Looking at Fact Patterns

The image investor relations people have of investors is that they sit at their computer monitor all day long and review spreadsheets.  The reality is more complex, but many of the most astute investors I know rely as much on tangible fact patterns as they do on crunching the numbers.  A portfolio manager that I have great respect for once told me, “When you hang around this industry long enough, you come to recognize certain fact patterns as red flags that merit greater scrutiny”.  Here are a few that I have encountered over the years:

Sudden Departure of Key Executives

This is most visible when the Board replaces the CEO (See last week’s post, “Why Don’t They Just Tell Us Why They Fired Him?”), but it’s probably just as important when it involves the COO or the CFO.  If a COO leaves unexpectedly, it usually signifies either that the CEO thinks he could run the operations better himself, feels threatened by the COO or there is a strong divergence of opinion between the CEO and the COO on the direction of the company.  None of these is usually good for the investors.  If a CFO leaves unexpectedly, it raises questions about internal controls and accounting systems.

A Sudden Influx of New Executives from Outside the Company

Usually this means trouble as new executives struggle to fit into a corporate culture, or worse yet, try to replace the culture with their own.  For example, one only needs to look at the people Bob Nardelli brought into Home Depot.  They were all performance driven in a GE way, whereas the Home Depot was centered around customer service and decentralized management at the store level.  The result was stores that dropped the ball on customer service and a stock price that went nowhere for a decade.

Constant Turnover in the Executive Ranks

Almost every company will try to tell investors that they have a stable of executive talent that has long tenure with the firm.  These statements usually run along the lines of “Our executive management team has an average of X years with the company.  What they won’t tell you is that they are the ones defining the measurement pool.  What this means is that they can make the measurement pool as large or as small as they want in order to shade the numbers in their favor. It also ignores the people that have been terminated, hired away or even retired.  What investors need to do is to pull out an annual report from a few years ago and see how many of the executives from then are still around.  I did this with a company I’m familiar with and found that of 47 executive positions listed four years ago in the annual report, 19 had left the company, including the COO and the CFO.  That’s a turnover rate of 40%.  If you were an investor that bought that company’s stock four years ago, it could be argued that it’s not the same management team.

A Big New Initiative With Lots of Consultants Directing Events

This usually signifies a large transfer of wealth from shareholders to the consultants.  These projects are usually accompanied by statements from management to the effect that the consultants are only at the company for a brief period of time after which the company will take over the project from the consultants.  About the time the company takes over the project is when the company stops talking about it. (See my September 24, 2008 post, “When Culture Meets Financial Theory”.)  Good luck trying to figure out if the company made a return on their investment.

International Expansion

Usually, when a company makes a big announcement about pursuing international markets, it’s an admission that they are almost out of room in the United States.  Given that international markets are almost always either 1) slower growth (think Western Europe) or 2) higher risk (think emerging markets) and 3) more difficult from a regulatory perspective, this means that shareholders will suffer in one respect or another.  In addition, it may mean that the Chairman and his spouse like to visit Europe a couple of times per year at the shareholders’ expense.

A Sudden String of Acquisitions

Acquisitions are, by their nature, disruptive, both for the acquired company as it attempts to fit into a new corporate system, and for the acquiring company as it siphons off resources to try and integrate the newly acquired company.  When you do a string of these, it has a compounding effect and the risk goes up that management takes their eyes off the ball of the main business. Or worse yet, the combined operations will make the numbers so confusing that rational year over year comparisons can’t be done, leaving investors scratching their heads while they try to figure out what’s really going on.

So if you’re an investor relations officer and are frustrated because you think analysts and portfolio managers don’t understand the underlying value of your company, you might look outside the numbers at some of the surrounding fact patterns to see some other reasons that investors might be leery of your stock.