The Relationship Between Sell Side Coverage and Commissions

Go to almost any gathering of investor relations officers and you are likely to hear them bemoaning the decline in the number of sell side analysts that follow their companies and publish earnings estimates. And if you are talking to small and even mid cap company IROs, you may hear them complaining that they are having trouble attracting sell side coverage at all. So I thought I would spend some time this week explaining why this might be so.

The answer is simple, really, and like many things in life, it boils down to “that’s the way the math works”. My children would always roll their eyes whenever I said that, so before I get to the quantitative part, a bit of historical perspective is in order. In the old days, before Elliott Spitzer, research departments received much of their budget funding from their bank’s investment banking departments and there was more coverage of companies because investment bankers wanted potential clients to get coverage from the firm. Of course, there were also quite a few conflicts of interest, as investment bankers only wanted the research department to have buys on potential clients. In addition, there was a lot of pressure from investment bankers for stock analysts to give generous recommendations to companies they were taking public. All of this culminated in the 1999 – 2000 dot com bubble when many highly touted internet company IPOs foundered on the shoals of reality.

Enter Elliott Spitzer, who, before he became Client 9, was Attorney General for the state of New York. Sensing that political hay was there to be made, Mr. Spitzer demanded that the conflicts of interest arising from the intersection of investment banking and research be eliminated. Using the bully pulpit of the Attorney General’s office, Mr. Spitzer was able to extract settlements from the investment banks that basically separated investment banking and research. No longer could investment banking departments contribute to the research budgets of their firms. In fact, investment bankers couldn’t even talk to research analysts unless an attorney was in the room to insure that no insidious conflicts reared their ugly heads.

This meant that research departments now needed to justify their existence based upon their only revenue source, which was commissions. And commission rates, due to a number of factors, were declining and continue to decline to this day.

This is where the math comes in, because for research departments, it all comes down to how many commission dollars covering your company can generate for their firm, and that in turn is heavily dependant on the average daily trading volume of the company in question. If you look at a mega-cap company such as Wal-Mart, they trade in excess of 14 million shares per day. Assuming an average institutional commission rate of $.04 per share, this means that on an average day, trading in Wal-Mart shares generates $560,000 in commissions. Even if you are a mid-tier analyst covering Wal-Mart, and you figure you can get credit for 5% of the commission flow, this means that potentially you have available to your firm $28,000 per day.

On the other hand, a small cap stock with average daily trading volume of 100,000 shares, generates commissions of $4,000 per day. Even if you figure the very top, go-to analyst on the stock can get credit for 25% of the commissions, the potential dollars available total $1,000 per day.

Wall Street firms are economically rational, and they will naturally gravitate to where the most money is to be made. And the long and the short of it is that it is a lot better to be a middle of the pack analyst following a mega cap stock than it is to be the number one analyst following a small cap stock.

So the next time you hear someone bemoan lack of sell side coverage, ask them what their daily trading volume is.

Because that’s the way the math works.

Take the Time to Say Thank You

I’m going to take a break this week from investor relations and instead talk about personal relations. After all, it’s my blog and I can write about what I want to.

The other day I had one of those “What ever happened to?” moments. In this case, I was wondering what had happened to my old track and cross-country coach. He had only coached me for two years in high school before moving on to a different school, but he was a great coach and had given me a love of running that lasts to this day. The Internet is a wonderful tool that allows you to reach out to people that in the old days you would simply have lost track of, so I gave it a try. I wasn’t real hopeful of finding anything, as it has been forty years since my high school track days, but lo and behold, after about five minutes with Google, I had an email address.

Then I did something that I should have done many years before: I wrote him, thanking him for the time, effort and consideration he had put into coaching a young and inexperienced runner many years ago. A couple of days went by and I was beginning to think perhaps I had a bad email address when I received a short email from my old coach saying “You made my day – I will call you”.

Several hours later, I got a call from him and I must say that it was one of the most enjoyable conversations I have had in a long time. Not only did my old coach remember me all these years later, but he even remembered some of my track times from my sophomore year in high school.

In our lives we all have people who have been important influences on who we are and what we have achieved. They may be teachers, coaches, scoutmasters, professors, relatives or even friends of the family. They are people who have taken the time and effort to help young men and women understand who they are and how to use the talents they have to move forward with their lives. They teach fundamental disciplines, help nurture young talent and often give considerable amounts of their own time.

