I'm a big fan of using other fields of sciences in the investment process - history, psychology, anthropology and many other sciences can give you new ideas and test your old beliefs. In the book “Why most things fail”, Paul Ormerod links his economic models with models of biological evolution, Ormerod's book is hugely interesting and entertaining, and there is one statistic that got my full attention; of the 6 million American companies in the American Office for advocacy, on average 600.000 companies a year disappear, and its not only the small and medium sized companies that are affected. From the 100 biggest companies in the world in 1912 only 19 remained in the top 100 by 1995 (29 of the original 100 went bankrupt).

The extinction pattern is not steady. In one year only a small percentage of companies disappear, while in times of economic turmoil whole groups of companies disappear, for instance the dot.com companies from early 2000 and several financial giants in the ongoing banking crisis.

Extinction has many causes; new technologies make old technologies obsolete, a financial crisis forces the less financially robust to go bankrupt or simple bad management can all lead to the downfall of a company. The problem for the investor is that it is difficult to predict factors that might lead to extinction.

New technologies are introduced on a daily basis, some might be ground breaking while others have little to no effect. The recent discovery of Bisin, a naturally occuring lantibiotic, which prevents the forming of bacteria and therefore decay of fresh food might lead to a fundamental change of the economy.

I used the example of Bisin to illustrate that, not only high tech companies might be affected by technological breakthroughs. Investors might argue that food retailers are safe investments because people always have to eat. In most cases this is true, but what if your vegetables, meat or milk can be kept fresh for 2 years? What would happen then? On one hand we have the food retailers with supermarket on every corner, on the other hand we have a company like Amazon specialised in the delivery of non-perishable goods. A simple article in the scientific section of a newspaper can be the foreteller of the disappearance of a complete sector.

In reality things wouldn't go that fast. Bisin might have serious side effects and even if it is completely safe it would take a long time before the general public is convinced it is safe. Other exciton factors are a lot more instant, in my article “Don't get burned by the Sun King” I describe the effects of fraudulent behaviour by the senior management. The prudent investor should be aware that bad management is more likely in a sector that is booming. The less scrupulous CEO might be tempted to massage his or her accounts if all his competitors are making huge profits and his/her companies profit is lacking.

The only thing that can protect an investor is diversification. Never assume that a certain company is immune to extinction. Many investors are tempted to concentrate their money in fast growing companies in hot sectors. This sector might however be part of the next wave of extinction. The prudent investor should therefore diversify his money by investing in different sectors. If the size of his portfolio is sufficient, diversify within the sectors as well. Have a look at the geographical spread of the turnover and try to invest in companies that are active in different regions. Be aware that extinction can be more or less instant and unpredictable. Keep your eye on hot sectors and/or sectors with imminent technological breakthroughs. It might be a good idea to take some profit and use this to diversify your portfolio further.

It is easy to be swayed by a positive story told by a charismatic CEO. His/her company will be an absolute success, turnover will increase significantly while costs will be cut. The bottom line will blossom making his/her company an absolute winner over the coming years. The CEO will emphasize the positives and downplay the negatives.

This might or might not be true. The CEO and the rest of the board might discuss the state of the company a little bit more frankly within the confidence of a board room. If an investor could turn into a fly on the wall he might be able to eavesdrop a board meeting and listen to the board discussing all the positives and negatives . However as far as I know it is not possible to turn into a fly and other methods of eavesdropping, like wire tapping, are illegal. This leaves the investor with a problem, how can we trust the words of the board? Do they really believe in the strategy? Believe it enough to risk their own money?

In my years as an informal investo,r I learned that it is not that relevant to listen to what the CEO has to say. They are trying to sell something to you. It is only natural that they will be positive. Rather then trying to be an amateur psychologist and guessing how truthful the statements were,  I would look at what the CEO did. Was he/she willing to risk a significant amount of his own money? Was the starting salary a bare minimum to make sure that the company had as much funds as possible to grow? If the answers were negative, and there wasn't a very good explanation, I would pass up on the opportunity no matter how good the story was.

The same applies to quoted companies. Wouldn't it be obvious for the board to buy more of the companies shares if they were convinced that the future was bright? If on a recent presentation the board told the investment community how good the prospects were, and the investors more or less ignored the statements keeping the shares attractively priced, making it a good opportunity for both the company and the board to buy some stock in the company. This insider trading(*) is a powerful signal that the people in the know,  think you should buy these shares.

Research on the subjects of insider trading reveal the existence of excess return using public available information. In the paper “Contrarian Investment, New Share Issues and Repurchases” Bali, Demirtas and Hovakimian explore the effect of the issue and purchase of company stock by the company itself. It turns out that companies that purchase their own shares do significantly better in the following years compare to companies that issue new shares. The effect is most pronounced in Value Stock but also applies for Growth Stock.

The dealings of the management are just as significant, there are several papers dealing with this subject. One I would like to highlight is “The Profitability of Insider Trades in the Dutch Stock Market”  former colleague, R. Doeswijk, is a co-author. In this paper Biesta, Doeswijk and Donker study the predictive power of stock dealings by (non)- executive directors. Even corrected for value/growth effects they find the can achieve a higher return mirroring the share dealings of the insiders.

Using the public available information on insider trading is a valuable tool. Say you researched a company and like what you see, checking the share dealings of the management might be a good idea to see if they share your enthusiasm. On the other hand if the company and it's management is selling their shares it might be a good time to say goodbye to your shares as well.

