Reposting: The Goal of Explanatory Depth

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This was originally published on January 13, in the Due Diligence category.
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In the prologue to the audiobook Miracle and Wonder: Conversations with Paul Simon, Malcolm Gladwell asks:

When we call someone like him a musical genius, what does that mean?  Can we be more specific about how experience and culture and talent and family combine to make music that endures?

We could offer similar questions about people who we think individually or collectively demonstrate investment genius.  Can we be more specific about what the qualities are that earn them that designation — or even about the calculus of the personal scoresheet we use to come to that conclusion?

This topic was addressed a bit in a previous posting, “Who Are These People Anyway?”  Now let’s extend it more broadly to consider the explanatory depth that is often lacking in due diligence efforts and (especially) reports and recommendations.   (The need for “explanatory depth” is one of the core themes of the due diligence course in the Academy.)

Explanatory depth

For those viewing investment problems through a quantitative lens, the explanations of a manager’s efforts over time are found in the numbers.  They encompass absolute, relative, and risk-adjusted performance, including many different metrics calculated from the return stream, plus factor and sector exposures from holdings analyses, as well as performance attribution, etc.  The predictive power of the measures are questionable, but they are the basis on which decisions are made by many.

As examined here, however, “explanatory depth” refers to the qualitative characteristics that are ascribed to managers by those doing due diligence.  You know the categories — process, culture, philosophy, leadership, people, and the like.

We can judge a due diligence effort on its examination of those dimensions, as well as the communication of the range of that analysis to others via reports and presentations.  Because that transference of knowledge requires editing (you can’t and shouldn’t try to tell everything you know), there are gaps between the two.  Each is important in considering the notion of explanatory depth.

Reporting the narrative?

An asset manager’s marketing collateral might say, “We are known for our collaborative culture.”  If a due diligence report then states, “The manager is known for its collaborative culture” (or a paraphrase of that), has analysis been done?  Maybe or maybe not.

Due diligence reports often include conclusions that fit that pattern.  The reader of the report has no way of knowing whether the assessment was the opinion of the person doing the due diligence or just the narrative of the manager being passed along.  Because of the need to condense information into a usable form, the statements lack context and it is unclear whose points of view are being delivered and what is behind them.

Therefore, in evaluating the quality of a due diligence effort, some testing is required.  If the marketing materials of the manager are at hand, scanning them versus the recommendation report usually turns up a number of topics with common descriptions between them.  Those should be probed to find out what evidence supports the assertions and what techniques were used to surface it.

If the manager’s materials aren’t available, an exploration of some of the conclusions can serve the same purpose.  Ask about the manager’s narrative, the conclusions (of the due diligence analyst) that have been presented, the techniques used to come up with them, and the evidence that supports them.  Doing that with a couple of those standard topics will reveal more about the nature of the investigation than the talk about investment ideas that usually dominates such interactions.

Either this stuff is important or it isn’t.  If there’s not much behind the conclusions (other than that narrative), then they are being oversold as essential elements of the analysis.

Deeper levels

Hopefully, the due diligence has gone beyond the immediately available narrative in ways that surfaced more detailed information.  Those managers who are best prepared will have ready answers for many basic lines of inquiry, so the narrative is not confined to the marketing materials.  There is more sorting to do.

The key is getting them past the point of preparation and to the nitty-gritty of the topic at hand.  Does the pattern of information support the claims that are being made?  What bits of it are the product of discovery by the analyst that wouldn’t be found in the meeting notes of others who do similar work?

Explanatory depth is a difficult standard.  You won’t (and can’t) understand everything about an organization, but you should be able to support the statements that you make about a manager based upon independently-surfaced information.  If you opine that a manager has a collaborative culture, then that view should be your own and you should be able to explain why that is an apt description based upon the work you have done.

(A very simple example of this principle can be found on a slide from the due diligence course.  On the left is an example of what a manager says about its sell discipline, which can also be found in due diligence reports about it prepared by others.  Presenting that description — in quotes — along with the column on the right makes clear the manager’s narrative, as well as characterizations and conclusions about it from the investigating analyst, plus a mention of the process used to arrive at them.)

Considerations

The kind of depth being sought requires an expansive view of due diligence practice.  For instance, you are unlikely to get a deep view of an organization through a single point of contact, or even through multiple contacts if they are tightly clustered in terms of responsibility.  The triangulation that comes from interviewing people in different functions and at different levels provides a more complete picture.

Searching for that elusive depth takes you into areas where others don’t venture, providing a richer vein of information.  It also helps you to locate boundaries that can illuminate even as they obscure, especially regarding questions that people can’t or won’t respond to, or things you aren’t allowed to observe.  (No one could visit Madoff’s 17th floor to see the IBM computer from which the customer statements flowed or the people in on the “operation.”  Nor could you see a Theranos blood machine in action — or audited financials for the firm, for that matter.  Less dramatic examples occur with regularity; even minor matters can provide helpful clues.)

Explanatory depth takes time.  That sets up a potential conflict:  When deadlines are short, as in a situation where there is an upcoming closing and — based upon limited information — you have a desire to get in, what do you do?

There is no right answer.  It depends on the beliefs and processes of your organization, and the trade-offs it is willing to make.  Your strategy may be predicated on quick responses made with less information.  If so, that should be clear to all (as well as the anticipated benefits and risks of such an approach).

Just don’t dress it up as thorough due diligence — or convey the manager’s characterizations as if they were your own.