Used Car Auctions, Disclosure and Investor Relations

Economists love auctions. Nowhere else can they as clearly observe the interplay of various causes upon supply and demand. It is capitalism at its most naked and allows economists to indulge their insatiable desire to measure the effect of different inputs upon prices. And sometimes they even come up with some useful stuff. 
The finance section of the November 24th edition of The Economist magazine featured an article on the work of several microeconomists that might actually have some useful application to real world markets. The one that caught my eye was a study by a couple of economists on the effect of information disclosure on used car auctions. (Information Disclosure as a Matching Mechanism: Theory and Evidence from a Field Experiment by Steven Tadelis and Florian Zettelmeyer, Electronic copy available at: http://ssrn.com/abstract=1872465).

Now you may roll your eyes and mutter, “What do car auctions have to do with investor relations?” but indulge me for a moment. What we are interested with here is the information being disclosed and its affect upon pricing, not the item being sold. To quote the authors of the article:

“A market’s efficiency critically depends on whether its participants have sufficient information about the nature of the goods and services being traded. The potential hazard a buyer faces when trading in markets with information asymmetries often leads to market imperfections and stifles efficient trade. Indeed, in resale, housing, labor, health care, and corporate securities markets, sellers may have better information than buyers about the good or service being traded. Furthermore, sellers may have control over how much information to disclose, and buyers may choose how much information to acquire.”
In a survey of over 8,000 used car auctions, what the authors found was that increased information disclosure regarding the quality of the cars increased expected revenues. This is in line with current academic theory. But there was an interesting twist to their findings. Cars in the middle of quality rankings saw only modest gains while the biggest gains in revenue resulting from increased disclosure came for the best and worst quality cars. You might expect this with higher quality cars, as people will bid up the price if they know they are getting higher quality, but if the disclosures are of bad quality, logic would lead you to the conclusion that prices would go down further. Here’s what the authors say about their findings:
“When disclosed information coincides with expectations given observables, then it does not affect the composition of bidders who bid on the vehicle, and as a consequence, the outcomes are the same as they would be without information disclosure. However, when the information disclosed is either a positive or negative surprise relative to expectations, it will attract bidders who are relatively strong given the disclosed information. This benefits the seller regardless of whether information is good or bad news.”
In other words, the additional disclosures, even if they are bad news, attracts new bidders who are interested in that class of goods and who may have a better understanding of the merchandise and its value to them. The result is that they pay more than bidders with a more general outlook. 
Now think of the implications for the stock market. Typically, weak performing companies tend to disclose as little as possible about their problems. As a result, there is usually a fair amount of uncertainty about their future performance and that helps keep their stock price depressed. According to this new research however, they would be better off to more fully describe their problems. By eliminating some of the information uncertainty, even though the news is bad, they will attract more value and deep value investors who are better able to assess the risks of the investment. The result would be a better alignment of the firm’s intrinsic value with its market value. (Of course, it will still be a lousy stock price because the outlook is bad, but it will be a better lousy stock price than without the additional disclosures.)
I would love to be able to test this academic theory in a real world setting where a company has hit a bad patch, but something tells me that I am more likely to find an honest used car salesman than I am to find a CEO willing to bare all about his company in bad times.

Economics, Incentives and Investor Relations

One of the favorite theories of economists is that people respond to incentives. Ask an economist about how to change a person’s behavior and they will respond that if you put into place the proper incentives, people will alter the way they do things.  Of course, there always seems to be unintended consequences, but that gives people like me something to write about.

Looking at incentives has a number of applications with respect to investor relations. For example, if you really want to understand why corporate managements are doing what they’re doing, look at the compensation programs their companies have in place. For example, if a company has as a key component of its incentive plan Return on Equity, investors need to consider the consequences. In itself, ROE as a measure used in compensation bonuses is not a bad thing, because it rewards efficient use of corporate capital and causes corporate managers to think twice before undertaking risky projects. However, the unintended consequence of using ROE may well be that instead of expanding the company through new projects, management will figure out that it is safer for their bonuses to buy back stock in order to lower the equity denominator in the ROE equation. As a result, the company may shift away from expanding its core business and focus instead on buying back stock, in essence becoming more driven by financial measures than operating measures.

