Materiality and the Little Voice in Your Head

Sailors have a saying: “The time to take a reef in your sails is the first time you think about it.”  What they mean by this is that it is if you think the wind is getting stronger, you are much better off shortening your sails now, before you are overpowered by the wind and the act of reefing becomes very difficult, if not dangerous.  There is a similar analogy that can be made with respect to whether you think a piece of information is material and should be disclosed. That is, if you have to stop and think about whether something is material, it probably is.  Or, to complete the analogy, the time to disclose information is the first time you think about whether it is material. 

 

I know that this goes against the grain of most corporate disclosure policies, which seem to be, “The time to disclose information is when we absolutely, positively have to, and can find no reason to hide behind, and can’t convince our lawyers that this really isn’t as important as it sounds.”  Nor is the legal profession without blemish in this regard.  There is a corollary, unwritten rule which seems to be, “If the Chairman doesn’t think something is material because he really doesn’t want to talk about it, (or he has goofed and let something slip, but now doesn’t want egg on his face by having to make a formal announcement) the General Counsel and outside attorneys will find a way to justify the information not being material. So I thought I would take a moment and wade into the legal thicket of what information is material. In a later post I will discuss when you should, as opposed to must, disclose material information.

 

The classic definition of what constitutes material information was set out by the United States Supreme Court in two cases, TSC Industries, Inc. v. Northway and Basic v. Levinson.  The pertinent language of the court was contained in two statements:  “Information is material if there is a substantial likelihood that a reasonable shareholder would consider it important in making an investment decision.” And “There must be a substantial likelihood that the disclosure of an omitted fact would have been viewed by the reasonable investor as having significantly altered the “total” mix of information made available.”

 

This seems relatively straightforward to me, as most of us can put ourselves in the shoes of a reasonable investor, and there is no mention in the Court’s language about the information being either positive or negative – it just has to be important.  Nevertheless, countless billable hours of lawyers’ time has been spent on this issue, which, when you think about it, is pretty silly.  Investor relations officers spent most of their time talking to – you guessed it – investors.  Who better to know what the reasonable investor considers important?  Yet we constantly have lawyers and accountants weighing in on the subject, even though none of them would know an investor if they ran into one.  Does this make sense?

The practice of investor relations involves a high degree of repetition in answering investors’ questions.  It doesn’t take long for an investor relations officer to get a pretty good feel for what investors consider important (of course, there are some analysts who think everything is important, but they, by definition, are not reasonable investors).    Therefore, as a corollary to the Supreme Court’s guidelines, allow me to propose another one of Palizza’s Principles: Something is material if the little voice in your head (or, if you prefer, your gut) tells you that investors would think this is important information. It seems to me that this is no less obscure than the language often used by the Supreme Court.  After all, it was Supreme Court Justice Potter Stewart who was famous for stating; “[I can’t define obscenity, but] I know it when I see it”.

The Trouble With PowerPoint

There was an old Star Trek episode, "The Trouble with Tribbles".  Without going into all of the details of the plot, suffice it to say that tribbles, which are adorable, cuddly creatures, when brought on board Captain Kirk's vessel, reproduce far too often and threaten to consume all of the supplies on the starship Enterprise. So it is with PowerPoint.  It's a (relatively) easy program to use and enables almost anyone to become a designer of graphic presentations. In fact, graphic designs proliferate to the point of threatening to consume all of the useful information in investor relations presentations.

I’ve spent some time lately poking around on the web looking at various companies’ investor relations presentations.  I have not been impressed.  Just about every presentation I looked at had something in it that bothered me. The combination of PowerPoint bullet point formats with bad graphics can be really deadly to good communications.  It’s clear to me that investor relations practitioners are better at verbal communication than visual communication, so I thought that I would share some of my thoughts on the subject. 

