A Hypothetical Model to Help in Thinking About the Value of Investor Relations

(Author's Note: A version of this post originally appeared on the web site Corporate Eye. I liked it so much that I am recycling it here.)

People in the academic world are big on constructing models to prove their financial theories. These hypothetical constructs blithely disregard such things as taxes, transaction costs and the fact that emotional, sometimes illogical humans are part of the market process. They don’t allow messy reality to interfere with their elegant equations, but the models are useful in highlighting a theory or hypothesis. Many an academic prize (and even some Nobel Prizes) has been won by building explanatory models that make huge assumptions and leaps of faith. In fact, my favorite quote about finance makes a nod to this as it relates to the Efficient Market Hypothesis. Fischer Black, a former Professor at the Massachusetts Institute of Technology (MIT), which sits next to the Charles River in Cambridge, Massachusetts, took a job with Goldman Sachs in New York, situated next to the Hudson River. After working there for a while, he was heard to remark, “Markets look a lot less efficient from the banks of the Hudson than from the banks of the Charles”.[1]

As I consider myself only a quasi-academic – that is, I teach but I don’t engage in any of the pedantic research that clogs the academic financial journals (plus, I have not yet sewn patches on the elbows of my tweed jacket, nor have I taken up smoking a pipe), I thought I would serve up for the benefit of my readers a theoretical quasi-model to help think about the value of investor relations. Recognizing that investor relations is a discipline that involves real people and information, I will keep it quasi-simple.

Start by thinking of two theoretical firms, both in the same industry and each performing exactly the same in financial terms. That is to say, according to their past performances, their growth rates are similar, their rates of return do not differ in any material way and they serve the same customer base. Firm A discloses exactly what is required by the regulations, and nothing more. It makes no effort to explain its more complicated accounting treatments and it does not reveal anything about its strategy or future plans. It does not respond to investor inquiries, does not make management available to investors and analysts, and does not present at any industry conferences. In short, beyond the regulatory filings it makes, it remains silent.

Firm B on the other hand, tries to be as open and transparent as possible, going beyond the regulatory disclosure requirements to explain its business and strategy, meeting with investors and regularly presenting at industry conferences. They keep up a steady stream of information that keeps investors informed on a timely basis, not just on a regulatory filing basis.

The question to be asked then, is under that hypothetical situation, should Firm B get a higher valuation than Firm A? I submit that under these conditions, it is highly likely that a premium will be attached to the valuation of Firm B, compared to Firm A. There are several reasons for this, chief of which is that investors will view the greater transparency into operations and management thinking about the future as enabling them to make better estimates about future cash flows. Secondly, the cost to investors of acquiring information has been lowered by Firm B, and this should show up in their valuation. Third, the amount of information asymmetry between the company and the investors has been lowered by Firm B, which should also be reflected in a higher valuation. Finally, although the information Firm B extends beyond that required by the regulations is not material in any one piece, in the aggregate it may help in the assembly of a mosaic of information that may be material to investors.

Unfortunately, I do not have an elegant equation to quantify the value of the of these investor relations activities. I do think it suggests however, that at least for companies where information is widely disseminated, much of the value in investor relations is in the selection and disclosure of information beyond what is required by regulation.

Now, if you want to nominate me for an academic prize, be my guest. Of course, with my luck it will turn out to be a quasi-prize…

---

[1] As quoted in Against the Gods by Peter L. Bernstein.

Thoughts on the 2012 NIRI National Conference

It is a well-known axiom among educators that different people learn in different ways. That’s why when you put together a program, you include a variety of different types of learning mechanisms. Alas, this is not a lesson that has been learned by the National Investor Relations Institute.

Last month I journeyed to Seattle to attend the NIRI Annual Conference. I had not attended the annual conference in several years and was hoping to get updated on the latest developments in the profession. What I was treated to was two and one half days of unremitting panel discussions. Not only that, but most of the panel discussions featured speakers that were subject matter experts in fields other than investor relations, so that we were hearing from them about specialized topics as they might relate to IR. The amount of coordination and preparation by and among the panelists appeared to be patchy at best. There may have been good information in there, but after the first couple of panel discussions I had gone numb.

