Stock Ratings from Lake Wobegon

Today’s New York Times reports that Merrill Lynch unveiled a new rating system that requires their equity analysts to assign “Underperform” ratings to 20 percent of the stocks they cover.  As a lead-in to the article, the authors refer to the Lake Wobegon quality of stock ratings – most stocks are rated above average.  (For those of you who are not familiar with Lake Wobegon, it is the fictional town in Minnesota featured in Garrison Keillor’s Prairie Home Companion radio show.  Each week Garrison Keillor reports the “News from Lake Wobegon” and finishes with the tag line, “That’s the news from Lake Wobegon, where all the women are strong, the men are good looking and all of the children are above average”.)  The article goes on to cite Bloomberg data to the effect that only about 5 percent of all stock recommendations on Wall Street fall into the “Sell/Underperform” category.

 

Now, I could have a lot of fun with this, as clearly, far more than 5 percent of all stocks are going to underperform.  Even if you throw in a “Neutral” category, a normalized distribution would require far more than 5 percent “Underperforms”, even adjusting for the market’s tendency to rise over time.  But that would be too easy.  So what I want to do is examine the reasons “Outperform/Buy” so dominate the world of stock ratings and “Underperform/Sell” is so rarely seen.  After all, it’s not like all these MBAs suddenly become Pollyannas when they get assigned to equity research.  This is Wall Street we’re talking about here, so cynicism is not in short supply.  Clearly, a different set of incentives is at work.

 

Quite simply, if an analyst puts a sell on a company stock, the company hates him, the long only investors that currently own the stock hate him, the long only investors that don’t own the stock aren’t going to buy it, and the firm’s investment bankers get really mad at him.  Only the short sellers will like the sell rating.

 

Understandably, if a company receives a sell rating from an analyst, they don’t like it.  Ratings changes can occur for a variety of reasons – valuation, fundamentals, sector or industry changes; but companies usually don’t care.  A common reaction by companies is to cut analysts off from corporate access.  Much as we like to think that analysts are engaged in independent research, much of their information surrounding formal disclosure comes from talking to the investor relations contact at the company.  Cut off this flow of information and deciphering the balance sheet and cash flow statements becomes much more difficult.  The analyst will also find that the probability of their being able to ask a question early in a company conference call is remote.  Companies control the order of the question queue and they are not going to feature an analyst with a sell rating as the first questioner on the call.

 

Further, much of what the Buy Side values from the Sell Side these days is access to management.  Just try arranging a trip to company headquarters for your clients if you have a sell on the stock.  If you’re an investor relations officer with more requests for meetings than you can handle, think about trying to convince your management to take a meeting for someone who has a sell on the stock – the same person whose name your CEO mentions only in combination with an expletive.  There are better ways to spend your day. 

 

As to the Buy Side of the equation, if a firm owns a stock, they’ve made a commitment to it and have often invested a lot of research in it (not to mention that they often become emotionally attached to it as well).  Then along comes a Sell Side analyst and tells them they’re wrong.  The Sell rating may have already caused the stock to decline, plus he’s making either the Buy Side analyst, the portfolio manager, or both, look bad.  This is a situation that can cause conflict and strife.  Plus the commission flow from the Buy Side firm is likely to decline because they're mad at the analyst, which will antagonize the Sell Side firm's sales force and trading desk.

 

Finally, investment bankers really don’t like it when they’ve invested weeks, months or years trying to build a relationship with a company, only to have an analyst rain their parade by putting a sell on the company stock.  There may be a theoretical Chinese wall between investment banking and research, but don’t think that company managements give a hoot about that.  A sell rating stands a good chance of tainting the whole firm, thus jeopardizing all those juicy M&A and underwriting fees.

 

Is it any wonder there are so few sell ratings?  The incentives are all going the other way.  It’s just too painful to put out a sell rating, which is why you usually see them only after the stock has already collapsed or on companies that are small and don’t command much respect when it comes to fee generating abilities.

 

I’ve been thinking about alternatives to the way stocks are rated, but I’m going to save it for another post.  I’ve got to go – my broker just called with a great buy rated stock

More information is Better; Less Information is Bad

Yesterday The New York Times ran a story in its Business section entitled, “Retailers Get Stingy With Data”.  The gist of the story was that an increasing number of national retail chains are abandoning their long standing practice of reporting monthly sales and forecasting annual profits (providing earnings guidance).  It seems the chains think that such information encourages short-term decision-making and can confuse investors.