Let me start out by saying that I have a bias when it comes to presentations – the presentation should enhance and clarify the data, not distract from it.  To understand how good presentations can work and what constitutes bad display of data, every person that has to make or prepare a presentation should read Edward Tufte’s book, “The Visual Display of Quantitative Information”.  It is the seminal work in this area and it sets out with much greater authority and detail than I can the elements of good data presentation.

Having said that, here are some of the chief complaints I have about the presentations I’ve reviewed:

1.  Cheesy backgrounds – just because PowerPoint gives you all sorts of ugly templates to choose from doesn’t mean that you have to use them.  All they do is distract from the message you are trying to deliver.  My advice is to hire a professional design group to help you set a template, which ties into your corporate design or this year’s annual report.

2.  Runaway fonts – it is not unusual to see five or six different fonts and type sizes on the same slide.  This is sloppy and distracting.  This is a particularly egregious sin of PowerPoint, which will automatically resize type on slides unless you take out a whip and chair and tame it.

3.  Use of acronyms and abbreviations – Corporate America loves TLAs (three letter acronyms).  Unfortunately, while they may be a handy shorthand for those in the know, when encountered later, on a slide on the company’s investor relations website without accompanying commentary, they merely serve to obscure things.

The foregoing, while distracting, are design errors, and can be forgiven as simply in bad taste.  In the parlance of my religious upbringing, they are venial sins, as they don’t really bring into question the integrity of the presenting company. However, some of the things I’m going to talk about now are issues where the visual information is manipulated to make data appear more favorable than it really is, which is something no self respecting investor relations practitioner should stand for. 

4.  Using objects that grow in volume to show linear growth.  Unfortunately, we’ve all seen this one far too many times.  Using pictures to show the growth of say, revenue, introduces a distorting factor as the volume of the object depicted grows much faster than the growth of a linear object such as money.   If you have to jazz up your charts with cute pictures or expanding objects, you probably don’t have enough data for a chart.

5.  Conveniently changing scales on charts to make data appear to fit your point.  Not all charts and graphs need be zero based, but you need to be careful about the scale you use.  It is far too easy to manipulate the visual impact of change by zooming in on a scale, which makes a single percentage point change seem huge.  A corollary to this is changing scales on two adjacent charts to make it appear as if everything is moving in the same magnitude and direction simultaneously.

6. Omitting inconvenient data.  I find it hard to believe that companies would do this, but I’ve seen it with my own eyes.  If a particular year doesn’t fit the fact pattern that companies wish to talk about, they simply omit the data from the chart.  I guess they think that no one will notice the year missing from the bar chart.  A different take on this is to put the inconvenient data on the chart but then assert in words that something different and more favorable is going on.  My favorite example of this is a chart that shows a large dip in earnings in a recent year with an arrow going right past it stating “Continuous growth”.  Last time I looked, continuous meant without interruption, which clearly wasn’t the case for the earnings growth shown on the slide. 

There are more examples of bad and misleading graphics out there, but I think I’ve made my point.  Besides, I have to prepare some slides for a speech I’m giving at the NIRI Southwest Regional Conference next month and if I can just get the dancing 3-D graphics to work, it could be a real triumph of form over substance.

More on Blogging and Investor Relations

There are over 2,200 stocks listed on the NYSE and over 3,000 stocks listed on NASDAQ and guess how many have blogs for their investor relations areas?  The answer is one – Dell Shares is the only corporate investor relations blog that I have been able to find.  I think that the fact there is only one blog in this area (you can find blogs in other areas, be it CEOs, sales or product teams, etc) is indicative of the mindset most corporations have about investor relations.  In most organizations, IR is trapped in a box of regulations and legal liability. Moving outside the box requires more time, effort and political capital than it’s worth.  For example, in one organization where I previously worked, it took a year of lobbying to get the concept of quarterly earnings conference calls approved.  Once approved, the scripts for the calls were reviewed by the CEO, COO, CFO, Controller, General Counsel, securities law counsel, outside securities law counsel, Treasurer, internal auditor, external auditors and at least 6 other people.  Needless to say, by the time the final document was ready, it was pretty bland mush.  Try thinking about how blogs translate into this type of environment and you see why most companies don’t even try.  Blogs are supposed to be quick, spontaneous and resonate with the voice of the writer.  Good luck to that under the foregoing scenario.

