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…

Sell Side Coverage, Part 2

A couple of weeks ago, I wrote about the relationship between Sell Side Coverage and a company’s ability to generate commissions. The long and the short of the article was that the sell side is paid via commissions and therefore, the more trading volume your stock has, the greater the likelihood a sell side analyst will cover your company. This is bad news if you are a small capitalization company, as the volume of commissions generated by your average daily trading volume will not make you a high probability candidate for coverage.

So if you are a small cap company, the question becomes, can you achieve any meaningful sell side coverage? The answer to this is yes, but like so much in life, in order to achieve your goal, you must be willing to spend a good deal of time and effort in order to get where you want to be.

There are a number of approaches to this, but in the end, they all come down to doing things that make you more attractive to the sell side. First, you can institute a marketing campaign to make your company more known to the sell side. This means reviewing who covers your peers and others in your industry and contacting them regarding your company’s investment thesis. While this alone is unlikely to result in sell side coverage, it does get you on the radar screen and raises your profile with the sell side. It also helps if you can present the sell side with a compelling reason to follow your company, such as a unique market niche, product or approach your company has that will enable the sell side analyst to be more knowledgeable about the industry than his competitors.

Second, you can make yourself more known to the sell side’s clients, the buy side. This involves the somewhat labor-intensive task of segmenting, targeting and positioning the company’s message to the buy side community followed by lots and lots of mostly fruitless phone calls. The result of this can be two things that will get the sell side’s interest: more trading in the stock and more questions about the company from the buy side. In this process it is wise not to ignore the IR officer’s anathema, hedge funds, as that is where a significant portion of today’s stock trading volume resides.

Next, you can make your management more accessible to the sell side. This may help sell side analysts fill in gaps in their knowledge about the industry and your company’s position in it, or may give them more product knowledge. As the sell side is expected to be experts in all aspects of the industry they cover, helping them gain more knowledge will put you on their radar screen. Additionally, doing a sell side analyst’s conference or using them to help arrange non-deal road shows allows them to show the buy side that they have management access, something they do get compensated for by the buy side.

One thing to keep in mind about this process is that it takes time and commitment from company management to raise the profile with the sell side. If a company has a dedicated investor relations officer and that person has a good working knowledge of how the Street operates, and the willingness to spend the time, then it can be done in-house. If, however, like many small cap companies, the CFO is filling the role of principle spokesperson to the Street, then it makes a lot of sense to hire an outside IR advisory firm to do the heavy lifting described above.

(Full and fair disclosure: the author is a consultant for Three Part Advisors, an investor relations strategic communications and consulting firm.)

The Relationship Between Sell Side Coverage and Commissions

Go to almost any gathering of investor relations officers and you are likely to hear them bemoaning the decline in the number of sell side analysts that follow their companies and publish earnings estimates. And if you are talking to small and even mid cap company IROs, you may hear them complaining that they are having trouble attracting sell side coverage at all. So I thought I would spend some time this week explaining why this might be so.

The answer is simple, really, and like many things in life, it boils down to “that’s the way the math works”. My children would always roll their eyes whenever I said that, so before I get to the quantitative part, a bit of historical perspective is in order. In the old days, before Elliott Spitzer, research departments received much of their budget funding from their bank’s investment banking departments and there was more coverage of companies because investment bankers wanted potential clients to get coverage from the firm. Of course, there were also quite a few conflicts of interest, as investment bankers only wanted the research department to have buys on potential clients. In addition, there was a lot of pressure from investment bankers for stock analysts to give generous recommendations to companies they were taking public. All of this culminated in the 1999 – 2000 dot com bubble when many highly touted internet company IPOs foundered on the shoals of reality.

Enter Elliott Spitzer, who, before he became Client 9, was Attorney General for the state of New York. Sensing that political hay was there to be made, Mr. Spitzer demanded that the conflicts of interest arising from the intersection of investment banking and research be eliminated. Using the bully pulpit of the Attorney General’s office, Mr. Spitzer was able to extract settlements from the investment banks that basically separated investment banking and research. No longer could investment banking departments contribute to the research budgets of their firms. In fact, investment bankers couldn’t even talk to research analysts unless an attorney was in the room to insure that no insidious conflicts reared their ugly heads.

This meant that research departments now needed to justify their existence based upon their only revenue source, which was commissions. And commission rates, due to a number of factors, were declining and continue to decline to this day.

This is where the math comes in, because for research departments, it all comes down to how many commission dollars covering your company can generate for their firm, and that in turn is heavily dependant on the average daily trading volume of the company in question. If you look at a mega-cap company such as Wal-Mart, they trade in excess of 14 million shares per day. Assuming an average institutional commission rate of $.04 per share, this means that on an average day, trading in Wal-Mart shares generates $560,000 in commissions. Even if you are a mid-tier analyst covering Wal-Mart, and you figure you can get credit for 5% of the commission flow, this means that potentially you have available to your firm $28,000 per day.

On the other hand, a small cap stock with average daily trading volume of 100,000 shares, generates commissions of $4,000 per day. Even if you figure the very top, go-to analyst on the stock can get credit for 25% of the commissions, the potential dollars available total $1,000 per day.

Wall Street firms are economically rational, and they will naturally gravitate to where the most money is to be made. And the long and the short of it is that it is a lot better to be a middle of the pack analyst following a mega cap stock than it is to be the number one analyst following a small cap stock.

