Work With Human Nature

 | Jan 08, 2013 | 11:30 AM EST
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Most investors are familiar with Adam Smith as the author of the seminal book The Wealth of Nations. In that historic work, Smith lays out his beliefs and observations about what must occur for markets and economies to function and prosper. What many may not know, however, is that Adam Smith laid forth some invaluable principles that are at the heart of successful investing. Applied today, these lessons form an intelligent framework for rational investment decision making.

Consider the following observation Adam Smith made about the corporation: "The directors of such companies, however, being the managers rather of other people's money than of their own, it cannot be well expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own..."

Notice that Smith doesn't lay fault or blame on the company or its "directors." Smith simply observes that you can't expect people to treat other people's money with the same diligence as their own. Exhibit A is the housing and mortgage crisis. Tempted by the availability of easy credit and little or no equity, thousands of individuals decided to roll the dice and speculate on housing. The risk profile was asymmetrical: if real estate prices increased the borrower reaped a fantastic return on investment but when real estate prices decreased, banks were left with the collateral.

What Adam Smith observed more than 200 years ago remains perhaps the most insightful investment lesson of all. Notice Smith didn't say the issue was bad management, but rather human nature by stating, "It cannot be well expected." How many of us take the time to wash a rental car? It's not because humans are bad that we don't treat others belongings as well as ours, it's simply human nature that we watch over our personal assets more diligently.

As it relates to investing, this doesn't mean that a company with little insider ownership is a bad company, but rather the flip side: When you find a business in which management's fortunes are really tied to the fortunes of a company, pay extra attention because that is a special circumstance. That's why, for example, when Michael Dell uses $500 million of his personal funds to buy shares in Dell (DELL), I take notice.

Another interesting company investors should take note of is automotive retailer Penske Automotive Group (PAG). Insiders own more than 50% of the company, and nearly all of it is in the hands of the Penske family. The valuation is attractive but, in addition, new car sales have been growing each year and look set to grow by another 5%-6% in 2013.

So it's not that companies whose managements lack significant skin in the game will be operated poorly. Instead, it's that you can take greater comfort -- especially during the worst of times -- that when folks have their own money at stake, the forces of human nature will be on your side.

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