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.

A Dive Into Dark Pools

Earlier this week the luncheon topic for the NIRI Houston chapter was “Dark Pools”. This is a subject that has received much press lately, most of it with ominous overtones to accompany the rather sinister name, so I went with much anticipation, much like you’d go to a scary movie. I have to confess that I knew very little about all of this before I went, and when the luncheon was done, I was more confused than ever. So on the premise that I can’t be the only one who is confused, I decided to do a little more research and, at the expense of stretching a metaphor, try and shed some light on Dark Pools.

First, what are these things? As I understand it, a Dark Pool is an electronic crossing network that allows buyers and sellers of stock to place liquidity (an offer to buy or sell) into a pool anonomously and wait for execution while disclosing little, if any, information. Only when an order is executed is the information on the trade made public. To use a phrase from Bruce Springsteen, these market participants are “Dancing in the Dark”. This is in contrast to normal markets where public order flow allows market participants to judge supply and demand for a stock and adjust accordingly.

Second, are these things inherently good or bad? The ostensible purpose of Dark Pools is to allow holders of large blocks of stock to execute their buy or sell orders without indicating to the markets what they intend to do. Therefore Sellers can sell without driving the price down and buyers can buy without driving the price up. The pricing is done within the Best Bid or Offer context of the National Market System, so price discovery is occurring using normal market systems. This seems like a good thing if you are a large institution looking to move large blocks of stock. Additionally, if you are looking to buy or sell a relatively illiquid stock, dark pools can help you do so with a minimum of price disruption. If you are a company, it would seem that this balances itself out, especially when you consider that institutional investors trade approximately 80% of the stock volume in the U.S.

Third, why the big deal about all of this? Follow the money. The Exchanges – NYSE and NASDAQ, hate these things because they pull significant amounts of orders off the exchanges, which means less order flow and less earnings for them. Traders and specialists hate them because they obscure market information and eliminate trades that they would otherwise execute by putting it all into a machine. This eliminates both the lifeblood of traders – information – and jobs. So much volume has come off the floor of the NYSE that there are significantly fewer traders these days and they have been forced to close trading rooms.

Finally, are there things that should be of concern? If too much volume comes off of the visible Bid/Ask market system, the bids and offers shown on the publicly displayed market quotation system might not accurately reflect true supply and demand. This is why we are seeing rumblings by the SEC to regulate areas of dark pools if too much volume is traded in them. (The nature of regulators is to regulate.) While dark pools are good for large institutional investors moving large blocks of stocks and companies that trade using sophisticated algorithms, it is considerably less clear that they offer any benefit for anyone else.

I think what is happening here is that technology is opening up new channels for trading and moving things away from the old duopoly of the NYSE – NASDAQ. As they are the ones with the most to lose, they are also the ones that will yell loudest. At the end of it all, the lesson is that not all investors are equally suited to all markets. With the emergence of several new ways to trade stocks we are moving away from a “two markets fits all” approach to customized execution based upon the needs of the investor. Many permutations on order execution are bound to follow. The exchanges better figure out how they fit into all of this or they will be left behind.

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.

Stock Ratings from Lake Wobegon

Today’s New York Times reports that Merrill Lynch unveiled a new rating system that requires their equity analysts to assign “Underperform” ratings to 20 percent of the stocks they cover.  As a lead-in to the article, the authors refer to the Lake Wobegon quality of stock ratings – most stocks are rated above average.  (For those of you who are not familiar with Lake Wobegon, it is the fictional town in Minnesota featured in Garrison Keillor’s Prairie Home Companion radio show.  Each week Garrison Keillor reports the “News from Lake Wobegon” and finishes with the tag line, “That’s the news from Lake Wobegon, where all the women are strong, the men are good looking and all of the children are above average”.)  The article goes on to cite Bloomberg data to the effect that only about 5 percent of all stock recommendations on Wall Street fall into the “Sell/Underperform” category.

 

Now, I could have a lot of fun with this, as clearly, far more than 5 percent of all stocks are going to underperform.  Even if you throw in a “Neutral” category, a normalized distribution would require far more than 5 percent “Underperforms”, even adjusting for the market’s tendency to rise over time.  But that would be too easy.  So what I want to do is examine the reasons “Outperform/Buy” so dominate the world of stock ratings and “Underperform/Sell” is so rarely seen.  After all, it’s not like all these MBAs suddenly become Pollyannas when they get assigned to equity research.  This is Wall Street we’re talking about here, so cynicism is not in short supply.  Clearly, a different set of incentives is at work.

 

Quite simply, if an analyst puts a sell on a company stock, the company hates him, the long only investors that currently own the stock hate him, the long only investors that don’t own the stock aren’t going to buy it, and the firm’s investment bankers get really mad at him.  Only the short sellers will like the sell rating.