Evidently Dell takes seriously its image as a technology provider and is out in front on this development.  I’ve spent some time over the past few days looking at their blog and I think they do some things well.  First, they are timely and responsive.  They seem to write about developments quickly and respond to comments rapidly.  According to a statement made by a Dell spokesman at the 2008 NIRI conference, their position is that in establishing a blog they did not need to change their disclosure policy or get prior approval of each posting from their legal department.  Rather, their view is that the blog is merely another extension of what they do everyday in investor relations, either on the telephone or in person.  They are aware of the things that can and cannot be said and in writing on the blog simply adhere to the same guidelines as they would in other channels of communication.

The communications person in me cheers this attitude.  Phrases such as “IR workers of the world unite!  You have nothing to lose but your lawyers!” run through my brain.  Of course, having practiced law for ten years, the other half of my brain says “Yeah, but if you screw up with an analyst on a phone call you always have the chance to call him back and correct yourself, or, if you’ve inadvertently given them non-public information, to ask him to treat what you’ve said as confidential.  When it’s on the world wide web, it goes out to the whole world and you’ve created a written record of your mistake.”  I guess all technological advances come with attendant risks. 

Secondly, I think Dell is bringing more information to a wider audience.  They refer to this as a democratizing of investor information and I certainly think they are moving in the right direction.  They have made video clips available on the blog with members of management discussing some of their more obscure business initiatives (what the heck is virtualization anyway?).  All of this helps to gets information, which before was available only to large institutional investors out to a wider audience. This is one of the major benefits of the web.  Business school professors refer to this as disintermediation.  To put it plainly, you get your information direct from the source, and not filtered through others.  I applaud them in their efforts to date to get information out to a wider group of investors.

Naturally, in my self-appointed role of investor relations critic at large, there are several things that I think they might be able to do better.  First, in reading the blog, I didn’t get a real sense of Dell as an organization.  I think that Dell has a tremendous opportunity through its blog, to put a human face on a highly complex organization.  Thus far, the posts to the blog have been governed by the issue du jure without any effort that I can make out to explain the organization as a whole, which I think would be helpful to the average investor visiting the blog.  Turns out there is a good introduction to Dell on the Investor Relations web site in the form of an interactive letter to shareholders from Michael Dell, but it required navigating back to the Dell home page and three further clicks to get to the letter.  It seems strange to me that there is no direct link between Dell Shares and the IR web site, as there is a link going the other way. 

Related to this I think that Dell has an opportunity to save themselves a great deal of repetition and time by creating a series of explanatory blogs about the areas of their business that generate the most questions from investors.  I see the beginnings of some of this with the video clips with interviews of business segment managers, but as they are a very large and complex organization, more can be done. 

Next, as you might expect, everyone is relentlessly on message in their posts.  I can understand why this is, but it can make for some bland reading.  If I were an equity analyst, the blog is not where I’d go to try and find any nuggets of information, although it would be required reading.  Maybe it would help if someone would exhibit a sense of humor once in a while. 

To a certain extent, I’m picking nit with all of this.  Dell deserves a lot of credit for establishing their blog.  In tech-speak, they have achieved first mover status.  While I believe that good things will accrue to them as a result, as with many things in investor relations, it may be hard to measure, and probably only in retrospect.

