Stop the Earnings Guidance Madness

The subject of issuing earnings guidance is one for constant hand wringing by companies, analysts, commentators and even the National Investor Relations Institute.  Companies hate it, because their stock gets hammered if they miss their guidance by so much as a penny.  Analysts hate it because if they follow a company’s guidance and it turns out to be wrong, they feel duped.  On the other hand, if the analyst goes their own way and publishes an EPS forecast outside the company’s range, there is a good chance the company will either treat him as if he’s crazy, or nag him until he comes in line with the consensus. Reams of studies have been conducted about all of this, generally stating that the process puts too much focus on short-term quarterly results.

With all of this floating around, I thought that I would take a shot at bringing some light to the topic.  First, consider that analysts are not going to stop making estimates for quarterly earnings by companies just because companies stop giving earnings guidance.  Public companies in the United States report on a quarterly basis and, therefore, analysts will make earnings estimates on a quarterly basis, whether companies issue guidance or not. 

Further, whether or not a company issues earnings guidance has little to no effect on the pressure it feels to report good quarterly earnings.  To paraphrase one of my least favorite presidents, “It’s the earnings, stupid”. Companies that do not issue guidance feel pressure to hit the consensus earnings number that is every bit as intense as the pressure felt by companies to hit their guidance number. 

When the economy gets dicey, as it is now, issuing EPS forecasts becomes particularly hazardous.  When companies issue guidance, they almost never want to appear too downbeat, as it will act as an overhang on the company’s stock price for the foreseeable future.  So you usually get “cautiously optimistic” forecasts, which the company winds up revising downward as the year progresses.  Neither situation is good for the company.

So here’s my proposal – I call it “Less and More”.  Companies should give less in the way of specific EPS guidance; in fact, they should eliminate quarterly EPS guidance altogether.  In its place, I would suggest companies issue long term goals: revenue growth, key return criteria such as Return on Equity, Assets or Capital, the planned improvement in earnings growth and the manner in which they see achieving their goals, be it margin improvements, cost containment or simple growth.  These goals would be issued as target averages, with the explanation that any given year could vary from the goal, but over time, the expectation would be to achieve the target. 

On the other hand, companies should issue more short-term information in order to allow the market to work more efficiently.  This would involve companies releasing key performance metrics on a regular monthly basis.  This information would be along the lines of sales, order backlogs, customer mix, product mix and other key information that would allow investors to better assess the current state of business.  This would modestly increase a company’s reporting burden, but it’s not as if companies don’t already have this information – they run the businesses based upon it.  If they don’t have the information on at least a quarterly basis, they should.  Key metrics consistently reported monthly would increase transparency and help eliminate surprises.  By supplying what they consider to be important information on a monthly basis companies can eliminate the “black box” syndrome where investors have no idea what is happening at the company in between quarters.

It’s not a perfect solution for all concerned – some analysts will not be happy unless they have a direct feed from the reporting company’s mainframe computer, while many managements will groan at the thought of telling the street more.  What it will help to achieve is a better balance between allowing a company to focus on its longer-term goals, while supplying the market with timely short-term information that progress is being made towards those goals.

What Makes for Great Investor Relations?

There was an interesting profile in this Sunday’s New York Times about Jim Collins, the author of a number of well known business books such as “Built to Last” and “Good to Great”.  One of the things that became apparent from the article was that Collins likes to ponder and write about big questions that interest him.  Naturally, after reading the article, I got to thinking about one of the big question that interests me, namely “What makes for great investor relations at companies?”

Over the years, I’ve read my fair share of business books, many of them with multi-step procedures for achieving greatness.  Frankly, I can’t remember most of them, so when I sat down to think about how to convey the essence of great investor relations, I decided to try to keep things simple.  When I was growing up, I used to listen to radio broadcasts of the New York Yankees baseball games.  They were sponsored by Ballantine Ale, and to this day I can still remember Mel Allen advising us that the three rings on the Ballantine label stood for “Purity, Body and Flavor”.  So I decided to try and boil down the attributes of great IR to three key items.  (This might also have something to do with my Catholic schooling – the trinity and all that - but I really don’t want to go there, and besides, I remember the beer commercials much more clearly.)