Or consider how a company’s bonus plan is constructed. If management’s bonus is calculated off actual results, the focus will be on achieving that particular target, whether it is improvement in EPS or operating profit or something more exotic. However, if a compensation plan is constructed to measure against management’s plan for the coming year, then there is every incentive for management to sandbag the plan, thereby setting up easily achieved bonus goals. In such a case, investors need to ask “What’s the plan?” because if management exhibits a low opinion of its ability to hit operating goals, investors shouldn’t be expected to build in large gains into their stock performance expectations.

What caught my eye and started me thinking about incentives actually comes form the opposite side of the equation. As you may recall, the Dodd-Frank Financial Reform Act of 2010 contained language regarding payments to whistleblowers in fraud actions. In short, if a whistleblower provides independent information of fraud to the SEC that results in a successful enforcement action that recovers at least $1 million in sanctions, the whistleblower is entitled to recover at least 10% and up to 30% of the recovered funds. For more on the law, see my blog post “Whistle While You Work” dated February 28, 2011.

Now, a little over a year after the law went into effect, The Wall Street Journal through its Marketwatch web site reported on October 18, 2012 that the SEC is averaging 8 tips about fraud per day, for a total of 2,820 to date. It seems as if the incentive part of the law is working. Of course, receiving a tip and conducting a successful prosecution are two separate things, as the same article reports that to date, only one whistleblower has received a payout under the provisions of Dodd-Frank. The unintended consequence here may be that the SEC simply doesn’t have the resources to sift through all the information to determine the best cases to prosecute.

Selling the Academic Side of Investor Relations

When you are an academic, if you really want to make it big, you need to come up with a snappy way to sum up your thinking on your area of expertise. For example, Porter has his Five Forces that describe his thinking on strategy – supplier power, buyer power, competitive rivalry, the treat of substitution and the threat of new entry. Similarly, Kotler has the four Ps of marketing: product, price, promotion and place. So I’ve been thinking: Why doesn’t investor relations have a way to neatly encapsulate what it is we do? Seeing this as a real hole in the academic literature, I have decided to step into the void and propose (with apologies to T. E. Laurence and the Seven Pillars of Wisdom), Palizza’s Five Pillars of Investor Relations.

I choose the wording of pillars because what I am about to describe are the skills needed to form a strong support base for an investor relations program (also, I couldn’t come up with a clever acronym or make everything begin with the same letter).  Plus, this allows me to crate a clever visual slide for my class featuring Greek columns to drive the point home. So, without further ado, here is a brief description of what I consider to be the essential skill and knowledge requirements to do investor relations well – the pillars of investor relations.

FINANCE – It is essential that a good investor relations officer have a thorough understanding of the components of his company’s income statement, balance sheet and cash flow statement, as well as the accounting treatments they derive from. On the theoretical side, the IRO needs to be comfortable with the different valuation models used by Wall Street to value his company’s stock and the role of investor relations in the efficient markets.

MARKETING - How to segment the investment universe, target appropriate investors and position the company story to appeal to those investors are basic marketing skills that are critical to good IR. At a deeper level, using marketing techniques to more efficiently use limited resources to focus on the most important investors can help IR have a bigger impact.

COMMUNICATIONS – Crafting a memorable message that resonates with investors is a critical communications skill that is used in IR. This is closely followed by figuring out what disclosures, above and beyond those mandated by regulations, will assist investors in understanding the intrinsic worth of a company. All of this presupposes a solid understanding of your company and industry. Finally, the skilled use of multiple communications channels is becoming ever more important as new means of communication such as social media proliferate.

LAW – Everything in investor relations is circumscribed by laws, regulations and case decisions. They cover everything from what you say (the periodic reporting requirements of 10-Ks and 10-Qs and mandated disclosures of 8-Ks), to when and to whom you say it (Reg. FD) to why you say it (the case decisions concerning materiality and other items). 

CAPITAL MARKETS – Knowledge of how the stock markets work is an essential skill of the IRO. If you don’t think so, try telling your CEO that you don’t really understand what the markets are doing the next time he sticks his head into your office and asks why the stock is trading down. Understanding liquidity, volatility, auction markets and the other things that impact the way your stock is traded and how to access information about them quickly are necessary pieces of information for the IRO.