* Insider trading is defined as trading of the companies stock, bonds or other forms of securities by individuals with potential access to non-public information about the company. In most counties there is strict regulation to prevent abuse of insider knowledge. A CEO buying his own companies stock the day before a take over bid has a lot of explaining to do.

Early in my career I was a food retail analyst. Star performer those days was a Dutch company called Ahold. It had a long history and was growing fast in Europe, USA and several emerging markets. The CEO was a well known figure called Cees van der Hoeven, who regularly appeared in society columns. He was voted CEO of the year five times in a row

Naively I bought the hype and was positive about the company. I reasoned supermarkets are a safe bet, even in an economic downturn people would still buy food and other essentials. The management seemed to have a good track record acquiring other companies (more then 50 take overs in a 10 year period). A  fast growing company in a defensive sector, what more could an investor want?

In 2002 there was an abrupt change in fortune, a recently acquired subsidiary in the USA overstated their income. This led to future investigations into the dealings of the company, and more fraudulent behaviour was uncovered. This led to a sharp price fall, the supposedly safe investment was anything but safe.

Ahold was not the only company that had a charismatic CEO leading an apparent fast growing company. Lay of Enron, Ebbers of Worldcom and Kozlowski of Tyco are other famous sun kings. In the last few years the Sun Kings seem to be prevalent in the banking sector. Many famous financial institutions have ceased to exist or are in government hands. The narcissistic CEO who wants to grow his company faster than is realisticly possible is something that an investor has be on the look out for. Luckily there are many warning signs:

• The company grows a lot faster then other companies within the sector. Be especially careful if this growth is fuelled by take overs.
  
  
• The CEO is a well known figure with a regular appearance in the media.
  
  
• The payment package is excessive. Big bonuses and stock options “force” the CEO to increase the stock price to an unsustainable level.
  
  
• Look at the corporate governance structure, how strong and/or independent are the non-executives directors and the CFO.
  
  
• Try to get a feel for the corporate culture, is it about long term development with all of the stakeholders involved, or is it about short term profit and/or stock market performance.
  

So the next time you are looking at this stellar performing company have another good look. Ask yourself what kind of CEO am I dealing with? Is the performance sustainable or is there a possibility of fraudulent behaviour. This is especially important in a Bull market where the average Sun King blossoms. Investors are looking for ever increasing returns and the unscrupulous CEO might just give this retur . The question is howeverhow long will this excess return las?

Investors tend to look at history in a one-sided way. They focus on a specific time frame in a selected geographic area. This generally means only the winners in history get studied properly. The lessons supposedly learned are used to predict the future.  History is seen as deterministic process with a certain outcome. If you study a similar looking event in the past you can use this to produce better forecasts and generate excess returns.

Investors generally look at American, and to a lesser extent Western European, economic history.  Over the last 100 year the stock markets in these areas moved in a healthy upward trend. Sure there were crashes but the market always recovered. The market taught itself that after a crash it was a good time to buy, because the market always recovered. On average an investor could get a yearly return of around 8%.

This might indeed be true but it is probably not the lesson that should have been learned from the past. To illustrate what I'm trying to say I will use two historic events that had or could have had a major impact on  the capitalist free world. The first one is very well known event but is often analysed in a very deterministic way.

The second world war influenced every nation in the world. The outbreak of this war is seen by many as inevitable. Nazi Germany and the other Axis powers were bound to start a war sooner or latter. At the same time the Axis powers were destined to lose this war against the combined economic weight of the Allies. The inevitability of war I will discuss later. On the outcome it is easy to think of many scenarios that might have let to an axis victory of some sort. A defeatist British government, a fully neutral USA and/or the development of the atomic bomb by the Axis for instance.

The second lesser well known fact is the Polish-Soviet war of 1919-21. The war was fought in the aftermath of the first World War. This war might have been more an accident then a planned affair but is significant nonetheless.  In an unexpected victory the Poles stopped the Soviets in the battle of Warsaw. Would this not have been the case Soviet leaders like Stalin, Trostky and Lenin might have thought it a good idea to export the Revolution further westward into a ruined Germany and eventually the Bourgeois Western Democracies.

Luckily this didn't happen and the lost war led to a more cautious stand from Stalin, a leader just as murderous as Hitler. Unexpected early setbacks could have lead to a more careful Nazi Germany and the avoidance of the Second World War as well.History is full of dangerous dictators with the potential to engulf the world in flames. It is however not easy to predict who will cause Armageddon in the end.  Hiler did it while Stalin became cautious.

We must judge economic history in the same way. Yes, the USA were the economic success story of the 20th century but could an investor predict this in 1900? Germany was rapidly becoming an Economic powerhouse,  Russia was developing with a massive railway expansion and the Argentinian GDP growing by 8% per year.  A global investor would have diversified his portfolio with stocks and bonds  from these countries.

Through revolutions, war and economic mismanagement an investor would have lost a small fortune by investing in one of more of the economic losers. The yearly return of 8% is therefore likely to be overstated because it is based on the assumption that the investor was only active in the successful American stock market and didn't invest im some of the promising losser

Will the American economy decline like the British economy did after the first World War?. Which emerging county will be hit by economic mismanagement, revolution and/or war?  We will know that there will be losers and winners. Some countries are more likely to be a winner then others but if they are unexpectedly a loser wouldn't it hurt so much harder? The investor might have the illusion that he can market time himself out of trouble. But just as the CIA failed to predict the fall of the Berlin wall, predicting is always difficult especially if it concerns the future.