Because the people being helped are young, they often don’t realize how they are benefiting. I used to think that my track coach was good because he made me a better runner. It was only many years later that I realized that as good as he was at making me a better runner, he was just as good at instilling in me disciplines such as hard work and attention to detail that were to benefit me long after I stopped running competitively. But this realization didn’t come until later. When I was young, I was busy getting on with my life, and so I moved on and didn’t give it, or the influencers in my life, a whole lot of thought.

So here’s the thought for the day: take ten minutes and thank someone who has been an influence on you life. I doesn’t matter if it’s an email or a phone call or you stop and chat when you see them in the grocery store. The important thing is to just say thank you. It’s a simple thing to do, but too often we put it off until it’s too late, so do it now. Not only will it make the day of the person you thank, but I guarantee that you will get a big benefit from it as well.

One Generation’s “Nice to Have” is the Next Generation’s Essential

In our mind’s eye, we never age. We remain slim, dark haired and up to the moment in developments. However, every now and then something happens that reminds us that our view of the world is different than those younger than ourselves.

Just such a moment happened to me the other day when I was teaching my class in investor relations. We were discussing a case in class that revolved around how to improve a company’s visibility with investors. One of my students suggested that one thing the company could do was to improve its web site. As the case occurs in 1993, I said that most companies did not have web sites back then. My student looked at me as if I were from Mars. The concept of a company not having a web site was utterly foreign to her.

The reason I find this interesting is that it points out how quickly something can go from being almost non-existent to becoming an essential part of the information mix of a company. For those of us with a little (or in my case a lot) gray hair, we tend to think of web sites as a secondary means of transmitting information, following real information, which is imparted via pieces of paper and speaking to people. However, if you have grown up in the Internet age, information is first gleaned from the web, and then secondarily refined through other means. For example, if I want to find a good quote for use in writing, I am likely to turn to my trusty volume of Bartlett’s Quotations. My children, on the other hand, would not dream of pulling down a book, but would immediately do an Internet search.

One of the ways this intersects with investor relations is in the way companies treat their IR web sites. Older investor relations officers tend to think of IR sites as “adjunct” or “supplementary” information backing up the annual report, press releases, conference presentations and one-on-one meetings that are the grist of the daily IR mill. Yet with each passing day, more and more analysts are coming out of graduate school with the viewpoint that the Internet is the primary source of information. Just as another data point, it is not unusual for me to see papers from MBA students where all citations are to internet sources, with not a single book cited.

What this means for IR practitioners is that the content of their investor relations web site is increasingly important. The design, information content and logic of the IR site are things that should be given considerable thought. Further, given the pace of change for web sites, the IR site should be thoroughly reviewed at least once a year. This means that delegating maintenance of the IR site to the junior member of the IR department and forgetting about it isn’t an option any longer. Just as the senior member of the IR department wouldn’t dream of letting the junior member of the department do one-on-one meetings with the company’s most important investors, they shouldn’t delegate or outsource the web site. Investor relations sites are rapidly becoming the primary source of information about companies and they need to be accorded a high level of attention.

Otherwise, the likely scenario going forward is that investors, rather than contacting the company, will go elsewhere on the web to get their primary information.

Motive Doesn’t Matter

The insider trading trial of the century has started in Manhattan featuring Raj Rajaratnam, his Galleon hedge fund and a diverse set of characters ranging from a former Goldman Sachs director to consultants and naturally, other hedge fund managers. The trial is providing plenty of grist for the mill, but I wanted to focus on one interesting article that appeared the other day in the Wall Street Journal entitled “Motive for Stock Leak Can Be Respect, Love”. The story looks at the motivations for some of the people that leaked inside information to hedge fund manager Raj Rajaratnam and others involved with the Galleon hedge fund. It turns out that not all of them did it for the money.

Mind you, the ultimate recipient of the information appears to have been in it for the money, profiting handsomely from the information given to him by his network of informants. And filthy lucre also appears to have been a part of one of the initial witnesses at the trial who testified to being paid $2 million. (As an aside, it’s kind of hard to argue that you don’t know you were doing something wrong when you’re being paid in an offshore account in your housekeeper’s name.)

However, others appear not to have been motivated by money or to even have profited by their leaks. In the case of one Intel executive, friendship appears to be the motivating factor. In the case of an IBM executive, a desire to impress a woman with whom he had become intimate was the reason cited by the executive in explaining himself the judge in his case.

