Monday, July 7, 2008

The Ten Percent Rule

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

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

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

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

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

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

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

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

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

No comments: