Keep it Simple, Stupid

(By Richard Holway 1.00pm 26th March 09) Without giving away too many confidences, last year one of the boards on which I sit as a director discussed allowing the fund manager to use derivatives. I was against this. As it turned out, this was an extremely astute decision on my part as many other funds who went down the derivatives route have since found to their (and their shareholders) cost.

But, if I was being extremely honest, the reason I was so against deriviatives was simply that I don’t really understand them. I’ve had a long standing principle that I will not invest in things I don’t understand and I will not sit on boards where I don’t understand the product or service being offered. This isn’t a universal recipe for success either – in that things I thought I understood initially have sometimes turned out not to be so!

I therefore read the article - Daddy, tell me, what exactly is a derivative? in today’s FT - with great interest.

Let me quote what James Carville says in the last couple of paragraphs:

"As someone who has prided himself on being able to reduce complex problems to simple messages, I am totally stumped by derivatives.

After hours of research, they seem to be something rich, greedy bankers thought up to make more money selling them to other rich, greedy bankers. They did not understand what they were selling. Buyers did not understand what they were buying and insurers did not understand what they were insuring. Now the taxpayer is stuck with these things that no one can explain.

I thought Mr Obama did a good job on Jay Leno explaining the AIG situation until he used the word “leverage” (translation for laymen: financial shovel that people use to dig themselves into a deeper hole), a term that escapes 97 per cent of the public. It is not that Mr Obama is not communicating as well; it is that what he is communicating is too complex to reduce to simple words, especially when in the last 40 years, the length of a TV soundbite has dropped by 40 seconds. That being said, try this experiment. Contact an engineer and ask him what a bridge is. Or contact a doctor and ask what surgery is. Then walk into your local bank and ask your friendly banker what a derivative is."

In our own sector, the reason I liked companies like Capita, Sage and Autonomy is that it is really very simple to understand and explain to others what they do. That is NOT the case with many other SITS companies who have overly complex businesses. I remember visiting the old Trace in the 1990s only to be confronted with a presentation containing over 40 different business streams!

I’d always thought that Banks borrowed money from savers and lent it to house buyers and businesses for a slightly higher interest rate. Such a simple model seemed to have worked for most of my working life. I also thought that Investment Trusts invested in companies where they believed in their medium-long terms prospects. I was wrong here too as clearly short selling and derivatives have turned many Investment Trusts into little more than gambling clubs.

Personally, I’m in the KISS club. If I’m not bright enough to understand complex instruments or companies, then so be it.