When I sat down to write out my list, three things immediately popped up: Honesty, Consistency and Knowledge.  

Honesty to me is the most important aspect of what good investor relations is all about.  Investors deserve nothing less.  The Securities laws try to mandate honesty, but what I’m talking about is HONESTY.  If you always deal honestly and forthrightly with investors, it might be painful at times, but you will always be able to look yourself in the mirror.  Further, investors will come to believe you, which will pay rich dividends when things get rough, and the valuation of your firm will more accurately reflect its intrinsic value.

Some people like to think of investor relations as an advocacy position, similar to the way our trial system works.  The thinking is that IROs present the party line and then it is up to analysts and investors to challenge the story, with the truth coming out as a result of the process.  Unfortunately, this also means that you are training investors to believe that there is a significant other side to the story, which the investor relations department is concealing from them.  In my opinion, it is better to acknowledge the other side of the story, the potential issues that your company may face and admit to some of the things your company might be able to do better.  In the long run, investors will give much more credence to your story.

Consistency is next on my list because investors keep notes.  If you are talking to someone about the latest quarter’s results, chances are very good that they have in front of them their notes from the same quarter last year.  Nothing drives investors crazy faster than changing your story or the way you present data or, heaven forbid, the way you calculate your data.  It doesn’t matter if you do it for the purest of reasons – investors will always assume the worst, because they’ve seen many examples of data being manipulated to favor management.  Having a comprehensive set of metrics about your business that you report consistently, quarter in and quarter out, will gain you a lot of traction with investors.

The same principle also applies to the way a company deals on the human side with analysts – consistency in the way you work with analysts day in and day out will earn respect over the long haul.  This means no favorites, no disparaging of analysts with a sell recommendation and equal opportunities for access to management.

Finally, knowledge.  Analysts don’t call up investor relations officers to learn something they already know.  At least, they hope they don’t.  They call because they are attempting to understand what goes beyond the contents of the press release or 10K filing.  This means that the good investor relations officer will be an expert, not only on his company, its accounting systems, its culture and its markets, but also on his industry.  The ability to put developments in context, both for your company and for the bigger picture, will assure that investors will call you before they call the trading desk to place a sell order.

So, with a nod to Ballantine Ale and Mel Allen, the greatest voice in baseball broadcasting, there you have it:  Honesty, Consistency and Knowledge.  Now I think I’ll slip off and have a cold one…

Helping Filter Out the Noise

One of my favorite sayings about Wall Street is: “Over the short term, the market is a popularity contest, while over the long term the market is a discounting machine”.  What this means is that on a day-to-day basis stock prices react to all sorts of noise in the system, whether it’s fears about swine flu or the current political mood of the country, while over the long term stock prices tend to reflect the market’s view of the value of the company’s stream of future cash flows, the intrinsic value of the company.

Fayez Sarofim, one of the great long-term investors of the last fifty years, puts another spin on this.  He says, “Nervous energy is a great destroyer of wealth”, and illustrates the statement with the chart I’ve reproduced below.  

Assuming that a firm’s value rises over time (we are, after all, talking about well run firms here), an investor can potentially lose a lot of money by buying or selling based upon the latest short-term market reactions.  The patient, well-disciplined long-term investor can avoid those pitfalls and the associated trading costs that accompany them by focusing on the intrinsic value of the company.

The holy grail of investor relations is the patient, long-term investor who sees the value of management’s longer-term investments in the business and is willing to let them play out over time.  Unfortunately, in investor relations we spend 95% of our time responding to the other investors, so that’s where I’m going to direct my remarks.  One of the jobs of good investor relations is to engage in the IR version of damage control – responding to the market gyrations and the concern du jour; the large rises and drops represented by the dotted line in the graph.  Good investor relations seeks to squeeze out the volatility of the ups and downs of the market concerns by giving investors a full and complete picture of the company’s intrinsic value so that market value can more closely match intrinsic value. 

This means several things:  First, providing clarity to the numbers.  Mandated disclosure filings are good at telling investors what happened, but less good at explaining why they happened.  A good investor relations officer will fill in the gaps.  Secondly, investor relations can provide context to what is going on.  Many analysts following companies today don’t have a long history covering the company, whereas management has usually been there a long time.  Providing historical context can be very helpful. 

