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.

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.