Well, there you have it: The Five Pillars of Investor Relations. Now all I have to do is sit back and wait for the book offers to come rolling in…

A Hypothetical Model to Help in Thinking About the Value of Investor Relations

(Author's Note: A version of this post originally appeared on the web site Corporate Eye. I liked it so much that I am recycling it here.)

People in the academic world are big on constructing models to prove their financial theories. These hypothetical constructs blithely disregard such things as taxes, transaction costs and the fact that emotional, sometimes illogical humans are part of the market process. They don’t allow messy reality to interfere with their elegant equations, but the models are useful in highlighting a theory or hypothesis. Many an academic prize (and even some Nobel Prizes) has been won by building explanatory models that make huge assumptions and leaps of faith. In fact, my favorite quote about finance makes a nod to this as it relates to the Efficient Market Hypothesis. Fischer Black, a former Professor at the Massachusetts Institute of Technology (MIT), which sits next to the Charles River in Cambridge, Massachusetts, took a job with Goldman Sachs in New York, situated next to the Hudson River. After working there for a while, he was heard to remark, “Markets look a lot less efficient from the banks of the Hudson than from the banks of the Charles”.[1]

As I consider myself only a quasi-academic – that is, I teach but I don’t engage in any of the pedantic research that clogs the academic financial journals (plus, I have not yet sewn patches on the elbows of my tweed jacket, nor have I taken up smoking a pipe), I thought I would serve up for the benefit of my readers a theoretical quasi-model to help think about the value of investor relations. Recognizing that investor relations is a discipline that involves real people and information, I will keep it quasi-simple.

Start by thinking of two theoretical firms, both in the same industry and each performing exactly the same in financial terms. That is to say, according to their past performances, their growth rates are similar, their rates of return do not differ in any material way and they serve the same customer base. Firm A discloses exactly what is required by the regulations, and nothing more. It makes no effort to explain its more complicated accounting treatments and it does not reveal anything about its strategy or future plans. It does not respond to investor inquiries, does not make management available to investors and analysts, and does not present at any industry conferences. In short, beyond the regulatory filings it makes, it remains silent.

Firm B on the other hand, tries to be as open and transparent as possible, going beyond the regulatory disclosure requirements to explain its business and strategy, meeting with investors and regularly presenting at industry conferences. They keep up a steady stream of information that keeps investors informed on a timely basis, not just on a regulatory filing basis.

The question to be asked then, is under that hypothetical situation, should Firm B get a higher valuation than Firm A? I submit that under these conditions, it is highly likely that a premium will be attached to the valuation of Firm B, compared to Firm A. There are several reasons for this, chief of which is that investors will view the greater transparency into operations and management thinking about the future as enabling them to make better estimates about future cash flows. Secondly, the cost to investors of acquiring information has been lowered by Firm B, and this should show up in their valuation. Third, the amount of information asymmetry between the company and the investors has been lowered by Firm B, which should also be reflected in a higher valuation. Finally, although the information Firm B extends beyond that required by the regulations is not material in any one piece, in the aggregate it may help in the assembly of a mosaic of information that may be material to investors.

Unfortunately, I do not have an elegant equation to quantify the value of the of these investor relations activities. I do think it suggests however, that at least for companies where information is widely disseminated, much of the value in investor relations is in the selection and disclosure of information beyond what is required by regulation.

Now, if you want to nominate me for an academic prize, be my guest. Of course, with my luck it will turn out to be a quasi-prize…

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[1] As quoted in Against the Gods by Peter L. Bernstein.

Thoughts on the 2012 NIRI National Conference

It is a well-known axiom among educators that different people learn in different ways. That’s why when you put together a program, you include a variety of different types of learning mechanisms. Alas, this is not a lesson that has been learned by the National Investor Relations Institute.

Last month I journeyed to Seattle to attend the NIRI Annual Conference. I had not attended the annual conference in several years and was hoping to get updated on the latest developments in the profession. What I was treated to was two and one half days of unremitting panel discussions. Not only that, but most of the panel discussions featured speakers that were subject matter experts in fields other than investor relations, so that we were hearing from them about specialized topics as they might relate to IR. The amount of coordination and preparation by and among the panelists appeared to be patchy at best. There may have been good information in there, but after the first couple of panel discussions I had gone numb.