Here’s a case in point:  Recently, Walgreens has announced that it is testing a program to reduce the product assortment in its stores.  The thought process is that by reducing clutter on the store shelves, the company can more prominently feature key items and sales will go up, even though there are fewer items in the store.  Not surprisingly, this assertion has met with some skepticism in the investing community.  Yet Walgreens has an example in its own recent past that proves their thesis.  Back in the early 1990’s Walgreens reduced the number of newspaper advertisements it was running from two per week to one.  Everyone (including company management) thought that sales would go down, but instead, sales increased because better items and ads resulted from the reduced clutter.  If Walgreens were to provide such context to investors, it could mitigate some of the doubts being voiced (you will never eliminate them entirely – this is, after all, Wall Street we’re talking about).

Third, and as important as the other two items combined, good investor relations dampens volatility by providing credibility for the company.  This comes in a variety of forms, whether it’s access to management, consistency and even-handedness in how, when and where disclosure is accomplished or doing what the company says it will do, to name a few.  Every IR officer that has been around for a while has experienced situations where the stock suddenly plunges (or, less frequently, rises) and their ability to say much is severely constrained by the circumstances.   If you have credibility, investors will tend to give you the benefit of the doubt and give less credence to the rumors swirling about.

So that’s it in a nutshell:  lessen the noise, squeeze out the volatility and get your market value in line with your intrinsic value.  Simple, eh?

Getting My Act Together and Taking It on the Road

Over the past two months I’ve been in the active phase of teaching my course on investor relations at the Jones Graduate School of Management at Rice University.  It’s something I really enjoy - combining academic pursuits with the realities of Wall Street and how companies interact with investors.  With the term over for the year, I’ve had a chance to step back and reflect upon the state of education for practitioners of investor relations in the real world. The conclusion I come to is that the profession has a scattershot approach to teaching the fundamentals of IR.  The seminars, conferences and courses that I have seen on the subject are, in my opinion, too expensive, both in cost and participants’ time.  Further, they are usually taught either by volunteer practitioners on an ad hoc basis, or in rare cases, by business school academics with very little experience in the real world.  The result is a very uneven learning experience.

One of the great things about capitalism is that if there is a market that is underserved, a product or service will arise to fill the need.  In this case, I propose to fill the gap in the investor relations education market by offering seminars for the profession.  Over the course of a thirty-year career, I have been involved in investor relations as a lawyer, a corporate practitioner, an officer of a buy side firm and an educator.   As a result I believe that I bring a unique blend of practical experience, knowledge and teaching experience to the field.  The seminars I plan to offer will build upon the lectures and textbook I developed for my investor relations class but will be very practical rather than academic in their content. 

The first seminar I have developed is “The Fundamentals of Investor Relations” and is aimed at the person who is relatively new to IR or who has been in the job for a short period of time and wants to make sure they have covered all the bases.  I believe that the basics of investor relations can be taught in an intensive one-day seminar at a modest cost ($300 - $400 per person, depending on location) and further, in order to be respectful of people’s time by eliminating travel, I think that the seminar ought to come to the students’ home market.  In short, I propose to offer a first rate educational experience in an efficient manner at a reasonable cost.  A second seminar, currently in the planning stages, would be for more seasoned practitioners and would feature “Best Practices in Investor Relations”.

So much for the sales pitch.  What I really need now is some input from my readers concerning your interest levels and where you might be.  Additionally, if you are a service provider and think this is something your clients might have an interest in, I’d love to hear from you.  This could be an opportunity for you to reach out and offer them something unique and a little out of the ordinary.  Please email me at john@palizzapartners.com.  I look forward to hearing from you.   

A Jaded View of Investor Relations

Last week my investor relations class at Rice was privileged to have Rob Rohn, a principal with Sustainable Growth Advisors, come in and talk about what investor relations looks like from the Buy Side.  Rob has been in the business of investment management for over twenty years at some great money manager shops and has a wealth of experience trying to parse through what companies are really saying.  Rob started the class with a short tongue in cheek piece he titled “Jaded View of IR” that I thought was worth sharing with a larger audience.  Herewith, accompanied by a few explanatory notes is what Rob presented: 

The textbook I wrote for the Investor Relations class defines investor relations as follows:

“Investor relations is the process of a company conveying appropriate information to investors in order to allow them to make an informed investment decision regarding that company.”