Contrast this with TED Talks (http://www.ted.com/). If you’ve ever seen a speaker at TED, you know a.) They are passionate about their subject, and b.) They are committed to giving the talk of their lives in 18 minutes or less. The result is consistently fascinating information delivered in a riveting fashion. Why can’t NIRI, an organization of professional communicators, come up with a way to be as interesting? For communicators, a conference full of panel discussions is the equivalent of going to a decorators’ convention and seeing everything painted white.

So here’s a modest suggestion for the NIRI national conference: Put out a call to members of the profession for presentations, no more than 15 minutes in length, about something they do that is unique, different or best in class related to IR. The best presentations would then be featured at the NIRI National conference in front of their peers. Talk about a chance to shine and be recognized as one of the best in your profession. At the same time best practices would be shared in an entertaining format.

But it’s not just about sitting passively and listening to people talk. People learn by doing as well. Interactive learning through case studies is a great way for people to work with concepts in real life situations. The Houston NIRI chapter has successfully used case studies at the last two Southwest regional conferences they’ve organized and even received awards from NIRI for them. So when the Houston chapter offered to put on a case study at this year’s national conference, you would have thought that NIRI would feature it as a great change of pace and a different way to impart information. Instead, NIRI put the case study as an optional workshop after the main conference had ended. I was participating in the case study and even I was ready to go home by the time the case study started. As a result of the scheduling, only 30 people out of the 1,300 that attended the conference stayed around for the case study. Talk about the waste of a learning opportunity.

I have been making presentations for more than 30 years and have taught in business school for 5 years, and one thing I’ve learned is that people will remember things if you make it interesting and memorable. I hope that NIRI learns the same lesson before the next annual conference. 

Guidance? Here’s a Map - Find Your Own Way!

While there are sound reasons for some companies to issue earnings guidance, some of which I discussed last week, I want to go on record as stating that I don’t like companies giving guidance. Part of this is that I don’t like the gamesmanship that goes into the guidance number. (In business school, game theory was a continuous source of puzzlement to me – I never did figure out who was wearing the red hat.)

Because the market tends to penalize you heavily if you miss your guidance number, most companies sandbag the number to a certain degree. So after a few quarters where the company beats its guidance, analysts & investors have yet another reason to question the credibility of management. Then they start to raise their estimates because they are convinced that management’s estimates are too low, and management starts to get into the whole business of trying to keep analyst estimates in line. The end result is that it becomes a vicious cycle consuming a lot of investor relations time and effort that does little to help investors understand the intrinsic worth of the company.

So now that you know my bias, here are a number of reasons not to give guidance:

1.   Don’t give guidance if you are in an unpredictable business. This should be obvious, but you see it all the time. For example, insurance companies are in the business of underwriting uncertain risks. They don’t know when the next natural disaster will wreak havoc with their earnings, so it makes no sense for them to be giving guidance on earnings.

2.  Don’t give guidance if you are not very good at it. If your company has given guidance in the past, but you find that you have to constantly revise the numbers downward, guidance is more trouble than it’s worth. Find a better solution. (More about this later.)

3.  Don’t give guidance if it will cause management to engage is short-term practices that are not in the best long-term interests of the company. Jiggling things around to “hit the numbers” is a slippery slope at best and the road to perdition at worst.

Because the market is focused on future cash flows as a means of valuing your company, it will make an estimate of your revenues and earnings whether you help them or not. And if you don’t help them in some fashion, the dispersion of estimates will be wider than if they received some input from the company. But the input doesn’t have to be guidance.

If you feel that your company needs to give out guidance, then your company is not giving out enough interim information to let analysts and investors come to a reasoned estimate on their own. Many companies tend to be “black boxes” in between quarterly reporting periods.  This is unfortunate, because the ideal of a good corporate disclosure program should be to dispense enough information, and update the information frequently enough, so that investors are able to reasonably reach informed decisions about how you are performing.

For example, many retailers put out monthly sales numbers. By the time quarterly earnings come around, everyone knows the sales number for the quarter. For many companies, this eliminates guessing around one of the more uncertain numbers on the quarterly income statement and reduces the need for guidance.

Or consider Progressive Insurance, a company in an industry that is notoriously difficult to predict. Progressive doesn’t give out guidance. Instead, every month Progressive puts out a monthly income statement and balance sheet. And as a result, they are well followed and their stock trades with less volatility than many of its peers.

