As insiders, management has access to all sorts of information / insights which we as investors might not have knowledge or even heard about. Hence, there is this temptation, which every investor faces from time to time, to take every word uttered by these privileged individuals as coveted truth.

Far from questioning & thinking about what they are saying, we sometimes accept them as ‘the truth’ and is to be unquestionably believed.

Even a young auditor knows that external evidences are much stronger than what internal evidence (i.e. management representation) says but, as an investor, have seen even the experienced investors dancing to the tune of the ‘Piped Piper’ considering external factors as almost non-existent in their case.

And higher the complexity of the business, higher is the uncertainty and generally stronger is the tendency to go with what management has to say.

The ‘Edsel’ Case Study

Let’s take the case from mid 1950s of Ford’s much awaited car ‘Edsel’. It was no ordinary car atleast in the minds of Ford’s executives at the time. It was their bid to make in-roads in the fast expanding mid-range car market.

Even before the launch, they split it into a separate division called ‘Edsel division’, appointed exclusive dealers in every major town in US at the time and who were asked to put substantial money upfront, did a yearlong ‘teaser’ advertising campaign such that by the time of its launch every adult citizen of US had atleast heard about this upcoming ‘future car’ if not awaiting its launch. It had all types of bells & whistles embedded into its dashboard.

In all, Ford spent more than a staggering $250 million on a car with an unconventional design about which they had no idea how well will it be accepted by the masses and in the price segment where it was previously not present.

How would you react?

Consider yourselves at the midst of all this. Its been almost three years since you first heard about this mysterious sounding ‘E-car’, you have seen its ads in every prominent newspaper for months now and launch is just around the corner, management is upbeat – though they already spent a staggering amount promoting it they are confident of making several times over this amount. You have seen all the internal restructuring going within the company which reflects management’s confidence on the product. And then there are already hundreds of dealer appointed which will ensure that this car is available in every important place in the country and is never far from the potential customer.

So, you might conclude, there is dealer network in place, extensive promotion already incurred and now every potential buyer is aware about the product, management’s commentary has never been so upbeat and the segment where it aims to be in is just about to grow exponentially over next decade. An investment opportunity is just around the corner, right?

While the ‘story’ may look solid, underlying realities were far from it. Management was actually taking upon a gamble. Let’s think about it. Probability of success of a new model is never 100% (irrespective of whatever ad spends & marketing one might do) and that of a model achieving a flagship status (like say Maruti Swift or Honda Activa in our times) is considerably low. And all this further reduces if one accounts for the fact that for Ford it was a price segment where it was previously not present. Given the investments Ford was making, for it to recoup this, Edsel had to attain the flagship status – which is certainly a rare & an infrequent occurrence.

Result – Ford was able to sell about half the units of Edsel than required for this division to breakeven over a two-year period after which its production was stopped. Stock plunged by a third.

Needless to say, Edsel was a colossal failure. However, its impact on shareholders was though significant was not devastating since Ford had other models as well some which went on to do really well in their respective segments. For dealer who put up exclusive showrooms for Edsel, it was certainly destructive.

Today, Edsel’s failure is one of the important case studies taught at prominent business schools.

Conclusion

So how much emphasis can one put on the commentaries or guidance which these frontline players make and who are thinking 24×7 (hopefully) only about their area of business? If we were to go by cases like Edsel, one would say not much.

It is important for us to think like owners of the business but let’s not take this too literally. We need to think as an independent observer distancing ourselves from the business irrespective of the fact that we may be owning it. It is certainly not easy and requires a temperament which allows this to happen.

Best is to avoid businesses which are too complex for us to make an independent judgement about its future and hence forcing us, however unintentionally, to rely more upon management commentaries. Unless there is a good enough reason for doing so which is quite rare and is generally supported by presence of margin of safety along with certain confidence on stability of the underlying business.

It is not that management, in general, is not trustworthy for us to rely upon them. Far from that we are entrusting them, as shareholders, with assets and funds of the company. It is just that like any other mortal, sometimes they may be wrong in their assessment and we need to protect ourselves from those mistakes by being diligent instead of participating in it.

And moreover, as Kahneman says, leaders generally are optimistic and hence are risk seekers –

Optimistic individuals play a disproportionate role in shaping our lives. Their decisions make a difference; they are inventors, the entrepreneurs, the political and military leaders – not average people. They got to where they are by seeking challenges and taking risks. They are talented and they have been lucky, almost certainly luckier than they acknowledge. They are probably optimistic by temperament; a survey of founders of small businesses concluded that entrepreneurs are more sanguine than mid-level managers about their life in general.

Optimism is good force with which one wishes to live his life in general but you certainly don’t wish to let it influence your investing actions. As the old saying goes, trust but verify!