Of course, I suppose it’s only coincidence that they have come to these conclusions just when the economy is softening and consumers are spending less.  Everyone knows that sales numbers are not confusing when they are going up, it’s only when they start to head down that they can lead the poor unsophisticated Wall Street MBAs astray.  Further, by eliminating monthly sales reporting do they really think that they are encouraging longer term decision-making?  They still have to report sales on a quarterly basis, and I’ve never heard a CEO say that quarterly performance is long term.  It could be that they are engaged in the practice of hoping they can recover from one bad month’s sales in a quarter with a stellar performance in the other two months.  I’ve actually had a CEO tell me, “We don’t report monthly sales because our business can turn around so fast”.  Of course, this same CEO also said, “We’re a big company and trying to turn things around is like trying to turn a battleship”.  I don’t think you can have it both ways.

My favorite quote from the article is from a Macy’s executive talking about sales numbers being skewed by calendar shifts: “The numbers are increasingly confusing because of the calendar shifts”.  That darn calendar just gets more and more confusing every year. 

What it boils down to is this: when things look good, company managements don’t mind investors being well informed because it will help the stock price.  When things look bad, management would prefer that investors be kept in the dark for as long as possible, so that the bad news won’t impact the stock price and maybe they can fix things in the interim. As a Catholic, this reminds me of some of my early theological training.  Hoping for a miracle almost never works; it is better to confess your sins and shortcomings and ask for forgiveness.

In the long run, a company’s ability to generate earnings and cash flow will determine how its stock is valued.  In evaluating earnings and cash flows investors will consider their confidence in the data they are receiving, the clarity and quality of the information given, and the history and consistency of the data.  Eliminating data just at a time when investors need more information to separate companies that can perform well in a slowing economy from those that can’t is classic short-term thinking by management.

The Academic Research Surrounding Investor Relations and Disclosure

In preparation for my class on investor relations at Rice, I’ve been reviewing some of the academic research on the topic. It’s pretty tough sledding. Why can’t these guys learn to write in plain English? Here’s a direct quote from one of the articles I read: “Homogeneous precision of private information across investors ensures ex ante Pareto efficiency in the prior round of trade and the negative exponential utility function ensures concordant beliefs.” Write me if you think you can explain that to me. In the meantime I’ll omit the citation to avoid embarrassing the author.

In an effort to help explain why we engage in investor relations activities and voluntary disclosures beyond those mandated by regulations, I will attempt to summarize, in plain English, some of the research findings related to disclosure and investor relations.

Here are some of the key things I found:
1. Studies have found that improvements in the quality and quantity of voluntary disclosures improves a stock’s share price, trading volumes and narrows the bid – ask spread. The result of all this is increased liquidity and decreased volatility.
2. Sustained improvements in disclosure practices results in a lower cost of capital for the company as investors improve the rate at which they capitalize the firm’s earnings. This relationship held regardless of whether the firm actually posted improved earnings during the period.
3. The market reacts not only to the information contained in the disclosure announcements, but also to the flow of information itself. The reaction to the flow of information is the result of greater faith in management and its credibility, lowered estimates of the cost of information gathering and lowered risk assessments of the firm.
4. A firm’s lack of visibility, generally related to size, liquidity and exchange listing can hamper the effects of more disclosure. In other words, it does no good to disclose additional information if no one is paying attention. Smaller firms should engage in investor relations activities to raise their profile to complement their disclosure activities.
5. The effects of increased disclosure and investor relations activities take time. There is a lag period of about two quarterly reporting periods before the benefits to share price, increased liquidity and decreased volatility show up.

There’s more research out there, but frankly, I’ve had enough. There is a convincing case that increased investor relations activities and quality disclosures are good for a company’s share price over the long run. The question is, “Why do so many companies want to do as little investor relations as possible?” It’s a question for another day. Right now I’m going to go off and try and figure out the meaning of “ex ante Pareto efficiency”.

More Thoughts on Starbuck’s (and Other High Growth Companies’) Investor Relations

Last week the Houston NIRI (National Investor Relations Institute) chapter hosted a speech by Karen Blumenthal, author of “Grande Expectations, A year in the Life of Starbuck’s Stock”.  It was one of the best luncheon speeches I’ve heard in a long time.  Karen obviously knows her topic and, more importantly, knows how to tell a good story. 

During the course of the speech, Karen told the story about Starbuck’s annual shareholder meeting that I found illustrative. Starbucks annual meetings are something of an extravaganza, with thousands of small shareholders in attendance consuming large quantities of caffeinated beverages, while working themselves into a frenzy of adoration for the stock that they have done so well by.  It seems that during the meeting, when Karen began to talk to investors, Starbucks reacted negatively.  She was approached by a person with a headset on (think security type) who asked her if she was a member of the media.  When she acknowledged that she was, she was immediately requested to cease talking to people, and to leave the building.  The phrase “Media Alert!” was even heard to be spoken over the headset. 