Alternatively, if your management really means it when they say they are running the company for the long-term, tell the market what your long-term goals are, and how you’ve performed against them. This is known as putting your money where your mouth is…

Guidance – Part 1, Can’t Live With It, Can’t Live Without It

Back in the sexist days of yore, men had a saying: “Women – Can’t live with ‘em, can’t live without ‘em.” That’s sort of the way I feel about guidance, especially earnings guidance. Personally, I don’t like it, but I recognize there are times when it’s necessary. It seems to me that if you give guidance, and you hit your projected numbers, then you get no credit for it. On the other hand, if you miss the numbers you guided to, investors really penalizes you because they expect that you have better insight into the business than they do. And if you beat guidance, then you were sandbagging the numbers and analysts raise their future estimates so high that you are sure to miss in the near future.

Yet lots of companies give guidance, so they must feel they need to. According to a 2010 NIRI survey on guidance practices, of the 269 responding companies, 90% provide some form of guidance, 58% provide guidance on earnings/EPS and 62% on revenue or sales. Baruch Lev, in his book “Winning Investors Over” uses data from First Call and comes up with around 800 companies that provided quarterly guidance and 1,400 that provided annual guidance in 2007. Companies must feel compelled to issue guidance because no sane businessman is going to want to make a public forecast unless he is forced to do so.

So I went looking for some data to see if guidance was a good thing or not. Not surprisingly, the data is mixed. In his book Baruch Lev cites a number of academic studies in support of giving guidance. First, there is a study that shows that companies are more accurate at quarterly guidance than analysts. (This, of course, is not evidence that company guidance is necessarily very accurate, just that it’s more accurate than analysts’.) Second, he cites studies that indicate that guidance enriches the information environment in the capital markets. By this I think he means that the very act of giving guidance is another piece of information, which helps improve transparency. And academic studies show that transparency leads to higher stock prices, lower stock volatility and reduced cost of capital.

On the other hand, the consulting firm McKinsey, in a study published in the Spring of 2006, concludes “Our analysis of the perceived benefits of issuing frequent earnings guidance found no evidence that it affects valuation multiples, improves shareholder returns, or reduces share price volatility. The only significant effect we observed is an increase in trading volumes when companies start issuing guidance…”

So there you have it: dueling experts that lead you to exactly opposite conclusions. Given that it is not totally clear that guidance is for every company, I thought I would try to lay out some of the thinking that might lead a company to make an informed decision regarding guidance. My next post will take the opposite side, citing the reasons not to issue guidance and discuss some of the alternatives that I think are better.

You should engage in guidance if:

1. You are a small cap company and have low sell side analyst coverage. One of the big issues for small cap stocks is getting on the radar screen of analysts and getting coverage. Anything a company can do to improve their chance of coverage, including issuing guidance, should come into play in order to gain the increased trading volumes, liquidity and visibility that come with increased sell side coverage.

2.  You are in a predictable business with good insight into near term revenues and profits. Companies with recurring revenue streams or large backlogs of orders to be fulfilled in the near future are an example here. Businesses with wide swings in revenues dependent upon one-time orders are not good candidates.

3.  You don’t want to give continuous updates on your business in between quarters. The more transparent you can be on a continuing basis, the less you need to help the street by giving guidance. (More on this next week.)

4.  Management has the intestinal fortitude to run the business to plan and not manage the earning to hit guidance. Accounting is full of subjective judgments and timing issues. It is possible to move revenues into the current quarter or fiddle with loss reserves to make earnings look better in the quarter so you hit your guidance. This is almost never a good thing, but the pressure to “hit the numbers” can be overwhelming at times. Don’t issue guidance if it is going to warp the way you run your business.

5.  You figure that the market is going to make a forecast anyway, so why not take control of the process.

I suspect there are many companies that give guidance that do not fit any of the above reasons, but instead do it because all of their peer companies give guidance. This is probably the worst reason to do it, and for support, I cite motherly wisdom about all your friends jumping off a cliff.

One Tweet Over the Line - Social Media, Investor Relations and Common Sense

Occasionally a sacrifice must be made to the gods of new technology. That is why innovation is sometimes referred to as “the bleeding edge”.  The latest cautionary tale about the brave new world of social media just happens to be about Gene Morphis, the now former CFO of Francesca’s Holdings, a public company, who used Facebook and Twitter to make comments about company and board activities and got fired for his comments.

