The SEC and Climate Change – What Are These Guys Thinking?

First, a brief reminder that my seminar “Fundamentals of Investor Relations” will be held February 24^th in Houston. The seminar blends real world experience with some of the tools we teach in business school such as valuation, decision tree analysis and efficient markets as they interact with the finance, capital markets, legal and communications issues of investor relations. If you’re interested, go to my website, www.palizzapartners.com and click on the seminars tab.

The Securities and Exchange Commission faces a daunting array of issues that need attention - we’re just recovering from the most severe financial crisis our country has faced since the Great Depression which severely tested the structure of our capital markets, credit rating agencies face a crisis of confidence based upon their performance in rating complex mortgage backed bonds and the inherent conflict of interest they face in being paid by the issuers of the bonds they rate, the proper regulation of derivative instruments needs to be addressed, and their enforcement division wasn’t able to identify the billions of dollars being stolen by Bernie Madoff in spite of receiving complaints against him on at least two occasions. So what pressing issue does the SEC choose to tackle first? CLIMATE CHANGE! In the words of Commissioner Kathleen Casey (a Republican who voted against adoption of the release) “our consideration of this release today sends a curious signal to the investment community about what we view as the most pressing issues facing the Commission”.

The interpretive release, which the SEC commissioners adopted in a 3 – 2 party line vote (guess which party voted in favor of the climate change release) and which as of this writing still hasn’t seen the light of day (how’s that for timely disclosure of a material event?) purports not to change disclosure requirements. The last time I checked the definition of materiality as set out by the Supreme Court in Basic v. Levinson, it was “Information is material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision”. In over thirty years of working in the field of investor relations I have never had an investor who owns, or is interested in owning shares, ask a climate change question. Could I have been dealing with unreasonable investors all these years? I have had questions from advocacy groups, but they are not investors, which is a crucial difference as far as disclosure requirements go.

Previous SEC interpretive releases have focused on areas such as analysis of long and short-term liquidity and capital resources, segment analysis, the effects of federal financial assistance on the operations of financial institutions, and the disclosure of preliminary merger negotiations. It seems to me that these are proper areas for the Commission to be concerned with; they are concrete, defined in scope and fairly immediate. Now we have a release, which according to the speeches of the SEC commissioners, requires companies to consider the reputational damage and its effect on their financial condition caused by their greenhouse gas emissions and requires them to disclose if their operations may be at material risk from the physical effects of climate change. So here are a couple of questions: How do you measure reputational risk in a meaningful and defined way? How do you know if your operations are at risk from climate change as opposed to normal weather shifts? Last time I checked hurricanes didn’t come with tags that say, “climate change related”. This is just bad regulation, requiring companies to engage in speculation about future events. In most other instances the SEC discourages speculation and requires you to make disclaimers about how the events may not come to pass, but this is an issue that is on the political agenda for the party with the majority of Commissioners on the SEC and so speculation is okay.

And just to remind you, the SEC also put out an interpretive release requiring companies to discuss Y2K issues, and we all know how material they turned out to be.

Efficient Markets and Investor Relations

There is still time to sign up for my seminar "Fundamentals of Investor Relations" on February 24th in Houston. Just go to my website, www.palizzapartners.com and click on the seminars tab for more details.

One of the things you learn about in finance class during the first year of business school is the efficient market hypothesis. In its simplest form, the efficient market hypothesis states that security prices fully reflect all available information. The implications of this seemingly simple statement are profound, because if current stock prices reflect all relevant information, then prices will change only when new information arrives. New information, by its definition, cannot be predicted ahead of time, and therefore stock prices cannot be predicted ahead of time and will be random.

The efficient market hypothesis gave rise to an entirely new investment vehicle, the index fund, as numerous studies were done showing that active investing could not beat the market over the long term, after taking into account transaction costs and overhead.

There are actually three versions of the hypothesis: The strong form, which posits that ALL information, both public and private, is embedded in a security’s price; the Semi-strong form, which holds that all publicly available information is reflected in the stock price; and finally the Weak form, which says that a stock’s price reflects all information that is contained in the past prices of the stock. Of the three forms, financial economists are pretty much in agreement that the Strong form, that security prices embed all information about a stock, both public and private, overstates the case. If it were true, insider trading would not reap abnormal profits, which it clearly does. Most settle on the Semi-strong form of market efficiency as their preferred thesis. Since Eugene Fama initially wrote about efficient markets in 1969 literally hundreds of event studies have been done showing that markets rapidly react to widely available information.

So, you may ask, what has all of this got to do with investor relations? The key here is that investor relations has a fair amount of discretion over what information becomes widely available. Forget for a moment what you have to disclose because of regulations and quarterly filings and think instead about other things that make up your company.