 

Understandably, if a company receives a sell rating from an analyst, they don’t like it.  Ratings changes can occur for a variety of reasons – valuation, fundamentals, sector or industry changes; but companies usually don’t care.  A common reaction by companies is to cut analysts off from corporate access.  Much as we like to think that analysts are engaged in independent research, much of their information surrounding formal disclosure comes from talking to the investor relations contact at the company.  Cut off this flow of information and deciphering the balance sheet and cash flow statements becomes much more difficult.  The analyst will also find that the probability of their being able to ask a question early in a company conference call is remote.  Companies control the order of the question queue and they are not going to feature an analyst with a sell rating as the first questioner on the call.

 

Further, much of what the Buy Side values from the Sell Side these days is access to management.  Just try arranging a trip to company headquarters for your clients if you have a sell on the stock.  If you’re an investor relations officer with more requests for meetings than you can handle, think about trying to convince your management to take a meeting for someone who has a sell on the stock – the same person whose name your CEO mentions only in combination with an expletive.  There are better ways to spend your day. 

 

As to the Buy Side of the equation, if a firm owns a stock, they’ve made a commitment to it and have often invested a lot of research in it (not to mention that they often become emotionally attached to it as well).  Then along comes a Sell Side analyst and tells them they’re wrong.  The Sell rating may have already caused the stock to decline, plus he’s making either the Buy Side analyst, the portfolio manager, or both, look bad.  This is a situation that can cause conflict and strife.  Plus the commission flow from the Buy Side firm is likely to decline because they're mad at the analyst, which will antagonize the Sell Side firm's sales force and trading desk.

 

Finally, investment bankers really don’t like it when they’ve invested weeks, months or years trying to build a relationship with a company, only to have an analyst rain their parade by putting a sell on the company stock.  There may be a theoretical Chinese wall between investment banking and research, but don’t think that company managements give a hoot about that.  A sell rating stands a good chance of tainting the whole firm, thus jeopardizing all those juicy M&A and underwriting fees.

 

Is it any wonder there are so few sell ratings?  The incentives are all going the other way.  It’s just too painful to put out a sell rating, which is why you usually see them only after the stock has already collapsed or on companies that are small and don’t command much respect when it comes to fee generating abilities.

 

I’ve been thinking about alternatives to the way stocks are rated, but I’m going to save it for another post.  I’ve got to go – my broker just called with a great buy rated stock

More information is Better; Less Information is Bad

Yesterday The New York Times ran a story in its Business section entitled, “Retailers Get Stingy With Data”.  The gist of the story was that an increasing number of national retail chains are abandoning their long standing practice of reporting monthly sales and forecasting annual profits (providing earnings guidance).  It seems the chains think that such information encourages short-term decision-making and can confuse investors.

Of course, I suppose it’s only coincidence that they have come to these conclusions just when the economy is softening and consumers are spending less.  Everyone knows that sales numbers are not confusing when they are going up, it’s only when they start to head down that they can lead the poor unsophisticated Wall Street MBAs astray.  Further, by eliminating monthly sales reporting do they really think that they are encouraging longer term decision-making?  They still have to report sales on a quarterly basis, and I’ve never heard a CEO say that quarterly performance is long term.  It could be that they are engaged in the practice of hoping they can recover from one bad month’s sales in a quarter with a stellar performance in the other two months.  I’ve actually had a CEO tell me, “We don’t report monthly sales because our business can turn around so fast”.  Of course, this same CEO also said, “We’re a big company and trying to turn things around is like trying to turn a battleship”.  I don’t think you can have it both ways.

My favorite quote from the article is from a Macy’s executive talking about sales numbers being skewed by calendar shifts: “The numbers are increasingly confusing because of the calendar shifts”.  That darn calendar just gets more and more confusing every year. 

What it boils down to is this: when things look good, company managements don’t mind investors being well informed because it will help the stock price.  When things look bad, management would prefer that investors be kept in the dark for as long as possible, so that the bad news won’t impact the stock price and maybe they can fix things in the interim. As a Catholic, this reminds me of some of my early theological training.  Hoping for a miracle almost never works; it is better to confess your sins and shortcomings and ask for forgiveness.

In the long run, a company’s ability to generate earnings and cash flow will determine how its stock is valued.  In evaluating earnings and cash flows investors will consider their confidence in the data they are receiving, the clarity and quality of the information given, and the history and consistency of the data.  Eliminating data just at a time when investors need more information to separate companies that can perform well in a slowing economy from those that can’t is classic short-term thinking by management.