The Ten Percent Rule

Previously, I’ve written about the research surrounding the value of investor relations.  This is a question that constantly bedevils investor relations officers, as senior management, used to seeing quantifiable numbers such as increase in sales, Return on Capital and Return on Assets wants to know their ROIR (Return On Investor Relations).  Put bluntly, they want to know, other than frequent flier miles, what does their company get for the time and effort expended going to visit investors and enduring the often repetitious and sometimes inane questions from analysts who are young enough to be the Chairman’s grandchild?  Unfortunately, it is very difficult to separate the IR performance alpha from the firm’s performance beta or the general market performance (I’m going to resist the impulse to assign a variable to market performance, otherwise this would be all Greek to me).  It’s an intellectually challenging question, so I find myself returning to it time and time again.

There’s some interesting new research out, which I will get to in a minute, but first, just to refresh readers, what I’ve found so far is as follows:

Rivel Research has conducted two studies that touch on this area and are worth repeating.  In their study, “Perspectives on the Buy Side”, conducted during the Spring of 2007, Rivel conducted 243 interviews with Buy side analysts and portfolio managers.  As part of their study, they asked the question: “In your opinion, does good investor relations affect a company’s valuation?”  82% of the respondents to the question answered Yes, while 17% said No.  Further, the median premium assigned by the respondents for “superb IR” was 10%, while the median discount for “poor IR” was 15%.  In a companion study performed later in 2007, “Perceptions on the Sell Side”, the numbers were strikingly similar, with the median premium assigned for “superb IR” again being 10%, the discount for “poor IR”, 18% and 82% of all interviewed Sell Side analysts expressing the opinion that good investor relations helps a company’s valuation.  If you want to read more on this topic, see my post dated August 20, 2007.

I’ve also written about what the academic research has shown regarding investor relations.  In my March 13, 2008 post I talk about the effects that improvements in disclosure quality and quantity have been shown to have on liquidity, bid-ask spreads, volatility, and risk assessments of the firm.  While these studies have been illuminating, there hasn’t been a study that establishes a direct linkage between good investor relations and increased market valuation.  The studies have generally focused on one or two aspects and required you to make the logical inference that the result is better stock valuation.  Additionally, one tricky bit has been to identify who is doing “Good” investor relations so you can measure them against the average.  Now a study has done just that.

Professor Richard J. Taffler of The Management School, University of Edinburgh, together with Vineet Agerwal, Angel Liao and Elly A. Nash have authored a study entitled “The Impact of Effective Investor Relations on Market Value” that every investor relations officer should read.  In their study they use IR Magazine’s “Best Overall Investor Relations” awards over a three-year period as an indicator of quality investor relations.  Their study shows that firms that are seen as having effective investor relations, as indicated by being nominated for the awards, earn superior abnormal market returns both in the year of nomination and the year following the awards. 

The authors state that while superior market returns for stocks could be explained for the year prior to the nomination by analysts nominating firms which had performed well, this cannot explain the superior market returns for the companies in the year following their nomination for an award.  To quote the report: “Consistent with the predictions of information risk and agency theories, which together propose that enhanced corporate communications will reduce information risk or agency problems caused by high information asymmetry, we find that [IR Award] nominated firms experience an increase in stock liquidity, and a lower cost of equity capital.” In other words, companies that do investor relations well, as witnessed by nomination for Best Overall IR awards, are rewarded with better stock price performance and stock liquidity.

Of even more interest is the quantification the authors put on the abnormal risk adjusted stock returns earned by firms in the year following their nomination for an award.  The results show that all nominated companies earned 80 basis points per month superior market returns.  When I pull out my trusty Hewlett-Packard and compound 80 basis points per month over a full year, I get an excess return of 10%.

Based on the foregoing, I hereby propose Palizza’s First Principle of Investor Relations:  Superb investor relations will gain a 10% premium for your company’s stock price.  This rule satisfies my three main criteria for a principles:  1. It’s easy to remember, 2. It involves a nice, round number, and 3. It has at least 3 data points to support it.

Every investor relations officer should get a copy of Professor Taffler’s study and show it to their management, especially around budget time.  A relatively small increase in investor relations budgets coupled with increased transparency and disclosure above and beyond what is required by regulations can pay handsome dividends for shareholders.