The story struck a chord with me, as I have heard large institutional investors complain that Starbucks, for as great a company they may be, are extremely controlling about the information flow about the company.  One manager at a large Boston hedge fund went so far as to tell me, “You ask them a question and they tell you they’ll get back to you in a week or so.”  This is not exactly optimal investor relations.  This is “if I can control all aspects of what you know, then you’ll favor my stock” relations.  For some reason, many high growth, high P/E companies adopt this approach.  The thinking seems to be, “we’ve obviously invented a better mousetrap which is highly deserving of its rich valuation and we don’t have to go out of our way to answer all your pesky questions.”

What this ignores, of course, is that trees don’t grow to the sky.  Put another way, high growth rates sooner or later come to an end.  When the growth slows down, if the company has not built up its reservoir of good will and credibility with the investing community, the valuation decline will be faster, farther and last longer than if the company had established a strong voluntary disclosure program and stuck to it through thick and thin.

It’s not as if Starbuck’s doesn’t understand publicity.  Witness the recent media coverage of their three-hour shutdown to retrain their baristas in the Starbucks way of making coffee.  They had coverage in every major media outlet that I read or watch, from The New York Times to the Today Show (actually, my wife watches the Today Show, I just happen to eat breakfast in the same room.)  Yet they somehow seem to have a blind spot when it comes to dealing with investors.  Whereas more is more when it comes to stories that they can control or put in a favorable light, less is more when it comes to quantifiable data that will help investors make informed decisions.  Starbucks (and many high growth companies) needs to loosen up, give out more information and understand that not everyone will put the same spin on the information they share. To quote that great philosopher Yoda, “Train yourself to let go of everything you fear to lose.” After all, it takes both buyers and sellers to make a market.

That You Charlie?

For those of you not blessed with what passed for a multicultural education in the 50s and early 60s, “That you Charlie?” is the tag line from the old Kingston Trio song, Charlie of the MTA. (Three clean cut white guys singing folk songs was about as multicultural as we got back then.)  Charlie was the poor chump who boarded the Boston subway system, the MTA, by paying his ten-cent fare, but when they raised the fare by five cents, Charlie couldn’t get off of the train.  He was condemned to forever ride the MTA, as sort of an urban Flying Dutchman.

The song begins:  “These are the times that try men’s souls. In the course of our nation's history, the people of Boston have rallied bravely whenever the rights of men have been threatened. Today, a new crisis has arisen.”

Recently a new crisis has arisen regarding earnings conference calls.  The Wall Street Journal reported on Saturday that a mystery man has emerged on conference calls at least seven different times in the last few weeks.  Calling himself Joe Herrick of Gutterman Research, he initially poses as a well-known analyst so that he gets into the question queue, then reveals himself as Joe Herrick (a fictional name) and generally asks plausible sounding, highly detailed questions about supply chain management and lean manufacturing.  Company executives, not wanting to look dumbfounded by the questions, have generally attempted to answer the questions, not realizing that they were the victims of a prank.

Some of you may view this as harmless fun, and if I were 15 again, I might too.  Fortunately, I am no longer 15 and I work in a profession that depends on convincing executives that it is in their best interest to speak openly with Wall Street.  It doesn’t help to have some idiot out there posing false questions designed to make fun of the system and make executives look foolish.  If this process continues the result will be that companies will make it harder to participate in conference calls or perhaps even eliminate the question and answer sessions.  No investor relations officer wants their CEO to be the next victim.  Companies will think of more ways to control the process and the information imparted during the calls.  They may start to give passwords to only a few select analysts so that they are the only ones that are allowed to ask questions, as Coke did on a recent conference call.  Any way you look at it, the amount of information imparted on the calls will be reduced, and especially reduced in the area of conference calls that offer the best opportunity to gain incremental information – the Q & A session.  The end result is bad for all investors.

So Joe Herrick, if you are out there, please ride off on the MTA into the sunset and, like Charlie, stay there.  You’ve had your fun, but you’re not helping investors, large or small.

Hello Sailor

Yesterday’s Wall Street Journal contained an article where the lead line was “America’s captains of industry are starting to talk like, well, sailors.”  I read this with great interest, as I have been a competitive sailor for a number of years, spending many happy hours racing around buoys everywhere from the Great Lakes to Long Island Sound to Galveston Bay.  My reaction was, “Sailor’s lingo is perfect for our captains of industry; it contains technical terms that sound really imposing, but generally serve to obscure the issue at hand.”  Imagine my disappointment when I read the whole article and it turned out to be only about the use of the phrase, “we are facing headwinds”.  I mean, this really isn’t a great nautical term, nothing as evocative as “All hands on deck to haul the halyard and raise the mainsail.”  Rather, this is just the latest corporate cliché, replacing “We encountered a perfect storm” as corporate speak for “conditions were tough and we couldn’t overcome them to be as profitable as you expected us to be.”