We have been living with social media for a number of years now, so perhaps it’s not exactly leading edge, but in areas touching upon investor relations, companies have been late adopters, so there is not a lot of precedence to guide people. However, there are two touchstones people should use when putting out blogs, tweets and other social media postings.

First, consider what the Securities and Exchange Commission has said on the subject. To put it plainly, the SEC has stated that that statements made by a company, or anyone who could be considered as speaking for the company, must comply with all of the requirements and restrictions of the securities laws. That means that you must be truthful, complete and not misleading in any statements you make. You also have to comply with the requirements of Reg. FD, and if your blog or twitter feed doesn’t qualify as a broad based distribution method (and most probably do not) then you cannot use it to release material non-public information.

The second item to take into consideration in making social media comments about your company is plain old common sense. One way to test what you want to put in a blog or twitter post is to ask yourself, “Is this something I would be comfortable saying to a room full of equity analysts?” If not, then don’t put it out on the Internet where everyone can see it. This is not rocket science, but there seems to be a switch that gets flipped when some people get on the computer and start typing. People seem to think they can say anything and not be held to the consequences. Who can forget John Mackey, the CEO of Whole Foods making derogatory postings on a discussion board about a company Whole Foods later acquired? (As an aside, Mackey appears to have learned from his missteps as he now has a blog on the Whole Foods web site which gives you good insight into the way he thinks about his business.)

In the case in question, there are a number of statements Mr. Morphis made that are just plain dumb, and probably were reason enough to get him fired by a CEO and Board of Directors lacking in a sense of humor. One example was on March 6th when he said, “Dinner w/Board tonite. Used to be fun. Now one must be on guard every second." But the post that, in my view, he deserves to get fired for was made the following day when he wrote, "Board meeting. Good numbers=Happy Board." Given that the quarterly earnings were not released until March 13, it appears to me that he was making a comment on the upcoming quarterly earnings.  It violates both of the considerations I discuss above: it appears to disclose material non-public information in a selective manner, and it is something that even the most junior investor relations officer would have the common sense not to say. It is clearly, to misquote an old Brewer & Shipley song, one tweet over the line.

Read This Book - Winning Investors Over

To a large degree, investor relations exists in an academic research vacuum. It is hard to find good data on many of the issues IR practitioners spend their time on: guidance versus no guidance, how much information should be disclosed, how to be effective on conference calls, and the overall effectiveness of investor relations programs. Further, if you do go looking for the data, as I have done for my class at Rice, it’s buried in obscure academic journals and couched in dense academic verbiage. (If you are looking for a summary of some of the findings, you can find them on my July 7, 2008 and March 13, 2008 posts.) As a result, much of what investor relations people do is based upon common industry practices, hard learned experience and word of mouth, filtered through the particular corporate environment in which they operate. Hard data on whether or not these practices are effective is simply hard to find and so people go with their gut reaction and what they are comfortable with.

To a certain extent I think this is because effective investor relations covers a number of different disciplines, including finance, communication, marketing and law. Add to that effectiveness mix the need to be an expert on your company’s operations and industry and a comprehensive understanding of how the capital markets work, and you can start to understand why getting good comparisons on the difference between successful IR programs and run of the mill efforts is so difficult.

Recently however, I have run across a book that pulls together the research in the area of disclosure and investor relations activities and puts it into clear understandable language. (I’ve actually been reading the book for a while now, but I’m having trouble getting through it because I keep stopping to make notes to use in my investor relations class.) That book is “Winning Investors Over” by Baruch Lev, a professor at the Stern School of Business at NYU. It covers most of the issues that bedevil IR practitioners, discusses what the research data shows, and makes recommendations on courses of action. For example: Not sure what to do about guidance? Not only does this book show you what the research says, it also helps you put the decision process into a framework that helps you work through the issue. And he does this with issue after issue.

If you are an investor relations practitioner and you want your company’s investor relations and disclosure practices to be informed by the data, not just what everyone else does, you need to read this book. It is so far beyond what I have seen in other books about investor relations as to be in a class by itself.