Rob’s impression of how many investor relations people see their function:

Investor Relations is the art of selling the story without providing useful information while guarding the door to senior management.

Rob then went on to explain how to translate statements form management:

Management: “We are in a challenging environment”

What this really means: Business sucks.

 

Management: “We have not changed our earnings guidance”

What this really means: We might have to lower guidance.

 

Management: “Because of the uncertain environment we are suspending guidance”

What this really means: It’s getting worse.

 

Management: “We see signs of stabilization”

What this really means: It still sucks.

 

Management: “We see opportunities for efficiency improvements”

What this really means: Big write-offs and lay-offs are coming.

 

Before everyone gets offended and huffy about someone dissing the profession, please understand that these remarks were intended as tongue in cheek and I, for one, thought they were pretty funny.  Goodness knows we can all stand a dose of humor during these tough economic times.  Also, just to add my two cents, I think there is more than a kernel of truth to much of what Rob says.  Investor relations people often spend a lot of time and energy trying to put the best face on things, particularly when writing press releases.  This is just a reminder that we’re probably not fooling anyone, particularly not the professional investors.

A Gordian Knot – Investor Relations, Laws, Regulations and Case Laws

The academic part of my year is currently in full swing and that, combined with my other commitments, has caused me to fall behind on my musings. My apologies to those of you who have been eagerly awaiting yet another installment, but as a rational economic person, I’m going to do those things first which pay me, and frankly, this blog is never going to replenish my ravaged 401(K) account.  That being said, it was while I was preparing for one of this week’s classes that the idea for this post occurred to me.

One of my class topics this week focuses on the legal and regulatory framework surrounding investor relations.  It’s not a subject that business school students are naturally attracted to, but it is something that everyone involved in investor relations needs to master.  Back in the 60’s, there was a band by the name of Zager and Evans whose one and only hit was “In the Year 2525” which had the line in it, “Everything you think, do and say, is in the pill you took today”.  Which is a pretty good way to think about the laws and regulations surrounding investor relations – everything you think, do and say is governed by them.

One of the points I try to make in my class is that the laws and regulations surrounding IR are not the result of a coherent codification of the laws, cut from whole cloth.  Rather they have grown and evolved over time, from statutes, regulatory rule making and case law decisions.  The resulting Gordian Knot of laws, rules and case law is enough to send joy to the hearts of lawyers everywhere and give everyone else headaches.  Further, each is enacted from a different set of circumstances.

Statutes, for example, are usually enacted to stop some form of abuse.  This was true of the original securities protection acts, the state “Blue Sky” laws, and it continued to be true with the enactment of the Securities Act of 1933 and the Securities Exchange Act of 1934, which were enacted following the stock market abuses of the 1920s.  More recently, the Securities Litigation Reform Act of 1995 was enacted to curb abusive securities law class action claims and the Sarbanes-Oxley Act was passed by Congress in reaction to the Enron, Adelphia, MCI and Tyco scandals. Those of you who are looking for a common theme among these acts would do well to take up a different hobby. I suggest something much easier – say, along the lines of solving The New York Times Saturday crossword puzzle.

On the regulatory side, I find that the regulations that get enacted by the SEC tend to have a political background to them.  Take, for example, the disclosures surrounding executive compensation in the proxy statement.  As executive compensation has swelled, political pressure has built up, which has resulted in the SEC layering in more and more disclosure regulations surrounding executive pay.  Way back in the dark ages (the 1970s) when I was actually writing proxy statements, it was not unusual for them to be no longer than 8 – 12 pages.  Today, between tables, graphs, Compensation Committee and other reports, Proxy Statements routinely run 4 – 5 times that length.  It has to be extremely frustrating for politicians and the regulators, because the more disclosure they require, the bigger the pay packages seem to get. I have no doubt that if they could have enacted compensation limits, they would have. But the SEC’s regulatory authority only extends to disclosure, so they keep making companies say more and more about how they come up with their pay  schemes in the hope that shareholders will get outraged and rein in the pay packages.  Similarly, other disclosure regulatory requirements have waxed and waned depending on the political climate of the time.  As a result, any hope of consistency regarding how the regulations require you to act is a forlorn one. 