So the next time you hear someone bemoan lack of sell side coverage, ask them what their daily trading volume is.

Because that’s the way the math works.

Insider Trading – The More Things Change…

There’s an old French proverb, “plus ça change, plus c’est la même chose”, which translates into “the more things change, the more they stay the same” and that’s the way I feel about insider trading. Every few years, the topic seems to rear its ugly head long enough for prosecutors to make some headlines before moving on to other offenses.

In the past few weeks insider trading has come back into the news. Federal prosecutors recently unveiled a sweeping investigation centered upon the use of so called “expert networks” and involving subpoenas to SAC Capital, Janus Mutual funds, Fidelity Investments and Wellington Management. The current round follows about a year after the indictments announced in connection with the investigation of Galleon Hedge Fund and there appear to be a number of links between the two cases.

Insider trading issues are always going to be part of Wall Street as there is an inherent conflict of interests between our regulatory scheme and what motivates professional investors. The regulations seek to ensure fair and honest markets where all investors play on an even field. On the other hand, investors seek to gain an “investment edge” either through superior analysis or by figuring out insights to what may be happening at the company in question by piecing together disparate snippets of information. Given that there are significant amounts of money involved, Wall Street analysts are always going to push as hard as they can to gain an investment edge, up to, and sometimes over, the ethical line.

It doesn’t help matters that the current regulations and case law regarding insider information are not crystal clear. To greatly oversimplify things: If you are in possession of material, nonpublic information and you received it as a result of a duty to the corporation, or from someone who has such a duty, or if you have misappropriated the information in violation of a fiduciary duty, you can’t buy or sell the securities of that company. However, the mosaic theory, first enunciated by the federal courts in Elkind v. Liggitt & Myers, Inc., holds that analysts can assemble seemingly disparate non-material information into a material piece of information; that is, information that leads to a decision to buy or sell the stock. Of course, if some of the mosaic of information was obtained as a result of violations of duty to the company discussed above, things become somewhat less clear.

And there we have what I believe to be the crux of the current crop of insider trading cases. If you listen to the defendant’s attorneys you hear a constant drumbeat of mosaic this and mosaic that, portraying their clients as simple analysts who gain insight into companies by dint of digging harder than anyone else. If you listen to the prosecutors, what you hear is a tale of misappropriation of information that was known to be from sources that had a duty not to disclose the information, even if the piece of information was not material in and of itself. To my knowledge, there is no clear case law that governs in such a situation. Judges and juries are going to have to figure this one out, followed by inevitable appeals.

If we’re lucky, there eventually may be some clarifying language that will help people understand what they can and cannot do - what lawyers like to refer to as a “bright line” test. If we’re really lucky, the courts will give it a handy catch phrase such as “fruit of the poisonous tree” or “clean hands doctrine” that will help investors know what they can and cannot do.

Goodness knows, the securities laws could use some simple, clear rules that everyone can understand.

What Motivates Your Analyst?

The United States Court of Appeals for the Second Circuit once characterized the exchange of information between corporations and investment analysts as “a fencing match conducted on a tightrope”. If investor relations officers are going to be successful in such a treacherous environment, it helps to understand the analyst on the other side of the conversation and what motivates them. Different analysts have different approaches, and early on in this blog I wrote about “information vampires” (March 2007), “elephant hunters” (April 2007), and “channel checkers” (July 2007) as prime examples of the way some analysts approach things. Now comes a New York Times article published on September 12, 2010, entitled “The Loneliest Analyst” about Richard Bove, a banking analyst that offers some good insights about the way another type of analyst works.

The bulk of the article concerns the lawsuit brought by BankAtlantic, a Florida bank, against Bove for a report he issued about the banking industry in 2008, which ranked the bank’s holding company as among the most risky financial institutions based on financial ratios. The lawsuit was eventually settled without liability to Bove, but it left him the poorer by $800,000 in legal fees. While the drama surrounding the lawsuit is interesting to anyone who has ever listened to a CEO fume about what he thinks is unfair or inaccurate in an analyst’s report, the more interesting part of the article occurs when Bove speaks about his work.

The lead in the article talks about how Bove likes to take “extreme positions” which can occasionally move the markets, gaining him prestige and notoriety. It then cites as an example a recent opinion issued by Bove that government rules would curb mortgage profits and by implication, bank profits. When the share price of Wells Fargo, a large mortgage lender, begin to drop following the report, Mr. Bove’s phone lights up with calls and he states, “That’s what makes the game fun, right?”

According to the article, Bove’s work tends to focus on the big picture, because, as he puts it, “What’s the reason to pay me to be the 14^th guy to tell you what is going to happen in the second quarter at Citigroup? There’s just no utility for a guy at a boutique that operates pretty much on his own to replicate the work of other analysts.”

So one of the takeaways from the article come from learning that analysts at boutique firms may have an entirely different motivation in how they approach research. Without the resources of some of the bigger shops, their focus may be on hitting the home run as opposed to maintenance research, or on big picture, macro stories. Understanding if the analyst you are speaking with takes a differentiated approach will help you as an investor relations officer have a more meaningful discussion with that analyst.

