Golf and Investor Relations

Mark Twain famously called golf “A good walk spoiled”. I was reminded of this because last weekend I returned to playing golf after a ten-year hiatus. In between swings of the golf club (of which there were many), I got to thinking about what investor relations practitioners can learn from the game of golf. So, hard on the heels of a discussion of the infield fly rule and IR (May 25, 2011), here are some of the thoughts that popped into my head about how golf resembles IR.

First, the more people you have, the longer the process takes. A twosome in golf plays more quickly than a foursome. In investor relations, if you are drafting documents, a large group takes much more time writing, editing and revising than a small group. While in a normal quarterly release process, this doesn’t matter too much, except to raise the blood pressure of the investor relations officer that has to try and write clear concise prose after the securities lawyer, the accountants, the general counsel, the CEO and the operations people have had their say, it becomes much more important when faced with a crisis situation when speed is essential. So when you need to get a release or a response out quickly, have a smaller designated group lined up for those exceptional circumstances. To many businessmen, this is counter-intuitive, as they are used to solving issues by throwing more bodies at the problem.

A corollary to this is that you are only as speedy as your slowest player. If you are out on the course and have one player who is constantly searching for their ball, or taking eight or nine practice swings before hitting the ball, everyone has to wait. Similarly, in the editing process, if you have one person who is consistently late in sending in edits, the entire process slows down.

Both golf and investor relations have their own coded clichés designed to blunt the impact of bad news that we can pull out at a moment’s notice. For example, in golf, when you say, “You’re on the beach”, it refers to your having landed in the sand trap; not to taking a quick refreshing break at the seaside. Similarly, in business, the phrase, “He left to spend more time with his family” does not really mean that the person in question wants to become more of a family person; rather it means he was fired and the company does not want to tell you the real reason the executive was let go.

Finally, both golf and investor relations are governed by sets of complicated and arcane rules that can get you into trouble if you’re not careful. It’s important to know the rules and abide by them – in golf, no one wants to play with a cheater, whereas in investor relations, your reputation for honesty and integrity are of paramount importance. Interestingly, in both golf and investor relations, the primary means of enforcement is self policing, although there are notable exceptions. Golf pros are bedeviled by people watching on TV who will call the PGA if they think there has been the slightest rules infraction, and in investor relations the plaintiff’s bar is always willing to second guess disclosure issues if the company’s stock price goes down.

Well, that’s it for now – you don’t want to overdo these analogies. Besides, I need to go practice my swing – it could be that I will play another round before ten years is up.

Small Cap Companies and Efficient Markets

One of my favorite quotes about the capital markets comes from Fischer Black, the financial mastermind who helped invent the Black-Scholes option-pricing model. Black, who had been a Professor at MIT, situated on the Charles River in Cambridge, left the world of academia to work for Goldman Sachs, which sits near the Hudson River in Manhattan. After experiencing finance from both the academic and practitioner viewpoints, Black commented, “Markets look a lot less efficient from the banks of the Hudson than from the banks of the Charles.”

I bring this up because last week I was involved in the East Coast IDEAS Conference in Boston at which most of the presenting companies were small capitalization firms. My background is primarily in large capitalization firms, so the conference was an opportunity to see the other end of the spectrum and learn a few things. The most surprising thing I learned as a result of speaking to company managements was how difficult it is for good small cap companies to get noticed by investors. It seems that finding a good match between underfollowed companies and investors can be a daunting challenge.

Part of this can be ascribed to much less sell side coverage available to small cap stocks. The name of the game with sell side coverage is commission flow, and small cap stocks have a lot less of it than larger cap stocks do. Without the distribution of information available from the sell side sales force, small cap companies are forced to try and bring themselves to the attention of investors through their own efforts. Similarly, investors have a hard time finding the good companies through all of the “ground clutter” on their radar screens. Add to this the fact that many smaller companies do not have full time investor relations officers, relying instead upon their CFOs to speak to investors and you have a combination of factors that can lead to companies just not finding the right investors. The result is that the markets seem a lot less efficient in the small cap space.