Contrast this with TED Talks (http://www.ted.com/). If you’ve ever seen a speaker at TED, you know a.) They are passionate about their subject, and b.) They are committed to giving the talk of their lives in 18 minutes or less. The result is consistently fascinating information delivered in a riveting fashion. Why can’t NIRI, an organization of professional communicators, come up with a way to be as interesting? For communicators, a conference full of panel discussions is the equivalent of going to a decorators’ convention and seeing everything painted white.

So here’s a modest suggestion for the NIRI national conference: Put out a call to members of the profession for presentations, no more than 15 minutes in length, about something they do that is unique, different or best in class related to IR. The best presentations would then be featured at the NIRI National conference in front of their peers. Talk about a chance to shine and be recognized as one of the best in your profession. At the same time best practices would be shared in an entertaining format.

But it’s not just about sitting passively and listening to people talk. People learn by doing as well. Interactive learning through case studies is a great way for people to work with concepts in real life situations. The Houston NIRI chapter has successfully used case studies at the last two Southwest regional conferences they’ve organized and even received awards from NIRI for them. So when the Houston chapter offered to put on a case study at this year’s national conference, you would have thought that NIRI would feature it as a great change of pace and a different way to impart information. Instead, NIRI put the case study as an optional workshop after the main conference had ended. I was participating in the case study and even I was ready to go home by the time the case study started. As a result of the scheduling, only 30 people out of the 1,300 that attended the conference stayed around for the case study. Talk about the waste of a learning opportunity.

I have been making presentations for more than 30 years and have taught in business school for 5 years, and one thing I’ve learned is that people will remember things if you make it interesting and memorable. I hope that NIRI learns the same lesson before the next annual conference. 

Guidance? Here’s a Map - Find Your Own Way!

While there are sound reasons for some companies to issue earnings guidance, some of which I discussed last week, I want to go on record as stating that I don’t like companies giving guidance. Part of this is that I don’t like the gamesmanship that goes into the guidance number. (In business school, game theory was a continuous source of puzzlement to me – I never did figure out who was wearing the red hat.)

Because the market tends to penalize you heavily if you miss your guidance number, most companies sandbag the number to a certain degree. So after a few quarters where the company beats its guidance, analysts & investors have yet another reason to question the credibility of management. Then they start to raise their estimates because they are convinced that management’s estimates are too low, and management starts to get into the whole business of trying to keep analyst estimates in line. The end result is that it becomes a vicious cycle consuming a lot of investor relations time and effort that does little to help investors understand the intrinsic worth of the company.

So now that you know my bias, here are a number of reasons not to give guidance:

1.   Don’t give guidance if you are in an unpredictable business. This should be obvious, but you see it all the time. For example, insurance companies are in the business of underwriting uncertain risks. They don’t know when the next natural disaster will wreak havoc with their earnings, so it makes no sense for them to be giving guidance on earnings.

2.  Don’t give guidance if you are not very good at it. If your company has given guidance in the past, but you find that you have to constantly revise the numbers downward, guidance is more trouble than it’s worth. Find a better solution. (More about this later.)

3.  Don’t give guidance if it will cause management to engage is short-term practices that are not in the best long-term interests of the company. Jiggling things around to “hit the numbers” is a slippery slope at best and the road to perdition at worst.

Because the market is focused on future cash flows as a means of valuing your company, it will make an estimate of your revenues and earnings whether you help them or not. And if you don’t help them in some fashion, the dispersion of estimates will be wider than if they received some input from the company. But the input doesn’t have to be guidance.

If you feel that your company needs to give out guidance, then your company is not giving out enough interim information to let analysts and investors come to a reasoned estimate on their own. Many companies tend to be “black boxes” in between quarterly reporting periods.  This is unfortunate, because the ideal of a good corporate disclosure program should be to dispense enough information, and update the information frequently enough, so that investors are able to reasonably reach informed decisions about how you are performing.

For example, many retailers put out monthly sales numbers. By the time quarterly earnings come around, everyone knows the sales number for the quarter. For many companies, this eliminates guessing around one of the more uncertain numbers on the quarterly income statement and reduces the need for guidance.

