Used Car Auctions, Disclosure and Investor Relations

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

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

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

Moneyball for Investor Relations

I recently read Michael Lewis’ book Moneyball and was struck by some of the similarities between what it discusses and what commonly occurs in corporate investor relations. For those of you who may not have read the book or seen the movie, Moneyball is the story of Billy Beane, the general manager of the Oakland A’s baseball team who successfully positions his team to compete against teams with much larger payrolls than the Oakland A’s were able to afford. He does this by going against conventional wisdom and finding players that do not fit the establishment’s idea of what a professional ballplayer looks like but who contribute to winning in ways the establishment doesn’t value. In essence, the normal way of viewing these players allows their salaries to be mispriced in the marketplace and a general manager that appreciates this can assemble a winning team for considerably less money. (The football equivalent of this phenomena is Tim Tebow, who does not fit pro football’s concept of what a professional quarterback looks like or does. All he does is win yet the Denver Broncos seemingly couldn’t get rid of him fast enough.)

In investor relations, corporations are constantly applying conventional wisdom to their detriment, which in their case means that the value of their stock suffers. Take, for example, the following statement: “This is what the regulations require us to disclose, and therefore that’s all we are going to say”. This is what I call the regulatory mindset trap. The regulations describe the minimum disclosure requirements, but they don’t tell you to put it in context, or to make it intelligible. Anyone who has ever tried to parse through statements in annual reports dealing with deferred tax accounting or pension accounting can tell you that it is very difficult to make heads or tails of these sections without help from the company. In academic terms, when companies do this, they raise the cost of acquiring the information. This is because investors have to devote more resources towards understanding the information. Further, it also raises the specter of asymmetric information, that is, the information gap between what management knows and what it allows investors to know. Studies have shown that both increasing the cost of acquiring information and high information asymmetry will increase the cost of capital by lowering liquidity in the company’s shares.

Or consider the conventional wisdom that causes companies that take the position, “We simply report what we have done, and we leave it to the investors to figure out what our performance will look like in the future.” When you consider that the value of your company’s stock is equal to the sum of its future cash flows, discounted back to a present value (this is Finance 101), not discussing the future is obviously leaving off a critical piece of information. Investors will then make their own forecasts, whether a company helps them or not.  The forecasts then become harder to make and carry a greater degree of uncertainty without some input from the company. As a result, future values will be discounted to a greater degree, leading to lower stock prices.

So the investor relations thought for the week is that if you hear someone at your company say, “We can’t say that” or “We’ve never disclosed that”, question the conventional wisdom. Your stock could be mispriced simply because investors don’t have the right information needed to make an informed decision about the stock.

What You Don’t Say Can Hurt You

Back when I was an attorney, I used to have to negotiate a fair number of documents.  When I was doing this, there was an unwritten rule that said that if you had the choice between drafting the document or reviewing it, you always elected to draft the document.  The reason for this was that in writing the document you could control what went in and what got left out.  The hardest thing in reviewing a document is figuring out what’s not in the document that should be there.  We always tend to focus on what’s said instead of what is not said. 

 

In the realm of investor relations, corporations start at an advantage over investors.  Corporations almost always control the flow of information, choosing what they will say and staying silent on many items that don’t favor them.  It then falls to investors to attempt to get the corporation to speak on those issues, if they are tuned in enough to realize that the corporation is staying silent.  Alternatively, investors can parse through oblique and obscure references contained in the company’s press releases, regulatory filings and other commentary to try and triangulate the data in order to figure out what’s going on.  Companies hate it when analysts do this and often claim the analyst has got the analysis wrong, but by trying to hide the data, companies get themselves into this pickle.

 

For example, let’s take a hypothetical example of a company that in a conference call talks about having “nearly 50,000 employees”.  Thinking this number sounds different, an analyst starts to dig back through records until he finds the next most recent reference to employee count, in a 10-K filing from a year ago, a reference to the company having 50,900 employees.  It would appear that the company has reduced their employee count by about 1,000 people over the course of the year, but have never mentioned layoffs, hiring freezes or reductions in force.  It may sound like a lot, something that the company should be forthcoming about, yet they have remained silent over the past year.  Have they fulfilled their obligation to disclose by the obscure reference to “nearly 50,000 employees”?  Maybe there is a good reason for the lower headcount – a facility or two may have been shut down or consolidated, more efficient operations, or something else, but the investors are purposely being kept in the dark, so the logical explanation is that the company is trying to hide something, and that something is bad news – layoffs and firings.