In theory, (from the banks of the Charles) the efficient market theory would say that as long as your company information is public, investors will find you and properly value your firm. So filing required reports with the SEC and having a web site should be sufficient. In reality (from the banks of the Hudson) this rarely seems to be the case for small cap stocks. What is required of smaller companies is what I refer to as “retail institutional marketing”. They have got to go out and actively bring themselves to the attention of potential investors because they are competing with so many other small cap companies for attention and investment dollars. And it seems as though those investors are not easy to find.

There is a solution for this, and that is for investor relations firms with knowledge of the capital markets for small cap companies to bring companies and investors together. One way to think of this is that IR consulting firms step into the role of the sell side sales force in terms of their knowledge of what investors may be interested in, introducing their client companies to interested investors. The difference is in the method of payment. The sell side is paid for via commissions from the buy side, whereas IR firms are paid by the company. When done correctly, a good IR firm can add to the efficiency of the markets by helping to match the right investors to the right companies, helping them achieve better liquidity and proper valuations

(Full and fair disclosure: The author consults for Three Part Advisors, an investor relations consulting firm and a sponsor of the East Coast IDEAS Conference.)

The Infield Fly Rule and Disclosure

With the advent of Memorial Day and warm weather (down here in Houston we define warm weather by temperatures being above 90 degrees, where they will stay until late September), my thoughts have turned to baseball and what we in the investor relations profession can learn from it. After all, baseball is a deceptively simple game consisting of throwing a ball, hitting it with a stick and then catching the ball. This compares to investor relations, which on the surface is also deceptively simple, as it’s really just about talking to people about your company and how it’s doing.

In both instances however, what starts out to be simple, rapidly get complex as the result of rules. For example, in baseball, consider the infield fly rule. The infield fly rule is designed to eliminate a situation where a base runner might be damned if he does and damned if he doesn’t. That is, the purpose of the infield fly rule is to prevent the defensive team from turning a double play by intentionally dropping or not catching a fly ball hit to the infield. The rules of baseball define an infield fly as the following:

An INFIELD FLY is a fair fly ball (not including a line drive nor an attempted bunt) which can be caught by an infielder with ordinary effort, when first and second, or first, second and third bases are occupied, before two are out. The pitcher, catcher and any outfielder who stations himself in the infield on the play shall be considered infielders for the purpose of this rule. 
When it seems apparent that a batted ball will be an Infield Fly, the umpire shall immediately declare ”Infield Fly” for the benefit of the runners. If the ball is near the baselines, the umpire shall declare “Infield Fly, if Fair.” The ball is alive and runners may advance at the risk of the ball being caught, or retouch and advance after the ball is touched, the same as on any fly ball.

There are several interesting aspects to the rule, such as it requires the judgment of the umpire that the ball can be caught with ordinary effort, an outfielder can be an infielder for purposes of the rule, and it has exceptions for line drives and attempted bunts. And, in true regulatory fashion, this is just the definition. You have to go to another rule to discover the effect of the rule, which is that the batter is out. This is a rule that only a lawyer can love.

Next consider the rules and regulations surrounding disclosure of material non-public information. The rule here appears to be a little less complex than the infield fly rule (although technically speaking, it’s not a rule at all as it came out of court decisions), and goes as follows:

“Information is material if there is a substantial likelihood that a reasonable shareholder would consider it important in making an investment decision.” And “There must be a substantial likelihood that the disclosure of an omitted fact would have been viewed by the reasonable investor as having significantly altered the “total” mix of information made available.” (TSC Industries, Inc. v. Northway and Basic v. Levinson.)