Just to take one example, say you have a terrific management team. If you don’t get them in front of investors so that they can judge how great they are, that information is not widely available and the market will never know about it. If investors don’t know how good the entire management team is, they can’t build that into their expectations of future profits and therefore it will not be reflected it in your stock price.

Another example is corporate culture. Nothing in the regulations or disclosure requirements will ever force you to talk about your company’s corporate culture. Yet that very same culture may be a big reason behind your company’s performance and its future prospects. Wal-Mart comes to mind as a company that puts its culture in front of investors by letting them attend Saturday meetings in Bentonville and welcoming them to the extravaganza they have each year at their annual shareholders’ meeting.

What you choose to disclose is entirely up to you and (here’s the rub) your management. Every company is good at something – brand management, technical expertise, distribution or operations, to name a few. Disclosing data of this nature with investors can help them more efficiently value your stock. The key is that the information has to be widely available. That doesn’t mean that you have to disclose it in your filings or put out a press release. Not all information rises to the level of materiality. But it does mean that you have to have a consistent effort to disclose those pieces of information, both in good times and in bad, to all your investors.

Do that and you will have done your part in making the markets more efficient.

Learning from European IR Websites

First, a brief announcement: registration is now open for my seminar, “Fundamentals of Investor Relations” to be held February 24^th at The Houstonian Hotel. If you are interested in attending, simply go to my web site www.palizzapartners.com, click on the Seminars tab and follow the instructions at the bottom of the page to register. We are offering a high quality educational experience at a compelling price.

And now for something completely different (apologies to Monty Python): Like most modern day office workers, I spend a lot of time in front of my computer getting information off the web. When I do research on companies, I usually start at a general financial information site (my personal favorite is Google Finance, but there are plenty of others out there) to get a quick overview before moving to the company’s investor relations site. What I find when I get there is that many of the investor sites for U.S. companies tend to be very cookie cutter in their approach. In short, the sites are not very interesting or innovative. My impression is that the sites have been assembled from a menu of standard options, sort of the way you can order off a Chinese menu.

I find this somewhat depressing, given the decline in print media as a means of delivering a company’s story and the inherent flexibility that the web provides. As I thought further about it, my conclusions were that there are probably two factors at work here. First, most companies choose to outsource the process of building and maintaining the investor web site portion of their company’s site. I can’t say I blame them for this, as A. doing this well is beyond the capabilities of most smaller companies and B. if you’ve ever worked in a large corporation that maintains the web site internally, you know that investor relations is well down the priority list of most programmers.

Second, the market for providing outsourcing of investor relations sites is essentially a duopoly in the U.S., with all the implications that has on pricing and innovation. Least you think I’m just talking through my hat, over the past couple of years I have spent a fair amount of time looking at European investor relations web sites, and in a number of respects, they do it better. For example, as you can see in the screenshot below, the Italian energy company ENI has a killer main IR page that allows you to customize how you want the information to look through the use of movable widgets.

Or how about a graphics generator for your key data? The screenshot below comparing net income to free cash flow is a graph I generated on the website of EADS, the European defense contractor. The entire process took me six clicks of my computer mouse – no cutting and pasting, and no downloading financials and parsing through the entries and fussing with excel charting functions.

Finally, we live in an increasingly mobile society, but U.S. investor sites seem to think that everyone is sitting at their desk. Below is a screenshot of the Stay in Touch page for Aviva, the U.K. insurance company that gives investors a number of ways to receive their information.

The point of all of this is that here in the U.S. we tend to get a bit insular. We have the largest and most robust capital markets in the world, so naturally we think everything we do connected to those markets is the best as well. However, there seems to be some very innovative things being done for investors in Europe. We could improve our web sites by broadening our horizons a bit.

A Pricing Guide to Executive Education in Investor Relations

Competition is a wonderful thing. Competing offerings generally result in better offerings, more choices and lower prices for the customer. Conversely, when an organization has a monopoly or near monopoly on a product, prices go up and there is no way to know if you are getting the best the market has to offer. If you don’t believe me, just think about what American cars were like before they started to get serious competition from Japanese and German cars.

Until recently, people who wanted to go to educational offerings about investor relations have had very limited choices at very high price points. That’s why I’ve developed my seminar, “Fundamentals of Investor Relations”.

Talk is cheap (unless, evidently, you want to hear it about investor relations), so I thought I would set out how my new seminar compares to what’s currently being offered and let the readers decide.

Fundamentals of Investor Relations

Cost: $475

Duration: one day

Location: Houston, Texas

Instructor: John Palizza (me), lecturer at Rice University Jones Graduate School of Business, developer and teacher of the only MBA level investor relations course taught anywhere.