In an attempt to overcome my disappointment, I have decided to offer up a few nautical terms that corporate chieftains could employ to their advantage:

Pooped :  to be overtaken by a following sea and smothered in a mass of breaking water, which often causes the ship to founder.  For example, the housing industry has been pooped by the subprime mortgage crisis.  This expression also has the advantage of being highly evocative.

Leeway:  the lateral distance a ship is displaced from its course while sailing to windward.  Any CEO worth his salt would be able to use this one.  I can hear it now: “We made good progress against our objectives in the quarter, but lowered consumer demand produced leeway which has caused us to reset our goals.”  Translation:  We couldn’t quite hit our profit targets, so we reset our bonus objectives.

Widdershins: In a direction opposite to the usual, in a wrong or contrary to direction.  This will enable corporations to avoid talking about losses, they can simply say, “Profit was widdershins”.  Very similar to the military talking about retrograde maneuvers.

Jetsam:  Goods thrown overboard to lighten the ship during a time of emergency.  (As opposed to goods washed overboard and found floating on the sea, which is flotsam.)  This could enable CEOs to talk about layoffs without talking about people – for example, “There were 2,500 jetsam which will help us return to profitability next year”.

Gunboat diplomacy:  to influence by force of arms rather than skilled negotiation.  A perfect replacement for the term “hostile takeover”.  Microsoft’s handling of their bid for Yahoo comes to mind. 

Scud:  to sail before the wind in a storm under reduced sail.  There are plenty of companies that are scudding right now – think of the U. S. auto industry.

There are plenty of other examples I can think of, such as loose cannon (rogue trader), trim the sails (corporate layoffs) and oakum (old pieces of rope picked into shreds – think employees approaching retirement), but I think you get the idea by now.  No use flogging a dead horse.  As the sun is now over the yardarm, I think I will shove off and go splice the main brace.

Starbucks’ Grande Mistake

Yesterday Starbucks announced its first quarter results, a 2% gain over the same period a year ago.  This is a weak performance by Starbucks’ standards and was accompanied by a number of announcements regarding initiatives to turn Starbucks back into the Starbucks that people used to love.  What caught my eye, however, was the simultaneous announcement that Starbucks was now longer going to provide same-store sales numbers.  I think this is a grande mistake on the part of the company.

 

Now, for those of you who do not immediately see the impact of this, allow me to enlighten you.  I worked in the retail sector for 23 years at Walgreens and for 15 of those years I was responsible for their investor relations.  Walgreens released same-store sales on a monthly basis so that means that I went through about 180 monthly cycles of releasing sales numbers.  I can tell you that same-store sales are the most closely watched indicator in the retail arena.  The numbers help investors figure out if you are growing in your more mature stores and how successful your merchandising initiatives are.  And while everyone knows that one month’s sales do not necessarily set out a trend, a series of same-store sales numbers will certainly help people understand where the business is going.

 

So, just when things are going bad, Starbucks has decided to communicate less.  I don’t agree with what they are doing, so I took a careful look at the reasons they set forth for their actions, as reported in The New York Times and The Wall Street Journal.  (I find that I need to read both newspapers to get a balanced view of the world – one pulls you to the left and then the other pulls you to the right, so you wind up in the middle.)  What I found were two justifications for the decline in communications.  First, they said that a focus on increasing same-store sales is part of what led them away from their core strategy of creating a Starbucks experience, and second, same-store sales numbers would be “erratic” during the transformation.

 

Frankly, in financial terms, this is a lot of baloney.  The reason the Starbucks experience changed is that they stopped acting like a neighborhood coffee shop with a focus on coffee and started acting like a chain restaurant.  Everything became standardized, with a focus on cutting wait times and controlling the process.  This worked when the economy was robust and there was little competition, but things are tougher now. 

 

As to the second reason, Starbucks was happy to report same-store sales as long as they were robust, giving people the impression that they were going to grow to the moon.  Now, when same-store sales might be erratic, analysts can no longer be relied upon to draw the proper conclusions (read: conclusions that are favorable to Starbucks).  It doesn’t work that way.  You can’t close the curtains on the wizard.  If Starbucks thinks that they are going to enter a period of erratic same-store sales because of the transformation they are attempting, they should be prepared to explain to investors what they are doing, the impact it has on sales and how they believe it will improve sales in the long run.  That’s part of being a public company.  To put it into consultant speak, where performance plus perception equals stock price, Starbucks is cutting off an important component of the performance portion of the equation, which will throw into doubt investors’ perceptions of the company.

 

I think Starbucks is a terrific company, one of the great growth stories of the past 20 years.  I’ve been to one of their analyst days and I am convinced that they are one of the best marketing companies around.  They sure know how to sell the romance of a cup of coffee, creating a premium product out of what was once considered a commodity.  I just think they’re dead wrong on this issue.  I’ve seen the “No Same-Store Sales Numbers” movie before, Home Depot version, and it did not have a happy ending.