In another interesting portion of the article, Andy Kessler, a former Wall Street analyst, is quoted as saying that it’s common for analysts to change their opinion styles in order to cater to their clients: “If your clients are mostly hedge funds, you’re going to give mostly short-term analysis”. Given that a large percentage of trading volume these days comes from hedge funds, it’s no wonder that we get mostly short-term analysis.

So two quick takeaways from the article: understand what motivates the analyst, and know who his clients are will help you understand his research approach. Sounds a lot like the old broker rule of “Know your client”, but this time reversed.

Where Did You Say You Were Going?

I’ve said it before, but it bears saying again: investors buy a company’s stock because they believe they will receive a stream of cash flows in the future from the company. They only care about past performance of the company in so far as it gives them faith that the company will perform as they expect it to perform into the future. Analysts build their valuation models based upon future earnings, not past performance. So it’s surprising to me that companies don’t say more about what their plans are for the future – how they intend to make those future cash flows.

I would not want to make a general assertion about lack of forward looking information without any data, so I decided to do a quick sample of company presentations to see how much, on average, those presentations spoke to future plans. My search took me to the Internet to look for good examples of that staple of corporate communications, the PowerPoint slide show. If you go to investor conferences, almost every presenting company will accompany its speech with a slide deck illustrating their main points. What better way to quantify what companies are saying about their outlook for the future than by counting the number of slides they have shown to investors that contain points discussing the company’s future outlook. I thought it would be a relatively easy thing to go out and pull up the presentations of the various companies and analyze what I was interested in.

To my surprise, I found that it’s not quite so easy to go out on the Internet and find a representative sample of corporate investor presentations. In fact, what I found was that in a random sample of 20 large cap U. S. companies, only five companies (25%) posted their investor presentations from conferences. (I will admit that this is a small sample size, but you get what you pay for, and you’re getting this for free.)

In examining the presentations that I did find, it became obvious that companies were much more concerned with talking about past performance than future opportunity. My methodology was simple – I counted the total number of slides in a presentation and then counted the total number of slides that contained information concerning future operations. I tried to be overly generous in what I counted as a slide concerning the future, and any slide that had even a little bit of information about what a company intended to do going forward or the outlook for their products and markets was counted as being about the future.

What I found was that the percentage of forward looking slides in presentations ranged from a low of 6% to a high of 35%, with the average for all presentations being 20%. If we assume that the information being discussed generally follows in proportion to the slides in the presentation, this means that, on average, four-fifths of all information in presentations is about current or past activities. This is the equivalent of saying, “Not much new here; we’ll just make our money by continuing to do what we’ve always done”.

Now I will be the first to tell you that the bulk of all corporate profits come from continuing operations, but that doesn’t mean that those operations remain static. We operate in a dynamic economy - markets change; competitors react; new products are introduced; the economy impacts demand for the company’s products and services; and a host of other things mean that the future will not be the same as the past. Company presentations need to take these issues into account in order to give investors a clearer picture of where the company is headed.

In short, companies should spend a little bit more time and effort talking about where they’re going as opposed to where they have been. Because those future cash flows are a crucial component that investors use to value the stock.

Make Your Financials Easier to Understand

In my opinion, most companies do a lousy job presenting their financials on their websites. It’s not that the information is not there; it’s just that companies don’t make it easy for investors to work with the data. I find this surprising given that financial information is the lifeblood of understanding how a company is doing, but it’s probably part of the regulatory mindset of investor relations. Many companies will disclose their financials to the extent and in the form regulations require it, but no more than that.

Computers and the web give us lots of innovative ways to present financial information in an interactive and easy to use manner. Yet most financials I see on the web are static and limited in scope, with little to no interactivity. This means that companies are forcing investors to laboriously build spreadsheets by copying over information and then creating formulas to calculate ratios. We’re starting to see this change a bit as you can now copy and paste the basic numbers with the use of XBRL, but it’s still not that easy to deal with, and the time periods are limited to those set out in the 10-Q and 10-K formats. And don’t even get me started about the pain and suffering involved in creating useful graphs.

Just to prove my point, I went out and looked at the web sites of four major players in the discount store sector, Wal-Mart, Costco, Target and BJ’s Warehouse Club. Here’s what I found:

Wal-Mart: provides quarterly press release financials, SEC filings and their Annual Report. The financials from the Annual report are in pdf format with three years of income statement and cash flow data and two years of balance sheet data, as you would find in a 10-K.

Costco: same as Wal-Mart.

Target: In addition to the same information provided by Wal-Mart and Costco, Target also provides Summary financial information in pdf format for their consolidated financials, retail segment and credit card segment for varying periods of time.

BJ’s Warehouse Club: The smallest of the four companies mentioned here, BJ’s actually goes one better than everyone else by providing, in addition to press releases and annual reports, an excel download capability for their 10-Q and 10-K filings, based on XBRL technology. (This information is also available for the other three companies, but you have to go to the SEC website to get it.)

In this day and age, there ought to be a better way to present the financials so that investors can get to the information they want quickly and with a minimum of effort.

And there is. A company by the name of Virtua Research (http://www.virtuaresearch.com/) has created a product, which they call Interactive Analyst Center, which allows investors to go in and look at multiple years worth of data, ratios and charts, in an easily accessible format. I’ve spent some time looking at the product and I like what I see.