But here’s the thing that any prosecutor worth his salt will tell you when you start to trot out non-monetary motivations: IT DOESN’T MATTER. Knowingly passing along inside information is a crime and it makes not a whit of difference if you made millions as a result of the information or you did it for the love of mankind. There might be some distinction made by the judge between the two when you get sentenced, but make no mistake, if someone has acted on inside information that you knowingly passed along, the government has the obligation to track you down, take you to trial and convict you.

So here’s the point, from an investor relations and compliance viewpoint: A good IR Disclosure Policy and program will drive home the point that it is the disclosure of non-public information that can get you in trouble, not being paid for it. Most people can easily understand that if someone offers to pay them for confidential information, it is probably illegal. Harder for them to understand is that if they pass along the information because they wanted to impress their friend, or were out in a social situation and wanted to appear important, or they had a long standing friendship with the person they gave the information to, they can just as easily get into trouble.

So find a way to get people with access to inside information to understand that they don’t have to profit from passing along inside information in order to break the law. And just to drive the point home, remind them that whatever friend they pass the information to will not be serving jail time for them when everything unravels.

Whistle While You Work

If you look at the history of financial regulation in the United States, one of the things you notice is that almost all regulation of financial activity at the federal level comes as a result of some form of financial scandal or abuse. This goes all the way back to the Securities Act of 1933, which resulted from the stock market shenanigans brought to light by the Pecora hearings following the stock market crash of 1929. In more modern times, this trend has continued with the enactment of the Sarbanes-Oxley Act of 2002 in the wake of Enron, Tyco, and others, and the Dodd Frank Financial Reform Act of 2010 that was spawned by the housing and mortgage crisis.

These laws are usually enacted quickly, as legislators are anxious to demonstrate that they are doing something, but the resulting legislation lingers on for many years. Companies are left to deal with and adjust to murky legislative language and often burdensome regulations resulting from laws that are designed to prevent the last crisis. Often these laws have unintended consequences, such as the effect of Sarbanes-Oxley on the number of companies choosing to file their IPOs in the United States.

Now we have at least one provision tucked away in the Dodd-Frank law which may come back and bite public companies. I am referring here to the whistleblower provision in the financial reform act. Under this provision of the new law, if a whistleblower provides independent information of fraud to the SEC that results in a successful enforcement action that recovers at least $1 million in sanctions, the whistleblower is entitled to recover at least 10% and up to 30% of the recovered funds.

There are a couple of interesting twists to this legislation. The first is that the independent information regarding the fraud can come from independent analysis of public information. Thus, an outside analyst without any inside knowledge of the company’s books and records can blow the whistle on a company if their analysis shows that the company must be acting fraudulently. This was precisely what happened in the Madoff scandal, when Harry Markopolos went to the SEC with an analysis that showed the returns shown by Madoff were impossible to achieve. It doesn’t take a great leap of imagination to foresee a new subgroup of analysts devoted to looking for financial fraud with the thought of collecting a reward from the SEC.

It also doesn’t take a great deal of imagination to think that the plaintiff’s bar would be very interested in the new whistle blower rules. Now, instead of trolling through Form 4 filings to look for Section 16(b) short swing profits violations by insiders, aggressive attorneys can cultivate relationships with short sellers in the hopes of joining together to find companies engaged in fraudulent activities. Given that short sellers are almost always convinced that companies are defrauding the public and plaintiff’s lawyers never pass up an opportunity to turn a new legal provision into a revenue stream, this is a match made in heaven.

If nothing else, people involved in the disclosure of company information pursuant to the securities laws needs to take a close look at the whistleblower provisions of the Dodd Frank law. Under the current SEC proposed regulations, whistleblowers do not even have to first go through company channels before blowing the whistle. So the company needs to get their disclosures right on the first try, because if they don’t, there may not be a chance to remedy things before the SEC is notified. And the possibility of $100,000 or more in reward money can make it very tempting for whistleblowers to accuse first and verify later.

Social Media and Investor Relations Redux

Readers of this blog will know that I am somewhat of a skeptic when it comes to the use of social media in investor relations (and yes, I recognize the irony of that statement when written in a blog). It’s not that I think there is no use for twitter, linkedin and the other social media services, it just that they strike me as being over-hyped compared to the nitty gritty job of getting the basic message right. But I am here to report that even I can be convinced of the ways that social media can be helpful.