Finally, much of materiality and the definition of fraudulent behavior in the securities laws is the result of case law decisions.  These are instances where, except in the most egregious or fraudulent cases, reasonable people can differ. Yet this is how we come up with our definitions for materiality, how we interact with analysts, when we choose to disclose and a multitude of other things. 

I, for one, would like to see a comprehensive overhaul of the securities laws to bring some semblance of logic to them that would serve to eliminate much uncertainty (and billable law firm hours) from the process of being a public company. Like Alexander the overhaul would cut through the many strands of laws, regulations and case decisions that are tying us up in knots with a clear unified code of securities laws. Then again, given the current administration and the mood of Congress towards Wall Street, maybe its better to leave well enough alone…

How to Use a Computer to Read Company Reports

It has come as somewhat of a shock to me, but I realized the other day that personal computers can actually perform some very useful roles when it comes to reviewing company SEC filings. This is welcome news to someone who labored through the early days of DOS based PCs where it felt like you spent more time trying to get the blasted things to work than you did in actually getting any productivity.  It’s nice to be getting some productivity payback, even if it is twenty years later.

I’ve found that when investors are following a company, what they care about are the changes that are happening on the margin, particularly as it compares with the same period in the prior year.  Companies, of course, are happy to tell them when good things are happening at the margin and will supply lots of reasons why smart management has made good things happen.  The bad things, however, either get buried in the fine print, or, more than likely, omitted.  It’s these omitted things that are toughest to spot.  After all, the previous period was a year ago and who can remember that far back?  I’m lucky if I can remember what I had for supper last night, so good luck spotting that omission. This is where reading the periodic filings of a company with the aid of a computer comes in really handy.

First, let me say that it really helps if you have a very large display monitor, or, better yet, dual screens.  I switched to dual monitors about two months ago and it feels as if I’m saving about 10% of my time because I no longer have to dig through and move around the multiple screens that I’m working on.  With a super-sized viewing area it is then easy to go the Securities and Exchange Commission’s website (www.sec.gov) and search for the most recent filing by the company you’re interested in.  Once you’ve pulled that up, you then open a new window right next to it with the previous year’s filing for the same period in it.  So far, this is nothing you couldn’t do with paper on your desktop if you wanted to print out the documents and kill a lot of trees.  But now comes the cool part.  You can get the computer to search for the word or phrase you’re interested in.  Rather than parsing the document line by line to find out what’s missing, the computer can tell you exactly how many times a word or phrase was used in the company’s discussion.  Then you simply compare what you’ve found with the same search for the previous year’s filing.  If there is a big discrepancy, then a diligent investor will use it as a starting point to start asking questions. I’ve used this technique when writing some of my blog posts to look at the treatment of same store sales by Starbucks and the disclosure of the number of pharmacists working at CVS Drugstores (see Starbucks and Disclosure of Same Store Sales, December 5, 2008 and How to Read 10K and 10Q Reports, September 10, 2008).  My computer will tell me how many times the word or phrase is used in the document and take me right to the spot it’s used. 

 The system works because, by my estimates, 85% - 90% of the discussion material in the 10-K and 10-Q doesn’t change from period to period.  If you’ve ever sat in on a Disclosure Committee meeting, you know that the accountants and lawyers are trying to write the document by making as few changes as possible to the previous document.  Nobody has time to reinvent the wheel every quarter with a totally rewritten filing. So when they make a change, it’s usually because they have to make a revision due to changed circumstances.  Many times those changes, if they don’t favor the company, will get buried in the 10-Q or 10-K and it’s up to the intrepid investor to find them. 

And this is just the beginning of how computers can be used to analyze the textual discussion in company periodic reports.  Those of you who are intrigued by all of this should take a look at a site called Many Eyes (www.many-eyes.com) to see how see how graphics can be used to analyze text and changes to text.

It’s a brave new world…