The product allows companies to set up their sites to provide financial information to investors that they can use quickly and easily. For example, on the site I reviewed, there were five years of annual and quarterly financial data available. There was also a page that computed over 40 different financial ratios and even included some non-financial operational ratios that the company considered important. Finally, the part that I thought was the slickest, a charts page allows the viewer to go in and create charts with only one or two clicks.

I think many company websites could benefit from this product, as it compiles financial data about a company into a single easy to use package. In short, it allows investors to analyze instead of spending their time gathering data and crunching numbers. In this day and age of time stressed investors and short attention spans, anything a company can do to help investors get a handle on their financials should be worth a look.

(Full and fair disclosure: I have a potential financial interest in this product if sales result from referrals, so feel free to mention my name. It would be the first time I’ve made money from this blog.)

XBRL – Part Three, or, Son of the Return of XBRL

Back in January and February of this year, I wrote a couple of pieces about how I didn’t really get what all the whoopla surrounding XBRL was about. Those pieces generated a fair amount of comments and I even wound up talking to the folks at the SEC about XBRL. Not to put too fine a point on it, at the time I stated that I just couldn’t understand how XBRL was going to revolutionize the use of data by investors.

While I was doing research the other day on the SEC’s EDGAR database of filings, I noticed that reports are now beginning to be tagged as having “Interactive Data”. So I thought that I owed it to myself to go back and see how this XBRL stuff works in practice. Maybe the scales would fall from my eyes and I would see the error of my ways. Maybe I would be able to see how the data flowed seamlessly, enabling us to quickly reach investment decisions that were lost to us before. And maybe pigs would fly.

What I found when I went to the interactive data was that you could click on a heading such as Income Statement, and the P&L would come right up. I found the data had two properties: first, the headings were tagged. So for example, if you click on Revenues, you find that it’s US GAAP, the data type is monetary, the balance type is a credit and the period is the duration of the quarter. In other words, what you learn in Accounting 101. Secondly, you can grab the data and paste it into another document fairly easily. Also of note was the fact that the financials and notes are available as an Excel download, although everything I downloaded had a file name of “Financial_Report.xls”, so if you don’t rename the file right away, it becomes one of many with the same name.

After I had played with the data for a while, I sat back and thought about the cost /benefit analysis for what we’ve gone through with XBRL. On the benefit side we’ve gained a bit of functionality. I, for one, will welcome the ability to grab data off a downloaded spreadsheet rather than re-keying it when I want to do some analysis. But I don’t see a lot beyond that. The tagging of the data seems to merely tell me what I knew before. Further, professional investors have had the data in comparable and downloadable form for years. Systems such as Bloomberg and Telemet Orion (and I assume Reuters, although I have no experience with that system) already perform this function and a lot of other analytics as well. So my conclusion is that only relatively small investors are being helped. Against this we have to weigh the thousands of dollars spent and numerous man-hours invested by every company converting to XBRL.

To me this seems like another example of something that sounds good in theory, but the practical advantages just don’t seem to live up to the hype. In other words, it’s a governmental agency imposing a standard where the costs outweigh the benefits. The irony of it all is that the ultimate cost for all of this will be born by investors, because the cost of adopting to the new systems is a corporate expense, which lowers earnings, which will result in lower share prices.

Insider Trading Hurts Us All

There seems to be an epidemic of insider trading cases these days. First we started with the Galleon indictment alleging that Galleon profited from receipt of material nonpublic information from a variety of sources, including an investor relations firm working for Google, corporate executives at IBM and Intel, and a partner at the McKinsey consulting firm. This has been followed by criminal charges being brought against an additional fourteen people including hedge fund managers, a trader, a broker and a M&A lawyer, with five of them already agreeing to guilty pleas.

All of this raises some interesting questions ranging from, “Where have prosecutors been for the past several years?” to “What have compliance officers been doing at these firms?” but what I want to focus on is the bigger picture, insider trading itself. As you would expect, a number of commentators have expressed opinions about insider trading, and some people have gone so far as to suggest that the penalties for insider trading should be abolished because it’s common and impossible to police. Even beyond that, a number of noted academics have argued that insider trading is good for the markets because it makes the market more efficient.

Let’s start with the basics; the case law and the statutes surrounding he use of material non-public information are, with a few exceptions, pretty clear. To greatly oversimplify: If you are in possession of such information and you received it as a result of a duty to the corporation, or from someone who has such a duty, or if you have misappropriated the information in violation of a fiduciary duty, you can’t buy or sell that security.

The insider trading laws in the U.S. really get to the issue of fairness in our securities markets and go all the way back to the Pecora Commission hearings following the stock market crash of 1929. The result of those hearings was that the public was outraged that bankers and stock market insiders could manipulate company information for personal gain. The Securities Act of 1933 and the Securities Exchange Act of 1934 were a direct result of those hearings and the U.S. emerged with the most transparent market system in the world. The prohibition on dealing in insider information has served our markets well over the years.

In sum and substance, you cannot allow people to benefit from information simply because of their position, nor can you allow them to leak that information to a select few. To do so would mean that the markets were a rigged game, and people’s faith in the markets would take a severe blow.

