A Libretto for the Upcoming Legislative Changes

There is an old saying that goes “No man’s life, liberty or property are safe while the legislature is in session”. Recently we’ve been treated to a great example of this as the Obama administration introduced its proposals to overhaul the regulation of the financial industry and is revisiting a version of national mandates on health care. This being a blog on investor relations, I will focus on the process of changing the regulations in the financial industry, as eventually those of us involved in the equity markets will be impacted by such changes. Most aspects of the regulatory apparatus that oversees the financial industry, from the Securities and Exchange Commission, the Commodities Futures Trading Commission, the Federal Reserve, the Federal Deposit Insurance Corporation the Comptroller of the Currency and various and sundry other regulators have come under scrutiny. Nobody really knows how all of this will play out yet, but it makes great theatre, so I thought I would give everyone a guide to the proceedings.

Act One, Scene One: Capitalists will seek an investment edge that will allow them to reap profits. Once they find one that is legal, the early movers will become very rich. They will be followed by many more capitalists who, seeing the profits to be made, will expand the pool of money available for the investment in question. As more money chases a finite number of investments, standards will be lowered. See for example, the funding of start-ups in the dot .com boom, the prices paid for private equity deals in early 2008 and the sub-prime housing lending bubble. Eventually, when prices get crazy enough, the whole bubble collapses under its own weight. Investors lose tons of money. Everybody blames someone else for the collapse. There are outraged calls for Congress to act.

Act One, Scene Two: Enter the politicians and the bureaucrats. Sensing an opportunity to score easy points with the public, politicians begin to make proposals to protect investors, consumers or anyone else that can vote. After all, people vote, corporations don’t. The legislation that is proposed is designed to fix the immediate problem on hand and to demonstrate that Congress can act. Press conferences are held, laying out bold new initiatives to protect investors and consumers. Hearings are held, wherein the scapegoat du juor gets publicly flayed. While the politicians are preparing to act, the bureaucrats swing into action. This is where bureaucratic empires can be won or lost. Witness the recent struggles between the SEC and the CFTC. While it might make sense for one agency to regulate both securities and the derivatives that trade off them, neither the SEC nor the CFTC was going to submit to the other. Influence is wielded to protect regulatory turf and deals are cut.

Act One, Scene Three: Congress drafts legislation. In fact, they draft multiple versions of legislation. Nothing makes a Congressman or Senator feel better than to cosponsor legislation that will help them demonstrate to the folks back home that they are helping stamp out the evils of the flawed financial system that allows poor hapless consumers and investors to be sucked dry by rich bankers and hedge fund managers. Nobody pays any attention to the additional regulatory costs being layered onto the system. After all, corporations will pay that, and corporations don’t vote.

Act Two, Scene One: As the legislative process heats up, the fabled lobbying system swings into action. Lobbyists work on three basic premises: 1.) Time is their friend. The longer legislation can be delayed, the better the chance provisions can be inserted into it that benefit their organization. 2.) Every corporation resides in a home district or state of some Congressman or Senator and those corporations control jobs and investment spending in somebody’s home town, and those people do vote. 3.) While corporations don’t vote, their trade organizations control lots of money. And money is the mother’s milk of politics.

Act Two, Scene Two: Legislation finally gets passed. The President holds a bill signing ceremony and smiling legislators gather around him. The system works, sort of. The bill that gets enacted is usually far too long, with conflicting provisions and a very unclear legislative history. It will inevitably prove to have unintended consequences that will later require further legislative or regulatory fixes. Lawyers representing constituencies whose oxen are getting gored by the legislation are preparing to file lawsuits challenging the law even as the President is signing the bill.

Act Two, Scene Three: Capitalists begin combing through the legislation seeking an investment edge that will allow them to reap profits…

Email is Not Your Friend

Email is such an ubiquitous part of our lives today that we rarely think about the long-term implication of what sending an email involves. Recently we have been treated to the spectacle of the Securities and Exchange Commission bringing fraud charges against Angelo Mozillo, the former CEO of Countrywide, over statements he made in emails to his associates. The allegations are that in private emails he described one Countrywide product as “toxic” and another product’s performance so uncertain that they were “flying blind” while at the same time maintaining to the outside world that Countrywide was underwriting mainly prime mortgages using high underwriting standards. Of course, what we don’t know, and what will have to be decided in the courts, is whether such “toxic” products were significant enough to constitute a material impact on Countywide’s operations, thereby constituting securities fraud.

A lot of interesting things are at play here, not least of which is the SEC’s desire to appear tough following an era of lax enforcement. This is not very different from the description in Tom Wolfe’s “The Bonfire of the Vanities” of the desire of the district attorney to find a “great white defendant”. While I could devote my entire blog post to this topic, I’m going to focus on a much more mundane issue – the corporate use of emails.

It has been amazing to watch the explosive growth of emails, chat and twitter over the past few years. Back in the dark ages when I first started working, if you wanted to communicate with someone, you picked up the telephone and called them. Nowadays, many people make an appointment by email to make a phone call. When I was still in the corporate world, I would have people in the office next to mine email me rather than talk to me. Emails are such a part of business life that people don’t stop to think of the potential impact they may have using the 20/20 hindsight of litigation.

Once an email leaves your computer it takes on a life of its own. Not only does a copy go to the recipient, but a copy also goes to the corporate server, where your diligent IT department makes sure it gets stored forever. If you are sending the email to a corporate recipient, another copy gets stored on their corporate server. Not only that, but the electronic record is easily searchable for subject matter and key phrases. If that weren’t bad enough, your email is easily forwarded with the push of a button, so you’re never quite sure where it will wind up. Think about answering an analyst’s question and having your email forwarded to half a dozen hedge fund managers.

What all of this means for investor relations practitioners is, as the title of this post says, “Email is not your friend”. Investor relations people should never express opinions in emails that might come back to haunt the corporation at a later time. As a practical matter this means that things such as discussions about materiality of issues, concerns about business practices or other potentially controversial items should not be discussed in emails. The only exception is when the attorney-client privilege applies.

We work in a discipline that is fraught with legal liabilities. While it may seem as if it is taking a step backwards, when communicating with investors, or discussing potential disclosure issues, email should be used sparingly, if at all. You should write every email as if your email is being intercepted - because it is.

Stop the Earnings Guidance Madness

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

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

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

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

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

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

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

What Makes for Great Investor Relations?

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

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

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

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

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

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

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

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

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

Helping Filter Out the Noise

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

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

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

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

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

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

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

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

Getting My Act Together and Taking It on the Road

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

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

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

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

A Jaded View of Investor Relations

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

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

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

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

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

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

Management: “We are in a challenging environment”

What this really means: Business sucks.

 

Management: “We have not changed our earnings guidance”

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

 

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

What this really means: It’s getting worse.

 

Management: “We see signs of stabilization”

What this really means: It still sucks.

 

Management: “We see opportunities for efficiency improvements”

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

 

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