NIRI Introduction to Investor Relations

Cost: $1,195 for members, $1,495 for non-members

Duration: two and one-half days

Location: Boston, Massachusetts and Santa Monica, California

Instructors: Volunteer consultants, IR practitioners and NIRI staff

University of Michigan — Theory and Practice of Investor Relations

Cost: $7,200 for members, $8,100 for non-members

Duration: five and one-half days

Location: Ann Arbor, Michigan

Instructors: University of Michigan finance professors and Jeffrey Morgan, NIRI president.

Online Certification Program in Investor Relations, offered with the University of California, Irvine

Cost: Six required courses and one elective course at $660 per course for members, $860 for non-members, plus one elective course at $575, textbook cost of $100 per course and $125 candidacy fee. Total cost: $5,360 for members

Instructors: various volunteer practitioners

Certificate Program in Investor Relations at NYU School of Continuing and Professional Studies

Cost: five courses at $775 each, total cost $3,875

Instructors: various volunteer practitioners

If you’re wondering why I can offer this seminar at a price point much lower than anyone else, the answer is that I am much more interested in elevating the educational level available for the discipline of investor relations than I am in making a lot of money. Don’t get me wrong, I’m as driven by the profit motive as any good capitalist, but frankly, I think current offerings are overpriced, inconvenient and take way too much of people’s time. I know what the costs are to put on a seminar and I don’t see it justifying the pricing I see. I think the seminars are being priced for what the traffic will bear, not to the marginal cost of the product.

So here’s my promise: Attend “Fundamentals of Investor Relations” and you will be given the basic knowledge about investor relations you need to have a solid grounding in the legal, marketing, finance and stock valuation aspect of the discipline. I also promise you that we will not waste your time. And we won’t force you into a vendor’s showcase for “networking time”. All we’ll do is have a dialog about the essential knowledge you need to know to do your job well. When all is said and done, I believe you will get a better product – one that is used in a MBA curriculum - at a lower price than anyone else is offering.

This is my first time offering the seminar and it’s being offered in Houston. If we have success, we’ll bring it to other cities, so that it’s convenient to the customers.

If you’re interested, or know someone who might be interested, you can find more information about our upcoming seminar on February 24, 2010 under the Seminars tab on my website http://www.palizzapartners.com or you can email me at john@palizzapartners.com or call me at 281-727-6775. I love to talk about this subject.

More Essential Life Skills for the Investor Relations Professional

First, a brief commercial: I am happy to announce my seminar, "Fundamentals of Investor Relations" will be given in Houston on February 24, 2010. The workshop was developed from my MBA course at Rice University and is designed to be a comprehensive one day overview of the essentials of investor relations. At a cost of $475.00, it represents a great value. For more information, visit the Seminars tab at my website at www.palizzapartners.com.

In the early days of this blog (September, 2007), I wrote a humorous piece entitled “Essential Life Skills for the Investor Relations Professional”. Much to my surprise, the essay has proven to be one of the more popular posts I’ve written. I suspect that people do a web search looking for relevant advice about how to actually practice investor relations and wind up getting my advice about learning to talk with their mouths full, sound enthusiastic when they’re answering the same question for the thirtieth time and other odd bits of advice, but nevertheless, from the data, it appears that people actually read the post when they get there. Therefore, in an attempt to inject a little more humor into what tends to be a humorless profession, I introduce part 2 to my essential life skills series.

Today’s piece of advice is to learn to think of the analysts that cover your company as your children. This may sound like an odd analogy, but in my experience, their behavior often mirrors that of my children when they were growing up. Consider the following behavior traits:

They all want to be first in line. Think about the fight to ask the first question on your conference calls. Think about how quickly they want to get notes out on First Call.

They all want your attention immediately. When an analyst calls, they are interested in getting the answers to the questions they have NOW, not according to your schedule. This certainly sounds like my children.

They all want you to love them best. The job of an analyst is to assemble pieces of information into an investment thesis, and they all want better information flow (their version of love) than anyone else.

Because they’ve been to school, they think they have all the answers. In the case of my children, it was grammar school, while in the case of analysts, it’s business school, but other than that, it’s pretty much the same. Actual practical experience doesn’t seem to count for much.

When it comes to finding out information, they prefer to be told rather than dig the facts out of a book. My children would always opt to try and have me give them the answers instead of looking it up in a textbook. All you have to do here is substitute Report on Form 10-K for textbook and you can see my point.

I could go on, but by now I think you understand the analogy. The question then becomes what parenting skills come into play as essential life skills for investor relations professionals?