Because of the large sums of money at stake over inside information that traders can benefit from, there will always be a few people willing to test the system, from Dennis Levine and Ivan Boesky in the 1980’s to the Roomy Khans of today. But let’s be clear – these are not close calls. Everything I have read about the current series of cases involves people who knew they were going beyond normal everyday information gathering and into the realm of the illegal. The use of disposable cell phones to avoid detection and payment to sources of information are not things one normally sees in the normal information gathering process of analysts.

This is not a victimless crime – activities that bring disrepute on the fairness of the markets impact all of us because people will be less willing to commit capital to unfair markets. I have absolutely no sympathy for this type of crime and hope that prosecutors continue to bring cases where appropriate. Fortunately, I think we will continue to see these cases, as good prosecutors can make their bones on them – after all, look at what it did for Rudy Giuliani.

Reg. FD and the Law of Unintended Consequences

It used to be in the good old days (some would say bad old days) stock analysts saw a goodly percentage of their job as talking to and cultivating relationships with management. The classic example of this is the analyst I refer to as the “Information Vampire” who would talk to management until they felt they had sucked every last drop of information from them. The thought process was that by building a relationship, the analyst would pick up enough tidbits of information to give them an advantage over the average investor, and because management liked them, they might let the analyst know something important before everyone else, either in a one on one meeting or by being the first phone call they made when news is breaking. On such things careers were built on Wall Street.

Then along came Regulation Fair Disclosure, in which the SEC mandated that if a company is going to say something important, it has to tell everyone at the same time. It doesn’t matter if you are best buddies with the analyst who has followed you through thick or thin or if a portfolio manager had been a loyal shareholder for many years. The reasoning was that the securities markets need to appear to be a level playing field for all concerned, regardless of whether you are a professional money manager with $50 trillion in assets or you are a retail investor looking to buy 100 shares of stock. (This is very much the same type of governmental thinking that gave us the Robinson-Patman Act prohibiting price discrimination between customers, but that’s a subject for another day.) The SEC then proceeded to announce a series of enforcement actions to drive home the point that you can’t just go off and blab to institutional investors. They never actually won a court case on the subject, but they made their point and companies toed the Reg. FD line.

This, of course, did not stop Wall Street’s desire for an information edge. We are, after all, talking about an industry with serious amounts of money at stake. It just meant that the quest for information went elsewhere. Hence today, courtesy of Reg. FD, we have at least two new types of information hunters on the scene.

The first of these is the “Channel Checker”. This is a person who specializes in cultivating a network of industry sources, be they lower level employees of the company, suppliers, customers and competitors. They usually don’t talk to the company very much, if at all. This type of analyst has always been around, but since the advent of Reg. FD have increased in number as they try to supply investors with they type of information edge they can no longer get from the company.

The second type of information provider that has gained more prominence since Reg. FD has been the expert network systems. These are organizations that have created data bases of people with expert knowledge on particular subjects. Then, when an investor needs to get up to speed quickly on a subject, whether it’s current inflationary trends in the footware industry in China or the likelihood of a drug getting through the FDA approval process, there is someone out there, that for a fee, will expound on the subject. (Disclosure: On occasions, I have been retained by expert networks to discuss things about which I have knowledge.)

Companies, of course, don’t like either one of these developments, as they can’t control the information being disclosed or put any spin on the story. In and of themselves, the channel checkers and expert networks are not a bad thing, they are just different sources of information. It’s just that the SEC shouldn’t kid themselves into thinking that Reg. FD has made the information the same for everybody. It just means that professional investors have to redirect their efforts as to how they get it and how they pay for it.

How to Use a Computer to Read Company Reports

It has come as somewhat of a shock to me, but I realized the other day that personal computers can actually perform some very useful roles when it comes to reviewing company SEC filings. This is welcome news to someone who labored through the early days of DOS based PCs where it felt like you spent more time trying to get the blasted things to work than you did in actually getting any productivity.  It’s nice to be getting some productivity payback, even if it is twenty years later.

I’ve found that when investors are following a company, what they care about are the changes that are happening on the margin, particularly as it compares with the same period in the prior year.  Companies, of course, are happy to tell them when good things are happening at the margin and will supply lots of reasons why smart management has made good things happen.  The bad things, however, either get buried in the fine print, or, more than likely, omitted.  It’s these omitted things that are toughest to spot.  After all, the previous period was a year ago and who can remember that far back?  I’m lucky if I can remember what I had for supper last night, so good luck spotting that omission. This is where reading the periodic filings of a company with the aid of a computer comes in really handy.

First, let me say that it really helps if you have a very large display monitor, or, better yet, dual screens.  I switched to dual monitors about two months ago and it feels as if I’m saving about 10% of my time because I no longer have to dig through and move around the multiple screens that I’m working on.  With a super-sized viewing area it is then easy to go the Securities and Exchange Commission’s website (www.sec.gov) and search for the most recent filing by the company you’re interested in.  Once you’ve pulled that up, you then open a new window right next to it with the previous year’s filing for the same period in it.  So far, this is nothing you couldn’t do with paper on your desktop if you wanted to print out the documents and kill a lot of trees.  But now comes the cool part.  You can get the computer to search for the word or phrase you’re interested in.  Rather than parsing the document line by line to find out what’s missing, the computer can tell you exactly how many times a word or phrase was used in the company’s discussion.  Then you simply compare what you’ve found with the same search for the previous year’s filing.  If there is a big discrepancy, then a diligent investor will use it as a starting point to start asking questions. I’ve used this technique when writing some of my blog posts to look at the treatment of same store sales by Starbucks and the disclosure of the number of pharmacists working at CVS Drugstores (see Starbucks and Disclosure of Same Store Sales, December 5, 2008 and How to Read 10K and 10Q Reports, September 10, 2008).  My computer will tell me how many times the word or phrase is used in the document and take me right to the spot it’s used. 

 The system works because, by my estimates, 85% - 90% of the discussion material in the 10-K and 10-Q doesn’t change from period to period.  If you’ve ever sat in on a Disclosure Committee meeting, you know that the accountants and lawyers are trying to write the document by making as few changes as possible to the previous document.  Nobody has time to reinvent the wheel every quarter with a totally rewritten filing. So when they make a change, it’s usually because they have to make a revision due to changed circumstances.  Many times those changes, if they don’t favor the company, will get buried in the 10-Q or 10-K and it’s up to the intrepid investor to find them. 

And this is just the beginning of how computers can be used to analyze the textual discussion in company periodic reports.  Those of you who are intrigued by all of this should take a look at a site called Many Eyes (www.many-eyes.com) to see how see how graphics can be used to analyze text and changes to text.

It’s a brave new world…

And You Thought Our Stock Ratings System Was Screwed Up

In the February 8^th Sunday New York Times, the Business section contained an article entitled “Why Analysts Keep Telling Investors to Buy”.  It’s worth a read, even if it covers familiar ground to those experienced in the ways of Wall Street and investment analysts.  The long and the short of the article is that even in the mist of a terrible bear market, analysts still only have sell ratings on 5.9% of all stocks.  Having missed all of the warning signs for the current economic downturn, most analysts are now of the opinion that stock prices are so low that now is the time to buy.  Nobody wants to issue a sell rating just when the markets turn up.

I’ve written about this phenomenon before (see “Stock Ratings from Lake Wobegone”, May 15, 2008).  Leaving aside the tendency of the stock market to rise over time, all of the incentives on Wall Street favor the optimistic, bullish view.  When an analyst issues a sell rating, companies hate him, investment bankers hate him and commission flow goes elsewhere.  The only ones who like sell ratings are short sellers, and they are often viewed as the pariahs of the industry, commonly blamed for all sorts of financial misdeeds and shenanigans.  (My own feeling is that short sellers, like jackals and hyenas, form a natural part of the ecosystem, but that doesn’t mean we have to like them.)

None of this would be worthy of a lot of additional comment on my part, except that about the same time as I read The New York Times article, I also ran across a brief piece in the February 7^th issue of The Economist magazine that made me think that maybe, as skewed as things are here, they’re a lot better than some other markets.  The article, entitled “Bye bye sell” takes a look at research recommendations in the South Korean and Taiwan markets.  In both markets it appears that government regulators actively discourage brokerage firms from issuing critical research.  In South Korea, the Financial Supervisory Service has been known to investigate brokerage firms that issue critical research, while in Taiwan, if the press quotes critical research, the government requests brokers to provide “explanations” as the press is required to receive a securities firm’s approval before quoting research.

The results are predictable, as the research firms quickly learn that critical research brings more trouble than it’s worth.  For example, during 2008, there were 17,335 research reports issued in South Korea, and not a single one was a sell recommendation.  This is not what you think of when you start talking about efficient markets.  As bad as our distribution of stock recommendations is in the U. S. we are not burdened by a government bureaucracy that views stock markets as an instrument of optimistic government policy. Yet.  

XBRL – What Is This Stuff?

I don’t think of myself as a Luddite.  In fact, for someone with as much grey hair as I have, I think of myself as pretty tech savvy.  After all, I have a blog, I also have my own web site, I carry around a Blackberry and I spend much of my day in front of a computer.  But, I have to confess, when it comes to XBRL as it relates to investor relations, I’m lost.  I’ve been to presentations at NIRI conferences where I hear speakers expound upon their theory that XBRL will revolutionize the way we look at and use financial data.  I hear them extol the virtues of how the information will be tagged and prepared for automatic comparisons and I wind up more confused at the end of the speech then when I started listening to them.  I find that when people start talking about XBRL, it’s similar to when I listen to computer programmers – I’m pretty sure they’re talking English, but not in a way that I can comprehend.

Finally, I couldn’t stand it anymore and I decided to try and figure out how all of this will affect me.  So I went out and did a Google search on XBRL (I told you I was half-way tech savvy, didn’t I?)  Here’s what I found:

“XBRL, like XML, applies identifying tags to items of data, which allows them to be processed and analyzed. Like XML, XBRL is a language intended to be read by computers, not humans. The use of XBRL tags enables the automated processing of financial data by specialized computer software, which eliminates the need for the tedious and costly process of manual re-entry and comparison. Once data has been tagged, computer software, rather than human labor, is used to select, analyze, store and exchange information. Moreover, since it is a standardized language, XBRL enables an apples-to-apples comparison across multiple companies and multiple industries.” 