There are several striking similarities between the disclosure of material information and the infield fly rule. First, the judgment of the umpire, or in this case the arbiter of fact such as a judge, jury or your securities law lawyer, is called for to figure out what is important and what a reasonable shareholder would think. Next, if you think about the cases handed down about people who have been caught using insider tips, you know that outsiders can be considered insiders. Also, just as with the infield fly rule, there are clear exceptions to the application of the rule. Just as base runners cannot be forced to leave their base in the case of an infield fly, companies can’t be forced to disclose if the disclosure would interfere with sensitive negotiations (for example, in the event of merger negotiations) or if the issue isn’t ripe (due to facts still being discovered). Finally, just as with the infield fly rule, you have to go to a different rule, in this case Rule 10 b-5, to learn that failure to disclose a material fact is unlawful. Coincidence? You decide. It’s enough to make me think that Casey Stengel would have made a great securities law lawyer.

So the next time you’re confronted with a disclosure issue, think of the infield fly rule and take comfort in the fact that very few people truly understand the way these things work, and even fewer can make the right calls under the pressure of the moment.

Expert Networks Following the Rajaratnam Verdict

There was a front page article in today’s New York times as part of the coverage of the guilty verdicts against Raj Rajaratnam, that was titled, “Next Up: A Crackdown on Expert Networks”. The gist of the article is that federal prosecutors were now going to focus their insider trading crackdown on the use of expert networks. In fact, there have already been a number of indictments and guilty pleas resulting from the government’s investigation.

Expert networks, in a classic example of the law of unintended consequences, sprang into being following the enactment of Regulation Fair Disclosure. The theory was Reg. FD was forcing companies to stick to a plain vanilla disclosure script, telling everybody at the same time, whereas investors would pay to get something more than plain vanilla before everyone else. It proved to be a good theory, as on Wall Street, time and information are money, and expert networks could help investors with both. If an investor needed to get up to speed on a new industry, a new drug or a new technology, paying an expert for an hour or two of their time could be much more efficient than spending a week researching the topic. And presumably the investor could get the information free of corporate spin with some insights into the topic that corporate management might be unwilling to discuss.

Alas, like all good ideas, abuses soon appeared. Some expert networks solicited people to act as experts on the companies they worked for, with the implied marketing pitch to investors that they would be able to get an insider’s perspective. And lo and behold, some of the experts actually gave out material, non-public information about their companies. Many of these “experts” were in technical fields, such as medicine or technology, and it would be easy to say that they might not be expected to know technical SEC regulations. However, when someone is paying a person large sums of money to tell them about things that are not generally known about their company, it’s fair to say that person knows he’s doing something wrong. At the very least they are violating their duty of confidentiality to their employer, at the worst, they are violating the federal securities laws.

So now that people are beginning to be sentenced, what does it mean for expert networks?First, they’re not going away. The desire of Wall Street for fast information that may give them an investment edge will insure that the expert networks will continue to be around. Costs will go up as more compliance is layered into the process, both by investors and the networks, but the demand for the product will not go away. Second, companies will strengthen their disclosure policies to prohibit employees from acting as experts. As I write this I am sure there are securities lawyers all over the country drafting memos advising their clients to update their disclosure policies to prohibit all employees from participating in expert networks. Third, maybe, perhaps, we hope, the bad actors will be forced out of the business.

I hate to sound like a cynic about the last point, but when you’ve hung around the industry as long as I have and witnessed Michael Milken, Dennis Levine, Martin Siegel, Ivan Boesky, R. Foster Winans (The “Heard on the Street” columnist from the Wall Street Journal), James McDermott (the former CEO of Keefe, Bruyette & Woods who gave tips to his adult movie star mistress) and Martha Stewart, you get just a bit jaded about the ability of regulations and compliance programs to overcome the lure of making a quick buck.

Sell Side Coverage, Part 2

A couple of weeks ago, I wrote about the relationship between Sell Side Coverage and a company’s ability to generate commissions. The long and the short of the article was that the sell side is paid via commissions and therefore, the more trading volume your stock has, the greater the likelihood a sell side analyst will cover your company. This is bad news if you are a small capitalization company, as the volume of commissions generated by your average daily trading volume will not make you a high probability candidate for coverage.

