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.

Principle Based Disclosure for Investors

I’ve been thinking lately about the relationship between shareholders and company managements. The owners of a company are the shareholders. In a large publicly held company these shareholders are widely disbursed and do not have the capacity to manage the business. Company managers, on the other hand, are on the spot, relatively few in number and charged with running the company for the benefit of shareholders, although they own only a very small fraction of the company. In business school they refer to this as agency theory – management will act as agents for the benefit of the shareholders by running the company for them.

All of this is fine in theory, but unfortunately things seem to get muddled in practice. In reality, management tends to think of the corporation as “Mine” and shareholders who don’t like it can sell their shares and look for investments elsewhere. How else can you explain the outsized pay packages you see among America’s corporations today? Do you really think that multimillion-dollar compensation schemes unrelated to corporate performance are in the best interest of the owners? Or would it be more realistic to say that such pay packages are for the benefit of management?

Now, at about this point you may be asking, “What has this got to do with investor relations?” Well, I think there is a connection between the way management thinks and acts towards its owners and how they disclose information to their investors. If company managements think of the company as their own, they tend to view disclosure as simply a bothersome regulatory requirement. Management divulges exactly what the laws and regulations require, and not a single iota more. Given the standards of materiality outlined in current case law, this can leave an awful lot to the imagination.

On the other hand, what would be the outcome if management were to think of those pesky shareholders as owners? Perhaps they would be more forthcoming with information above and beyond the requirements of the regulations. A willingness to report on and continuously disclose information (either good or bad) about operations and initiatives would help the owners understand their investment with more clarity.

Here’s a quick example: Companies track their sales in a variety of ways, by customer type, geographically and by product type to name a few. Yet there is often a strong reluctance to share any of that information with shareholders. You hear a variety of excuses – proprietary information, don’t want competitors to know, if we discuss it the SEC will make us always disclose it, etc., but the fact of the matter is that companies don’t disclose such information because they’re not required to by regulation. Yet the managers sure want to know, so why wouldn’t the owners also want to know? You can bet that if the company were owned by private equity, the information would be available to the owners.

The point here is that disclosure of information should be principle based, not simply governed by regulation. The principle should be “The company will endeavor to continuously present all significant information to shareholders to enable them to make informed decisions regarding ownership of the securities of the company.” There are two concepts of note embedded in the principle: continuous and significant. Continuous should mean something more timely than quarterly, perhaps monthly. Every company I have known has a series of key metrics they track frequently, if not daily. Frequent updates of such information would be of great value to shareholders. Secondly. I would make the definition of “significant” considerably lower than materiality is today. There are many things going on at companies today which don’t by themselves rise to the level of materiality, but which have the potential to greatly affect the future profitability of the company. Shareholders should know about both the successes and the failures so they can make informed decisions.

The accounting rules and the regulatory scheme in place today are too complex and allow companies to hide behind the complexity. We need the emergence of some very simple principles to guide the disclosure of information. Just as in the old Federal Express commercials, those principles need to be simple enough so that even the CEO can understand them.