So as I understand it, we’re going to be able to grab all sorts of data and the computer will tell us if the information is comparable.  If it is, then we can drop it into spreadsheets and unlock all that hidden information.  Leaving aside the issue of whether or not companies will code everything in the same manner (which is a pretty big issue by itself), as I see it, there are two potential problems here.  First, the numbers that are being tagged by XBRL are being prepared by humans using accounting.  As we all know, accounting involves a multitude of judgments.  Things that seem straightforward on the surface, such as revenue, can actually be quite tricky when you start to adjust for accrual accounting with its accrued revenues, deferred revenues, advances, long-term contracts and exceptions.  The tagging for XBRL will follow the accounting judgments, so unless all companies start to account for things exactly the same, discrepancies will crop up in the numbers.  In my experience, every company has certain accounting items that they handle differently from other companies.  The reasons for this range from “We’ve always prepared it that way” to “The system can’t handle it that way” to a variety of other excuses, but I assure you these exceptions exist.  Unless you get uniformity, comparisons are an illusion. 

Second, and this goes back to something I learned when I was taught math (or as we used to call it in those days, arithmetic), you can’t just read the problem and say, “I understand it”.  You have to get out your pencil and paper and work the problem to absorb what’s happening.  Maybe I’m a dinosaur, but when I’m examining a company’s earnings report, I pull out a calculator and work out the relevant ratios and changes I care about.  That way, as I work my way through the financial statement, I find I have a better understanding of where the variances are.  Maybe the next generation will be better at letting machines point out these things, but having helped three children learn math, I don’t think so.  

So as I understand it, XBRL will allow people to use software to manipulate numbers easier and faster (because they’re already tagged) for purposes of analysis and comparison.  There is, of course, no guarantee that the analysis will be any better understood or that the comparisons will be meaningful, but hey, you’ve got to start somewhere.

Sounds to me as if the XBRL revolution is being oversold.

 

A One – Handed Economist

Harry Truman famously complained that what he needed was a one-handed economist, as all of the economists that were advising him would state “On the one hand… but then again, on the other hand…”  Old Harry S. can now rest easy in his grave, because yesterday I may have heard a one-handed economist.  

The occasion was my local NIRI chapter luncheon for January where we were treated to an economic outlook and forecast by an economist for an investment bank.  As you might imagine, given the current economic environment, the overall message the speaker was giving out was not overly optimistic.  I’m not going to depress you by going over all of the gory details, but there was one statement that caught my attention.  Speaking to the actions of the government and the Federal Reserve to combat the current economic downturn and credit crisis, he said, “They’re doing all the right things”.  That is about as straightforward a statement as you will ever hear from an economist.  This guy obviously did not take elocution lessons from Alan Greenspan.  

Naturally, when I heard something that simple and direct I got to thinking about it and I realized that there were a number of unstated assumptions in what had been said.  What I think the economist was really saying was, “[In my opinion, if this economic situation is similar to what we have experienced in the past, then] they’re doing all the right things.”  Of course, therein lies the catch – things are never quite what we’ve experienced in the past.  The financial markets that have evolved in the last ten years with Collateralized Debt Obligations, Mortgage Backed Securities, highly leveraged hedge funds and derivative markets are vastly more complex than anything that existed during any past financial crisis, be it the Great Depression, the Saving and Loan debacle or the Japanese economic bubble.  In each of these past downturns, policy makers thought they were doing the right things, but it’s only in retrospect that you know if they got it right or screwed up royally, because every time it looks the same, but it’s different. 

Which brings me to what we do in investor relations. (You knew I had to get here eventually, right?)  We are often confronted with situations that sort of look like what we’ve seen in the past, but things have changed.  Say you are going to make a presentation to an investor conference that you presented at last year.  You’re still the same company; the investors attending the conference are likely to be very similar to the investors that attended last year.  Things look pretty similar  - should you just mark up last year’s presentation and let it go at that?  Maybe, but are you really the same company you were last year?  Have your markets changed?  Perhaps you’ve gone from being a growth company to a value play.  Certainly your investors this year are not the same as they were last year as the market downturn has radically altered their view of the world.  Even if your company’s basic long term strategy hasn’t changed, it is probably time to think about a fresh approach to how you communicate your story to investors, taking the new reality into account. 

The same can be said for any number of situations we face in investor relations.  Should we be rethinking our approach to regulatory disclosure issues with the SEC smarting from some of its recent oversight failures?  Will non-governmental organizations and social activists gain more traction on proxy proposals with a more liberal administration and Congress in charge?  Are activist hedge funds relevant if access to capital is restricted?  We’ve seen all these issues before – interpretation of SEC regulations, proxy proposals, activist hedge funds – but not in the current environment.  History may be a help, but it is not a definitive guide.  You still have to bring judgment and critical thinking in order to weigh the issues and come up with a well thought out course of action because things are never exactly the same. 

There are more examples I could cite,  but I have to stop now – both my hands have gotten tired from all this shifting of issues back and forth.

The Curious Effect of Falling Stock Prices on Diluted EPS

As I’ve watched companies report earnings for the quarter that ended September 30^th, I’ve noticed a strange phenomenon – companies are getting help to their Diluted Earnings Per Share line from falling stock prices.  It’s no secret that the stock market has been brutal over the course of the past six months, and company equity values have taken a beating.  But there has been one small side benefit to the decline in stock prices.  Of course, companies won’t come out and tell you what it is.  You have to be a pretty savvy investor and know your way around a company’s financials in order to figure it out. 

