A Reputation of Integrity is an Undervalued Asset

If you find these posts to be value-adding, subscribe to Newcula

length ~8 minutes.

How much do law, medical, business, engineering or physics degrees cost these days from a reputable school? While doubtlessly these degrees tend to pay off handsomely as investments, they are also valued appropriately by the market.

An engineering degree from MIT or computer science degree from Stanford will cost an upward of $250,000 USD, not including the investment of your intellect, time, and opportunity cost of lost wages.

The intrinsic value of these degrees, if intrinsic value is defined as all future cash flows generated by an asset discounted back to today’s value, is pretty easy to measure. And despite what anti-elitist, anti-intellectual rhetoric says, that intrinsic value is highly positive.

A reputation of integrity, on the other hand, has intrinsic value which is much more difficult to estimate and measure.

Reputation Rescues Buffett’s Bad Bet

In 1997, Travelers paid a handsome sum of $9 billion in stock for Salomon Brothers. Salomon Brothers was an investment bank founded in 1910, but just five years prior to the Travelers’ deal, for at least several days, the intrinsic value of the company was likely no more than $0.

In 1987, Berkshire Hathaway’s stock could have been purchased for a bargain $3,500 a share. That year, Warren Buffett’s company earned about $350 million in after-tax profit. It also made a $700 million investment into Salomon Brothers in the form of convertible debt, which if redeemed would have granted them ownership of 12% of the entire company. To put this into perspective, Berkshire’s 2016 after-tax profit was in excess of $24 billion, twice that amount would be analogous to Buffett making a $50 billion investment today. As an aside, a single share of Berkshire is now worth $252,838 at the time of writing. Did I mention $3,500 was a bargain?

Basically this was the single largest and most important investment of Warren Buffett’s career to that point. Little did he know that he would receive a phone call on August 8, 1991 from the CEO of Salomon to essentially inform him that if no actions were taken, the value of the $700 million was going to zero.

For a full account of this story, check out this 1997 Fortune article. The short version is that the Treasury of the United States has strict rules about how and how much any individual firm could bid for Treasury bills and a trader from Salomon had deliberately broken those rules repeatedly. Not only that, but after the management became aware of the issue, they did not immediately report it to the Treasury but rather did nothing about the information for nearly six months.

This infuriated the Secretary of the Treasury, Nicholas Brady, to the point that he rightfully wanted to strip Salomon’s ability to bid for US Treasuries. To understand why this is important, look no further than the 2008 financial crisis. An investment firm like Salomon has $33 of debt for every $1 of equity. And that debt needs to be paid back, much of it on a daily basis. In this case, the bank would “roll-over” the debt by taking out another loan. Therefore, much of the intrinsic value of a bank is in the confidence it inspires in others to lend them money continuously.

During the 2008 financial crisis, the US government had to step in and back all of the banks deemed “too-big-to-fail.” Otherwise they may have all toppled one after another in crises of confidence. The government of the United States had to use its reputation to instill confidence, and to prevent the failure of the entire US banking system.

But Salomon Brothers was not too-big-to-fail, and there was no system-wide problem with the economy in 1991. And the angered Treasury department was in no mood to help the bank out. So John Gutfreund, Salomon’s CEO, turned to Warren Buffett and his reputation.

Warren Buffett took over as the interim-Chairman of Salomon and persuaded Nicholas Brady to rescind the ban on trading by promising to fully cooperate and be completely transparent. As a testament to the power of Buffett’s integrity and reputation thereof, not only did Brady rescind the ban, but when Buffett announced that several key executives had resigned in disgrace from a terrible scandal, and that as a result he would be taking over as interim-Chairman, the room of reporters and employees cheered, not a whiff of panic in sight.

While testifying before Congress relating to the Salomon Brothers’ scandal, Buffett uttered the now famous phrase, “Lose money for the firm and I will be understanding. Lose a shred of reputation for the firm and I will be ruthless.”

Because of his reputation with the US Treasury, Buffett was trusted to bring Salomon’s misdeeds fully into the spotlight and ensure it never happened again. For his troubles, Buffett cashed out his $700 million investment for $1.7 billion plus the $63 million a year in interest he earned for 10 years. A profit of more than $1.6 billion; not bad for an investment 48 hours away from being worth nothing.

Warren Buffett guards his reputation and the reputation of Berkshire Hathaway zealously. His simple advice to any employee, and implicitly to anyone with an ear to hear:

Never do anything in life if you would be ashamed of seeing it printed on the front page of your hometown newspaper for your family and friends to see.

What About the Cost?

Every good investor knows that price is what you pay, value is what you get. If a honorable reputation has clear value, what is the price that must be paid to attain it?

Having integrity isn’t hard. It’s just costly.

1. Don’t Lie

This is a hard one mainly because we want to do things but don’t want to bear the cost; for example cheating on a spouse without losing the relationship. So we substitute the cost of that something with lying instead. Let’s admit that outside of the reality distortion field of feel-good karmic teachings, lying works, and sometimes very well.

But there is a cognitive cost to it. Even for a sociopath who feels no regret from lying, our cognitive process must be engaged in each lie, which drains us mentally. Mark Twain said, “If you tell the truth, you don’t have to remember anything” and that cognitive ease is worth plenty.

So lying is a permanently payment for the cost of doing something. Rather, it’s simply a loan on our memory, cognition, and for many, conscience. Most often, such a cost cannot be effectively sustained long-term, the loan will need to get repaid. So overall we don’t end up saving anything, but end up paying the interest in the form of cognitive burden.

My assessment? The cost of not lying is negative – that is telling the truth is actually far more cost-effective than lying. This should be a no brainer then. You get to have a valuable reputation at no cost or even negative cost.

By remove lying as a possibility, and we can correctly assess our desires against the real costs associated.

2. Don’t Do Something for a Quick Buck

Everything about Newcula is future-oriented. There’s a reason for this – compounding is the “secret” to success. Reputation compounds.

After the successful rescue of Salomon and delivering on his promise of transparency, Warren Buffett was able to score much bigger deals in 2008 and 2009 with Goldman Sachs, Bank of America, and more. In absolution numbers, these deals were billions of dollars more valuable2 than his gain in Salomon back in 1997.

Any action that’s not repeatable long-term, and could have a negative impact on reputation is not worth it – even on a purely monetary basis.

Marketing is Always Important

One fallacy most often apparent in articles about honesty and integrity is that these qualities will simply be noticed by other people. Nope.

Other people are far too absorbed handling their own life to be on the lookout for your good qualities. Like any good product, marketing is still essential. Don’t expect your reputation to simply go viral. If there is truly substance behind, you have to take the time and the opportunities to craft your reputation.

People appreciate integrity – they just need to be reminded that it’s different than what they’re used to.

Reputation is a highly valuable asset and we should use it freely. However, it is also very brittle and must be guarded zealously at all times. Thankfully, our integrity is fully within our own control.

It takes 20 years to build a reputation and 5 minutes to ruin it. If you think about that, you’ll do things differently.

– Warren Buffett

1 MIT News – What’s the Cost and Financial Value of College
2 Bloomberg – BofA Forgiven as Buffett Says ‘You Do the Best You Can’

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s