You need to invest in companies you can trust: here’s how

CLSA's Christopher Wood, writing from Hong Kong, claimed in a note this week to be "gobsmacked" by the "moral frenzy generated by the alleged fixing of the London interbank lending rate (Libor)."

From a distance it all seems rather absurd to him. First, it has surely more often than not made people's borrowing costs lower. "What's the problem with that?" Second, he is bemused by the idea that anyone thinks there is a normal interbank lending rate even now, years after the fixing is supposed to have ended.

Just look at the huge and rising volume of reserves that banks keep with their central banks. At the end of June, US banks' excess reserves at the Fed came to $1.43trn. That's up from $936bn in September 2010.

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Pre-crisis much of that money wouldn't have gone to the Fed. It would have been placed with other banks. It isn't now, "precisely because banks do not trust the credit of other banks." This shows just how little has been resolved since the crisis began.

And, says Wood, the scandals within the banks should come as no surprise. They are the natural consequence of a situation in which those working within an institution "know it will not be able to go bust."

But this surely is why the public fury is not gobsmacking at all, but entirely natural?

We need to get rid of crony capitalism

Four years into the financial crisis, there has been no real change. Short-term crony capitalism still rules the banking sector.

One reason this change is not happening, is because central banks are obsessed with avoiding the usual process of capitalism. They refuse to ever allow a bank to go bust or to enforce losses on those who hold bank bonds.

As I wrote on my blog earlier this week, this is why the general hounding of Bob Diamond is more a key part of the recovery than a disgrace. It is now clear to the many who were having trouble with the concept that everyone bar a few bankers and big-man CEOs has had it with a system that enriches the few (and how!) at the regular expense of the many.

At the heart of all our problems is the division between ownership and management. In the 1700s, joint-stock companies were thoroughly disapproved of. Adam Smith, in particular, really wasn't into the idea.

His take? "The directors of such companies, however, being the managers rather of other people's money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in in a private co-partnery frequently watch over their own."

In the 1990s, attempts to deal with this problem led to the bonus and option culture. The idea was that if we aligned managers' interests with shareholder interests, all would be well. Unfortunately, while bonuses create an interest for managers, it is not the same as that of shareholders.

The result? Managers went all out for short-term share price success. This came at the expense of the long-term performance needed by the world's savers and pensioners. Smith was proven to be absolutely right (again).

This is something that is gradually being recognised as is the trouble it causes. Change should come over the next decade or so change usually takes longer than you think - as shareholders insist on a major shift in the system of rewards given to their managers. (It will be worth watching the rows over Diamond's golden parachute with this in mind).

Why you should look to invest in family-owned companies

However in the meantime, absent a new bull market, anyone investing in equities should make an extra effort to seek out companies that avoid these pitfalls.

The latest edition of investment trust magazine Trust (from Baillie Gifford) makes the argument for family companies, in which all shareholders "benefit from the founders' goals of developing and sustaining enduring profitable businesses over the long term".

Finding the right ones isn't easy. You want companies run by people with a strong family interest and a long-term approach. But you don't want the family to be in total control. (This tends to lead to lower than average productivity.)

Too big a stake and "vested interests may incline large stakeholders to ignore the wishes of external shareholders". Too small, and "management thinking may revert to that of the salaryman, emphasizing pay, perks, power and prestige over profits to shareholders".

The sweet spot? Around 20-30%. The key company names are Finnish elevator company Kone (Helsinki: KNEBV), its Swiss equivalent Schindler (SIX: SCHN), and the Swedish engineering company Atlas Copco (Stockholm: ATCOA).

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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