent Investor, Robert Cialdini, Professor of Psychology at Arizona State University, describes how the Madoff network skillfully created the illusion that it was difficult to penetrate its exclusive private club and how, by playing on how exclusive his funds were, Mr. Madoff shifted investors’ fears from the risk that they might lose money to the risk they might lose out on making money. “Once you were granted access, it would seem almost an insult to do any further investigation”.
 
It would be easy to accept this lack of due diligence from unsophisticated investors. But, according to the same blog, the Greenwich Roundtable, a non-profit that researches alternative investments, last year conducted a survey of consultants, pension plans, “family offices”, funds of funds, and other large investors who shop for hedge funds. As the blog states, “it’s hard to imagine a more sophisticated crowd”. Yet, one out of five investors in the survey reported that they had no formal analytical procedure but, instead “always followed an informal process” of due diligence. In fact, one out of four investors surveyed said they would invest without having studied the financial statements of a fund.
 

The Moral of the Story
 

When things go wrong, it is easy to point the finger to others, whether they are crooks, incompetents or the government (the three are not necessarily mutually exclusive). But in cases like the Madoff saga, accusations of greed and laziness must be shared: the investors themselves refused to see that what sounded too good to be true simply couldn’t be true. I will conclude with some wisdom from a recent editorial from The Huffington Post.
 
“If any good is to come out of the economic crisis, it has to be surely this: that, as all the filth and corruption of Madoff and his ilk is unveiled, we too need to take a long hard look at ourselves and actually start to take accountability for our actions.
 
We can't max out our credit cards every month or overspend without consequences. We can rant and rave about other people's failings - and sure, they deserve it - but the first person who made a bad decision - and deep down if we thought about, we knew it - was us.” (Posted December 14, 2008 by Vicky Ward)
 
François Sicart (In Mexico)
December 26, 2008
 
This article reflects the views of the author as of the date or dates cited and may change at any time.  The information should not be construed as investment advice, nor is there any guarantee that any projection, forecast or opinion will be realized.