First, just as you must love all your children equally, you must also love all the analysts that cover your company equally. There is no room for playing favorites. Many people will find this piece of advice difficult to follow, because, just as with your children, every analyst has a different personality, some of which are nicer than others. Nevertheless, you must act like an adult here and be fair and consistent, even if the analyst has a sell rating on your company.

A corollary to this is that, just as you teach your children to respect others, you must also respect all analysts. Company investor relations officers often lose sight of the fact that analysts are pulled in many different directions by portfolio managers, hedge funds, research directors and the need to continually generate investment ideas. Compounding this you have a divergence of viewpoints – to most IR officers there is little difference between the company and its stock, whereas to an analyst this is a crucial difference. Because of this, a lack of respect for the work being done by the analyst can arise. An essential skill of an IR professional is to respect the work an analyst does regardless of their conclusions.

Finally, actions speak louder than words. It doesn’t matter how much philosophy you may preach to your children, if you don’t walk the talk, they will see right through you. The same is true of analysts. You have to be honest and straightforward in how you respond to their questions. If in discussing a topic, you fail to cover some essential points simply because the question asked wasn’t specific enough, your credibility will eventually suffer.

Although I could continue in this vein for an extended period, I have to stop now. My children are home for the holidays and I have to go break up a fight about who gets to use the car tonight…

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.

A Discounted Cash Flow View of Investor Relations

Every now and again, it’s helpful to stop and think about the frameworks in which investor relations operates. From a finance viewpoint, traditional academic finance approaches the valuation of a company along the following lines: “the value of a company is based upon investors’ estimates of the sum of its future cash flows, discounted back to their present value”. (Investors will often use earnings per share and dividends per share as proxies for cash flows.) The confidence that investors have in those estimates is based largely upon: 1. A company’s past performance as a measure of its ability to continue to perform, and 2. The investors’ view of the economy and the markets as expressed by the discount rate they assign to the cash flows. In other words, what drives the equation are estimates about the future, using the past record of the company as a reality check.

When you think about it this way, several interesting things about investor relations pop up. First, the equation is predicated on what will happen in the future, yet most of investor relations is spent explaining what occurred in the past, i.e. last quarter. So it’s important that proactive investor relations officers spend much of their time discussing what the firm is doing to insure future revenues and where the markets for their products are headed. If investor relations can’t, or won’t, explain how the firm intends to grow revenues, earnings and cash flows into the future, they shouldn’t expect investors to make that leap of faith for them. Companies that have to sell products or services will almost always have better forward-looking market data than investors. Judiciously sharing that data with investors will help them make better estimates. And by removing some uncertainties, it can help lower the discount rate assigned to the cash flows, which results in a higher present value.

Secondly, management matters. How can investors be expected to place large bets on your company’s future performance through the ownership of stock, if they haven’t met and assessed management’s ability to continue to perform? Yet many investor relations departments view their roles as gatekeepers, only allowing access to management at limited times to favored investors. If you want to achieve fair valuation over the long haul, investors need to speak periodically with management. Investor relations departments can function to save management a lot of time by making sure investors understand the company before seeing management and by covering what I would characterize as “routine maintenance” questions, but eventually, investors need to hear directly from the management team to see if they have a grasp on strategy, details, customers and markets.

Third, consistent profitability over the life of the investment will be more valuable than big profits in the out years of the investment, because they will be discounted less and will help compound earnings projections in later years. Consistency will also help investors assign lower discount rates to future cash flows, as they are much more comfortable projecting based on visible trends than they are if your earnings are all over the map.

So why then does everyone make such a fuss about the most recent results, and why do the short-term results seem to have such an outsized influence on the stock price? The answer, quite simply, is “Because that’s the way the math works”. (When my kids were struggling with math in grammar school I used to tell them that all of life was a math problem – this is a perfect example.) If, based on recent results, an analyst reduces their estimate for the first year of a five year model, not only does the reduction count for more because it is almost entirely undiscounted, but it will reduce estimates in future years, as the models are constructed to build and compound on previous years. Further, if the model is taking dividends into account by estimating them as a percentage of earnings, it will reduce all subsequent dividends as well. Conversely, changes made to estimates in the later years of a model have a much smaller effect on estimated present value and the price investors will pay for a company’s stock.

To put all of this in perspective, smart investors are betting on your future success, and that’s where the bulk of investor relations communication should be. But don’t neglect to adequately explain current earnings because if you don’t, and estimates are too low in the early years of investors’ earnings models, the perceived value of your firm will wind up being too low.

In other words, the ability to adequately explain current and past performance creates the foundation necessary for investors to understand a company, but helping them understand the basis for future profitability is the structure they need for estimating a fair value for your stock.