 

Now let’s have some more fun with this hypothetical and say that the company has recently opened a new distribution center in the last quarter, one of a series that is designed to change the manner that the company gets product to market.  But their quarterly press release doesn’t say anything about the new facility, which cost many millions of dollars, nor does it say anything about the remaining distribution centers to be built.  If an investor is savvy enough to notice this silence, how are they likely to interpret it?  That things are great, but the company just didn’t feel like talking about the project?  Possible, but not likely; it’s much more probable that an analyst will conclude that the company is hiding something they would rather not talk about.  Investors will assume that if the news was good, the company would naturally talk about it.  Even if the project is going great guns, the company, by remaining silent, puts a negative inference on it. 

 

Companies constantly accuse analysts and investors of having a short-term focus.  Yet companies themselves are extremely guilty of engaging in selective, short-term dissemination of information.  The process goes like this: “If it’s good news, we’re happy to talk about it until the cows come home.  If it’s bad news, you won’t hear a peep out of us unless someone is holding a gun to our heads and forcing us to disclose.”  In other words, good news is long term; bad news is short term.  I’ve written about this before in the context of Starbuck’s same –store sales; they didn’t stop disclosing them until they started to look weak. 

 

The investor relations profession needs to start thinking in terms of standards:  if something is important enough to talk about when the news is good, it is also important enough to talk about when the news is less than good.  If you have important projects or metrics by which you measure your business, then the only way to build credibility is to report on them when the news is both good and bad.  Silence is not golden.  It may be permissible within the cockamamie regulatory system we have, but it will not make the market more efficient, nor will it add to the long-term valuation of your firm.  

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.

The Academic Side (or Lack Thereof) of Investor Relations

I’m happy to report that I have recently been appointed a lecturer in management to teach a class on investor relations at the Jones Graduate School of Management at Rice University. Teaching is something I’ve wanted to do since leaving the corporate world about eight months ago, so I’m delighted to have this opportunity, especially at an institution of the caliber of Rice.

Once the first blush of enthusiasm wore off, I started thinking about how to teach the class. Naturally, I immediately decided to do what all investor relations people do, which is to engage in peer comparisons. (Gale Wiley, the teacher of this class at Rice in previous years, has been generous in his advice, but I also wanted to try to get a larger picture.) I freely admit that if I could find good classroom materials and case studies, I would use them, as I had no desire to recreate the wheel. (I prefer to think of this as good research, not copying or plagiarism.) It turns out that the course on investor relations taught at Rice is the only class taught to MBA students that I could find. Northwestern, where I went to business school, chooses to teach investor relations out of the Medill School of Journalism, but beyond that I have found no other graduate school programs. There are certificate programs at several universities and a number of stand alone seminars in the subject, but no other graduate school programs that I could find.

Naturally, this started me thinking, why does this subject sit in academic limbo? Every publicly traded company has to deal with investors and is intimately concerned with its stock price, yet most business schools assume that if you just sort of throw the accounting numbers out there, the market will price the stock efficiently. What this ignores is that the stock price is a discount of future cash flows, and much of the future depends on management and their plans for the future. It is very difficult to figure much of that out without seeing management, hearing what they have to say and placing it in context. To put it another way, past performance coupled with the perception of future performance translates into stock price. The role of investor relations is to provide information both about why past performance was the way it was and what the expectations are for the future. Any finance professor will tell you that lack of information or asymmetric information leads to inefficient markets, so to put an academic spin on it, the role of investor relations is to make the market operate more efficiently by providing more information.

So perhaps this is the start of a campaign to bring more academic respectability to investor relations. When you think about the total value of stocks traded every day, it might make sense to pay a bit more attention to how information gets from companies to investors and the effect that has on investor behavior. On the other hand, it just might be the start for me of a long slide into academically obscure topics. Perhaps “Multidimensional Aspects of Asymmetric Information Flows Between Companies and Investors in the Equity Markets” would be a starting point.