Earlier this week I was privileged to give a speech to the NIRI Houston chapter on my favorite topic, the intersection of academic disciplines and real world investor relations. Before the speech I was introduced to Catherine Crofton of Q4 Web Systems. It turns out that Q4 Web systems had agreed to sponsor the luncheon and Catherine was going to introduce me. As we chatted about investor relations issues before lunch, Catherine told me about a success story of one of their clients in using social media. It turns out their client, TVI Pacific Inc., launched a campaign to use social media in their investor relations program that, coupled with a good story, helped to raise the firm’s visibility with investors, resulting in improved trading volumes and stock price performance. Q4 Web Systems has written about the program on their blog, which can be found at

http://www.q4blog.com/2010/01/11/tvi-pacific-shares-roi-of-using-social-media-for-ir/.

As I thought through this example, it occurred to me that the company in question, TVI Pacific, was a micro cap company, and one of the big issues facing small cap companies is simply one of visibility. If you are a Fortune 500 company, visibility is not an issue; many sell side analysts cover you, you have a large established base of institutional shareholders and the media is focused on you. However, if you are a small cap company, just getting on the radar screen of many investors presents a problem: the sell side may not cover you at all, very few institutions may own you and you are thinly traded. In short, the markets are a whole lot less efficient when it comes to small caps, mostly it seems because the information does not get in front of the right investors.

There is actually some interesting academic research on this topic. The title of the paper is “Investor Relations, Firm Visibility and Investor Following” and was written by Brian Bushee of Wharton and Gregory Miller of the Harvard Business School. The paper finds that investor relations efforts to improve a small cap firm’s visibility result in better trading volumes and increases in institutional ownership and better valuations.

The interesting thing about the TVI Pacific case is that they used social media in the form of postings on Twitter, Facebook, Fliker, YouTube and Slideshare and links on their website. Slideshare is a new one on me, but it turns out there is a site that allows you to post and share your slide presentations. (For those of us who have had to sit through endless boring powerpoint presentations during meetings, this may seem a bit masochistic, but it seems to be a popular site. Who’d of thunk?)

So if you are a small cap stock in need of visibility, social media may be an additional set of tools an IR officer can use at very low cost, assuming you can get the company’s general counsel to sign off on the use of them.

And it also seems as though a certain cranky IR observer may have to wind up eating his words.

Yowzer! Step Right Up and Hear the Professor!

I’m happy to report that I will be speaking on February 15^th at the Houston NIRI chapter on the topic of “IR Insights from Academia: Does Any of That Fancy Theory Apply in a Real World Context?” This will be the second time I’ve given this talk, having successfully addressed the Dallas NIRI chapter last November (at least they said it was successful). For those interested in attending, details can be found on the NIRI Houston web site, http://www.niri-houston.org/Luncheon--1.html?ModKey=mk$clsc&LayoutID=7&EventID=95

I find the topic fascinating because it gives me a chance to talk about the intersection of theory and practice. Since leaving the corporate practice of IR and developing my investor relations class at Rice University, I’ve had the opportunity to step back from the day-to-day pressures of IR and really think about what it is IR practitioners do and how all of that fits into things that are taught in business school.

When you think about the discipline of investor relations, it incorporates aspects of marketing, communications, finance, law and the capital markets. Further, the audiences it affects go far beyond just investors to encompass employees, customers, suppliers, creditors, bond holders and governmental entities to name a few. When you throw into the mix that there are some schools of academic theory that hold that active investing and investor relations activities add no value, there’s quite a bit that can be discussed.

Just by way of a teaser for some of the topics I cover in the talk, here’s some of the theory versus real world that I cover:

Finance – most valuation models are constructed using discounted cash flow techniques and how they work has a significant impact on your company’s stock price. Beyond the modeling technique however, there lies a significant takeaway to think about.

Marketing – a lot of investor relations literature talks about targeting investors, but that is only one-third of the three crucial steps to marketing.

Communications – there is a lot of really bad IR communications out there, much of it in the form of PowerPoint slides. I look at examples from some of the biggest corporations in the U. S. (This section is the most fun.)

Law – lawyers are taught to think in a particular way, and regulatory lawyers have a unique take on that. As someone who practiced law for ten years, I attempt to bridge the communications gap between lawyers and IR practitioners.

If you are in the Houston area, I hope you can join me. If you are not in the Houston area, but are interested in having me come to a local NIRI chapter, please give me a call. I’m somewhat of an evangelist on bringing more academic rigor to investor relations, so there is no charge for the talk other than travel expenses.