Or consider Progressive Insurance, a company in an industry that is notoriously difficult to predict. Progressive doesn’t give out guidance. Instead, every month Progressive puts out a monthly income statement and balance sheet. And as a result, they are well followed and their stock trades with less volatility than many of its peers.

Alternatively, if your management really means it when they say they are running the company for the long-term, tell the market what your long-term goals are, and how you’ve performed against them. This is known as putting your money where your mouth is…

Guidance – Part 1, Can’t Live With It, Can’t Live Without It

Back in the sexist days of yore, men had a saying: “Women – Can’t live with ‘em, can’t live without ‘em.” That’s sort of the way I feel about guidance, especially earnings guidance. Personally, I don’t like it, but I recognize there are times when it’s necessary. It seems to me that if you give guidance, and you hit your projected numbers, then you get no credit for it. On the other hand, if you miss the numbers you guided to, investors really penalizes you because they expect that you have better insight into the business than they do. And if you beat guidance, then you were sandbagging the numbers and analysts raise their future estimates so high that you are sure to miss in the near future.

Yet lots of companies give guidance, so they must feel they need to. According to a 2010 NIRI survey on guidance practices, of the 269 responding companies, 90% provide some form of guidance, 58% provide guidance on earnings/EPS and 62% on revenue or sales. Baruch Lev, in his book “Winning Investors Over” uses data from First Call and comes up with around 800 companies that provided quarterly guidance and 1,400 that provided annual guidance in 2007. Companies must feel compelled to issue guidance because no sane businessman is going to want to make a public forecast unless he is forced to do so.

So I went looking for some data to see if guidance was a good thing or not. Not surprisingly, the data is mixed. In his book Baruch Lev cites a number of academic studies in support of giving guidance. First, there is a study that shows that companies are more accurate at quarterly guidance than analysts. (This, of course, is not evidence that company guidance is necessarily very accurate, just that it’s more accurate than analysts’.) Second, he cites studies that indicate that guidance enriches the information environment in the capital markets. By this I think he means that the very act of giving guidance is another piece of information, which helps improve transparency. And academic studies show that transparency leads to higher stock prices, lower stock volatility and reduced cost of capital.

On the other hand, the consulting firm McKinsey, in a study published in the Spring of 2006, concludes “Our analysis of the perceived benefits of issuing frequent earnings guidance found no evidence that it affects valuation multiples, improves shareholder returns, or reduces share price volatility. The only significant effect we observed is an increase in trading volumes when companies start issuing guidance…”

So there you have it: dueling experts that lead you to exactly opposite conclusions. Given that it is not totally clear that guidance is for every company, I thought I would try to lay out some of the thinking that might lead a company to make an informed decision regarding guidance. My next post will take the opposite side, citing the reasons not to issue guidance and discuss some of the alternatives that I think are better.

You should engage in guidance if:

1. You are a small cap company and have low sell side analyst coverage. One of the big issues for small cap stocks is getting on the radar screen of analysts and getting coverage. Anything a company can do to improve their chance of coverage, including issuing guidance, should come into play in order to gain the increased trading volumes, liquidity and visibility that come with increased sell side coverage.

2.  You are in a predictable business with good insight into near term revenues and profits. Companies with recurring revenue streams or large backlogs of orders to be fulfilled in the near future are an example here. Businesses with wide swings in revenues dependent upon one-time orders are not good candidates.

3.  You don’t want to give continuous updates on your business in between quarters. The more transparent you can be on a continuing basis, the less you need to help the street by giving guidance. (More on this next week.)

4.  Management has the intestinal fortitude to run the business to plan and not manage the earning to hit guidance. Accounting is full of subjective judgments and timing issues. It is possible to move revenues into the current quarter or fiddle with loss reserves to make earnings look better in the quarter so you hit your guidance. This is almost never a good thing, but the pressure to “hit the numbers” can be overwhelming at times. Don’t issue guidance if it is going to warp the way you run your business.

5.  You figure that the market is going to make a forecast anyway, so why not take control of the process.

I suspect there are many companies that give guidance that do not fit any of the above reasons, but instead do it because all of their peer companies give guidance. This is probably the worst reason to do it, and for support, I cite motherly wisdom about all your friends jumping off a cliff.