So if you are a small cap company, the question becomes, can you achieve any meaningful sell side coverage? The answer to this is yes, but like so much in life, in order to achieve your goal, you must be willing to spend a good deal of time and effort in order to get where you want to be.

There are a number of approaches to this, but in the end, they all come down to doing things that make you more attractive to the sell side. First, you can institute a marketing campaign to make your company more known to the sell side. This means reviewing who covers your peers and others in your industry and contacting them regarding your company’s investment thesis. While this alone is unlikely to result in sell side coverage, it does get you on the radar screen and raises your profile with the sell side. It also helps if you can present the sell side with a compelling reason to follow your company, such as a unique market niche, product or approach your company has that will enable the sell side analyst to be more knowledgeable about the industry than his competitors.

Second, you can make yourself more known to the sell side’s clients, the buy side. This involves the somewhat labor-intensive task of segmenting, targeting and positioning the company’s message to the buy side community followed by lots and lots of mostly fruitless phone calls. The result of this can be two things that will get the sell side’s interest: more trading in the stock and more questions about the company from the buy side. In this process it is wise not to ignore the IR officer’s anathema, hedge funds, as that is where a significant portion of today’s stock trading volume resides.

Next, you can make your management more accessible to the sell side. This may help sell side analysts fill in gaps in their knowledge about the industry and your company’s position in it, or may give them more product knowledge. As the sell side is expected to be experts in all aspects of the industry they cover, helping them gain more knowledge will put you on their radar screen. Additionally, doing a sell side analyst’s conference or using them to help arrange non-deal road shows allows them to show the buy side that they have management access, something they do get compensated for by the buy side.

One thing to keep in mind about this process is that it takes time and commitment from company management to raise the profile with the sell side. If a company has a dedicated investor relations officer and that person has a good working knowledge of how the Street operates, and the willingness to spend the time, then it can be done in-house. If, however, like many small cap companies, the CFO is filling the role of principle spokesperson to the Street, then it makes a lot of sense to hire an outside IR advisory firm to do the heavy lifting described above.

(Full and fair disclosure: the author is a consultant for Three Part Advisors, an investor relations strategic communications and consulting firm.)

Not Too Hot, Not Too Cold, But Just Right

I had the privilege of speaking last week before the Austin- San Antonio chapter of NIRI. The topic was one of my favorites, Insights from Academia, or What I’ve Learned About Investor Relations by Teaching in a Business School. Every time I give the talk, it’s a chance to step back from the day-to-day activities that comprise investor relations and think about the process as a whole. This time when I gave the talk, I was struck by the need to achieve balance in what we do.

Those that are involved in investor relations recognize that in order to do it right, you need to combine skills from the disciplines of finance, marketing, law and communications. So there are a lot of factors at play. If one chooses to emphasize one factor over another the entire message can suffer. For example, if a press release is written where legal factors and accounting dominate, the result is a stilted document that tends to read like a SEC Form 10-K filing or a lawyer’s brief. In other words, something that’s deathly dull and uses language to obfuscate rather than clarify. Similarly, if the marketing and communications disciplines dominate, what you wind up with is a document that is more hype than substance and is bound to turn off your audience of sophisticated investors. The key to getting the message right is to balance the various factors.

One of the things I have learned from combing through business textbooks in preparing for my class on investor relations is that a catchy graphic helps to explain complex relationships. Couple that with the fact you almost can’t give a talk without powerpoint slides and I simply had to create a graphic to illustrate this point. So here it is – my attempt at capturing the need to combine all four disciplines in your investor relations message.

Of course, it’s one thing to understand the theory, it’s another thing entirely when you are trying to incorporate comments to your press release by the CFO, the General Counsel, the outside auditors and the communications department. This is where investor relations officers should think back to the Goldilocks story and say to themselves, “Not too much law, not too much marketing, but just right…” It’s at times like that I recommend you pull out the graphic to remind yourself what it is you are trying to achieve.

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.