Here’s how it works:  many companies have issued a large number of options over the last decade and have a large number of options that go into the diluted earnings per share calculation.  To grossly oversimplify things, the more options a company has outstanding and the deeper they are in the money, the greater the number of shares in the denominator for purposes of calculating diluted (as opposed to basic) earnings per share.  So far, so good, as long as the stock price moves in a smooth fashion.  However, when you get a steep drop in the stock price, many of a company’s options go under water.  When an option’s exercise price is above the fair market value of the stock, the options are excluded from the diluted earnings per share calculation, and they are anti-dilutive.  (This sounds to me suspiciously like anti-matter, but I don’t think accountants are that imaginative.) The result is that companies with large numbers of stock options and steep price drops in the stock price wind up with fewer fully diluted shares in their diluted EPS calculation and hence a higher diluted EPS number.  Good luck getting them to fess up to that however, they do their best to bury the calculations deep in the 10K or 10Q.

Sometimes the numbers can be startling.  A few years back Microsoft had 649 million shares excluded from the calculation of diluted EPS because they were anti-dilutive.  Talk about a big overhang on EPS if the stock price ever recovers.  More usually, the anti-dilutive effect is smaller, say one or two cents per share in each quarter.  The point here is two-fold: first, in Wall Street’s eyes, one or two pennies per share per quarter is a lot; when companies miss by that much, they get punished; and second, this is a non-operational benefit that companies are getting due to the bear market.  Companies are quick to tell you when non-operational issues hurt the EPS line, so why do they stay so quiet when it runs in their favor?

Finally, as long as I’m on my soapbox, where have all the highly paid Wall Street analysts been on this issue?  I have not seen a single analyst report that mentions this.  So here’s some advice to all my sell side friends – when diluted and basic EPS suddenly start looking the same where in previous years diluted was lower than basic, the company is probably getting some non-operational help from anti-dilutive options. Things aren’t as good as they seem.

Now, just like anti-matter coming into contact with matter, I will disappear.

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.

When Culture Meets Financial Theory

How often have you seen this: A company makes a big public announcement regarding a new strategic initiative designed to bring wiz-bang methods and profitability to the way the company does business.  Investors are intrigued because what the company has announced seems eminently reasonable and conforms to what the analysts were taught in business school. (Of course, the consultants that the company is using all went to the same business schools, so there is a bit of circular reasoning at work here, but leave that for another day.)  Following the initial splash of the announcement, investors clamor for more details on the big new initiative.  What they are usually greeted with are phrases such as “It’s still early days”, “It’s too soon to see anything out of this” or “This is a big project that touches many areas of the company and it’s very difficult to measure”.  Eventually, the amount of information about the project coming out of the company slows to a trickle and then stops.  In the noise of the market, investors forget about the project and look at other things.  No one ever really finds out if the project had an acceptable return on investment.

What’s going on here?  It’s not as if the company is no longer working at trying to implement the new project.  It’s not as if they don’t have internal measures that gauge the progress of the project.  If the news were great, would the company stay silent on the issue?  Maybe, but probably not - they would be much more likely to be trumpeting the triumph of new technology.  I would suggest that what is happening is the corporate version of a shell game: the company would prefer that you direct your attention to something else so they don’t have to explain why their vaunted project is not living up to it’s initial promise.

Large, radical new corporate initiatives almost always represent a break with existing corporate cultures.  I have a favorite saying about this situation: “When culture meets financial theory, culture almost always wins”.  The corporate culture in many organizations is part of the corporate DNA and will fight off attempts to change it.  The result is generally that the big new project will wind up costing more than initially planned, take longer than estimated and do less than the original projections.  When companies start to see this, they begin to build up a barrier around the project by limiting further disclosures.  I’ve seen this any number of times.  For example, during the 1980s Walgreen embarked on a “Strategic Inventory Initiative” designed, among other things, to lessen the amount of inventory carried in the stores.  Millions were spent on computer systems to help achieve optimal inventory levels.  Unfortunately, the culture of the Walgreens store managers was that they wanted their stores to look as if they had lots of inventory.  Their culture was to never to be out of a product if they could help it.  As a consequence, inventory levels never went down.  More recently, Home Depot went through a big reorganization to centralize many functions that had previously been done at the store level, running smack into a culture that had been centered around the store managers.  The result was a lot of dislocation and same store sales that were anemic for a protracted period of time. 

I’m not here to say that corporate cultures are always right – they’re not.  Many times corporate initiatives to change ingrained methods of doing business are both necessary and difficult.  But as I look at the way such projects are disclosed to investors, and the short-lived way that investors pay attention to the projects, I think things could be better.  Herewith, a few modest suggestions: For companies – if a project is important enough to announce to the public, it is important enough to continue to report about it until it reaches maturity.  Recognize that the project will vary from its original projections and provide sufficient metrics to enable investors to judge the progress of the project.  The ability for investors to determine if an adequate return is being achieved on the company’s investment seems to me to be a reasonable goal.  For investors – make the company continue to disclose.  Have a long-term outlook when it comes to this type of project.  Try to figure out how the project fits into the overall fabric of the corporation, not just whether it sounds like something your business school professors would recommend.  

Perhaps if corporations and investors take a longer tern view of these projects both sides will benefit – after all, more disclosure about things the company thinks are important should be better for investors as well.