Investor Relations Year in Review

Like Jimmy Buffet, I sat down last weekend just to try and recall the whole year; all of the faces and all of the places, wondering where they all disappeared. Unfortunately, unlike Jimmy, I didn’t run into a chum with a bottle of rum, so I wound up sitting right here. Writing this post, I may add. Herewith a quick review of some of the more notable things I noticed in the world of investor relations this year coupled with Palizza’s Predictions for 2008:

The World is Going Electronic: The SEC ushered in the era of more aggressive electronic delivery of proxy materials in 2007. Previously, shareholders could opt-in for electronic delivery of the proxy statement and annual report. Relatively few did. Now, companies can force them to opt out of electronic delivery. The first big annual report season for this new delivery method will occur in the Spring of 2008, and given the cost savings in printing and postage involved, most companies will make economically rational decisions and force shareholders to take action if they want to receive a paper copy of the annual report. After all, investor relations reports to the CFO, not marketing. Annual report printers everywhere have to be very concerned about the disappearance of the traditional printed annual report. Companies will like the cost savings and designers of annual reports should be neutral on the subject.

Hedge Funds and Activist Investors have a Bifurcated Year. The first half of the year saw lots of activity by hedge funds and activist investors. Deals were easy to come by and the credit markets were loose. Company managements were always looking over their shoulders to see who was sniffing around. All of this came to a screeching halt in the second half of the year as the sub-prime mortgage crisis caused the credit markets to lock up. Companies that have been underperforming or that are particularly subject to financial engineering because they have underleveraged balance sheets have gained a bit of breathing room. If they’re lucky, investor relations officers will be able to focus more on the longer term fundamentals and less on the short term trading trends in 2008.

A Corollary to the Credit Crunch: Look for the M & A pendulum to swing back in favor of strategic corporate purchasers over the next year or two, until the credit hangover eases. Of course, corporate purchasers will have to try and overcome the heightened price expectation of sellers who have seen the multiples financial buyers paid over the past few years. That should make for some interesting investor relations spiels from IROs as they attempt to justify the price being paid.

The U.S. Dollar weakened throughout the year against the British Pound and the Euro. U.S. equities must look like relative bargains to investors in Europe. On the other hand, whatever gains European investors had in U.S. equities this year were probably wiped out by currency conversions back into the Pound or the Euro. (The market giveth, and the market taketh away.) Look for more interest in U.S. equities from European investors in 2008 provided they start to think the U.S. dollar is at or near the end of its slide.

Four predictions is about all I can handle, so I will close out with best wishes for a happy holiday season for all and a prosperous new year. May the markets be kind to you in 2008!

What the World Equity Markets are Telling the U. S.

Last week I conducted a workshop on investor relations in Singapore for Asian companies. It has underscored for me the fact that we live in an increasingly global village. Yes, there are cultural differences. There are also time and distance differences that sometimes make communication difficult, but the process of transferring information from companies to investors seems to be remarkably similar worldwide.

We now have publicly listed companies in spots such as China and Vietnam. These are economies that did not even acknowledge the benefits of capitalism just a short time ago. I don’t know why, but it came as a revelation to me that companies in these countries worry about much the same things that investor relations officers do here in the U. S. – being undervalued relative to their peers and the index, managements that expect everyone to love their stock, how to measure the effectiveness of IR, and hedge funds, to name a few topics. There are differences – some of the companies I spoke with had relatively low levels of public float and a number of markets were heavily influenced by speculative individual investors, leading to volatile stock price movements. My impression, however, was that many of the differences related to the equity markets being younger, and that as the markets mature and deepen, with greater levels of liquidity and professional investors, most of the differences will work themselves out of the market.

One fact came through loud and clear however – none of the companies I spoke with were listed on a U. S. exchange, and further, none of them had any remote desire to list in the U. S. The reason universally cited was Sarbanes – Oxley. None of the companies wanted to voluntarily undertake the regulatory burden imposed by the legislation. Not so long ago, it used to be that listing in the U. S. was a sign that a company had truly arrived. Today, there are growing alternatives to the U. S. markets, including Hong Kong and London, which have more attractive regulatory environments. According to the Wall Street Journal last week, more IPOs have been filed this year in London than in the U.S. (although the U.S. is slightly ahead in dollar volume of deals).

I’m not in favor of a regulatory race to the bottom, but if seems to me that the U. S. has priced itself out of the equity listings market through the increased cost of compliance with our regulations. Clearly, the rest of the world is telling us that the increased security achieved through the oversight and controls required by Sarbanes – Oxley does not justify the increased cost. To put it another way, there would have to be a tangible benefit, shown by a premium to stock valuations for companies subject to Sarbanes - Oxley in order to justify the increased cost of complying with the regulations. Companies are not seeing it, and are taking their listings elsewhere. If the U.S. intends to remain a leader in the world equity markets, it needs to take a hard look at Sarbanes – Oxley.