Lessons @ NIRI-U of Michigan
This blog is a way for me to crystallize thoughts on investor relations and share some ideas as part of the larger online conversation among IR professionals. In that spirit, I’m offering notes this week on the Theory and Practice of Investor Relations executive education program, which I’m attending at the University of Michigan’s Ross School of Business.
The annual seminar is co-sponsored by the National Investor Relations Institute (NIRI) and University of Michigan.
My aim here is to share my own comments and take-home lessons on IR issues and trends as they are discussed. Obviously, these notes are no substitute for attending the seminar – they may be a reason for checking out the program yourself. We’ll see how a daily log format works …
Sunday … The “Finance 101″ lead-in to the seminar is foundational for people whose job is communicating information to enable investors to value their companies’ shares.
… “The fundamental law of valuation,” says Michigan accounting prof Russell Lundholm, is that “the value of any security is the present value of its future cash flows.” Clearly, IR people should concentrate on information that feeds the valuation process.
… Discussing the time value of money and financial valuation models, it seems to me that IR focuses too little on communicating the “time” components of performance. When “forward-looking information” just means guidance on next quarter or the year, we give in to short-termism and ignore the need of long-term investors to make informed assumptions about the future stream of cash flows.
… We also tend to ignore the discount rate investors may use in developing a valuation. Estimating risks affects that discount rate: Venture capitalists may discount expectations for a startup by 50 percent or more in calculating present value, while a mature cash flow stream may merit a discount rate of 6 to 10 percent. Yet companies tend to treat risks as boilerplate in a required legal disclosure, rather than a financial factor that investors need to quantify to arrive at a sound valuation.
… As an accounting expert, Lundholm notes that accruals (restructuring charges, inventory reserves, charge offs for discontinued operations) are grounded upon management judgments and can become a source of manipulation in net income. A company might move costs from one period to another for “smoothing” of earnings. A new CEO might take a big charge, blame the previous regime, and move some costs from the ordinary operating P&L into the “one-off” line. My thought: IROs should dig deeply into accruals and be ready to discuss them with skeptical investors.
Monday … In the legal segment, Michigan business law prof Dana Muir pulled hot topics from today’s headlines: governance & proxy issues, securities fraud, Reg FD issues, and insider trading. Highlights for me:
… Proxy challenges are a growth industry as activists target boards, comp committee members after pay scandals, audit committee members for accounting problems, and so on. Muir says we haven’t seen many proxy votes actually unseating directors - yet - but the trend has momentum. Add to that the fact that Barack Obama and John McCain both support requiring firms to put shareholder candidates into company proxies. So being a board member is no longer an entitlement.
… Securities fraud is violating the rule that material disclosures must be accurate and not misleading, either by what you say or don’t say. Muir says 57 percent of shareholder lawsuits allege securities fraud. Even more threatening are SEC or Justice Department actions, which devastate the reputations and careers of defendants – and can lead to jail time in extreme cases. IROs bear a sobering responsibility as gatekeepers and advocates of accurate disclosure.
… Regulation FD continues to confuse some companies, though a NIRI Executive Alert on July 21 noted that senior IROs generally think the ban on selective disclosure is healthy. Among ongoing questions, Muir cautions companies against reaffirming earnings guidance in one-on-one meetings a few weeks after broadly disseminating a forecast. Seems to me it is better to say something like, “We gave this guidance in our second-quarter release, and we’ll update it when we put out our third-quarter numbers.”
… Insider trading continues to pop up. Trading on material nonpublic information is clearly forbidden for employees and agents of companies, as well as close relatives and “tippers and tippees,” Muir says. Discussion on one gray area focused on conversations overheard in bars or restaurants – begging the question, why would responsible corporate staffers discuss material nonpublic data in a bar or restaurant? Any corporate conduct policy, clearly, should include warnings to employees about stewardship of confidential information – as well as, obviously, not trading on it.
Introducing a two-day discussion on capital markets, Michigan associate finance prof Tyler Shumway notes the distinction between “real assets” and “financial assets.” He says real assets are buildings, machines, knowledge, reputation, brands and people – while financial assets are claims on income generated by those real-world things. IR people and company disclosures often paint an abstract picture of a business model constructed only of numbers, but we might tell our stories more clearly for investors by focusing more on the real assets and how they generate returns.
Shumway offers an endorsement of the value of investor relations. After reviewing the mechanics of securities markets, he notes that transaction costs for an asset manager include not only commissions, but also the impact of the institution’s own trading on market price, a function of liquidity as measured by the stock’s bid-ask spread and depth of bid-and-ask orders. Total transaction costs range from 1.1 percent up to 10.3 percent per trade, and average turnover rates for mutual funds are more than 100 percent a year, Shumway says. So, he asks, “Is 1.1% something to worry about?” Big time. He sees transaction costs as a major focus of IR.
The clincher: For less transparent stocks, Shumway says, bid-ask spreads are larger and the depth is lower. He believes IROs should focus on lowering transaction costs by promoting liquidity, improving transparency and reducing information asymmetry. Shumway adds: “Lower transaction costs mean more people are willing to hold your stock – their holding-period returns will be higher.”
Tuesday … Moving to the investment process, Michigan associate accounting prof Reuven Lehavy focuses on what matters to investors who analyze stocks to arrive at valuations. My net-net for application in IR:
… Take a look at the most readily available information on your company. What does it say? Serious investors begin with information collection, Lehavy says. They’ll read the K and the Q and the press releases and your website – probably sell-side reports and possibly blogs or message boards – before ever calling the company. When someone takes that first step of data gathering, do they get “your story” (or something less) from each K or Q or release?
… Help investors understand the strategy. Digging through SEC filings and enduring conference calls is about identifying and evaluating a business strategy for generating abnormal returns. “What is your one single idea that, if you execute it, will cause you to do really well and make a lot of money?” Lehavy asks. “The first step for any communication … is identifying one product, one service, that you have, and no one else has, that’s going to make you a lot of money.” That’s the story.
… Give your macroeconomic and industry view (briefly). Many IR presentations go straight to the granular company-specific data. CEOs and IROs are all too familiar with their social and economic context. So, thinking everyone wants to hear about the trees, they no longer describe the forest. But Lehavy notes that investors do worry about all those outside factors – oil prices, wars, GNP growth, credit crises – and they need to know your view of what affects your business and what doesn’t. “Never assume people know everything,” he says.
… Seek consistency between accounting and strategy. Once investors get your strategy for creating value, they delve into the accounting data for evidence – that you are or are not achieving the strategy – Lehavy says. IROs should be internal watchdogs for the linkage between numbers and strategy. Are we reporting the right measures? What figures or ratios are the drivers of the performance we say we’re seeking? Are there inconsistencies or vulnerabilities? At the very least, IROs need to know the relationship between the strategy and their detailed numbers – and be ready for the hard questions.
Wednesday … Number crunching, as Lehavy sees it, aims for an understanding of what drives the value of a company – and then a forecast of how it will perform in the future to create that value. A few take-homes:
… The financial ratio that makes the most sense in analyzing a company is ROE (return on equity), Lehavy says. But it doesn’t stop there. He “decomposes” ROE into profitability, efficiency and leverage. That is, ROE is the mathematical product of profit margin (income/sales), times asset turnover (sales/assets), times financial leverage (assets/equity). From there, he parses ROE further to separate operating returns – everything related to the actual business – and returns on financial assets. An IRO should understand the drivers the go into ROE, such as gross margin or operating margin or inventory turnover or measures of solvency and liquidity.
… Full financial statements – P&L, balance sheet and cash flow – are essential to sound valuation, Lehavy says. Many analysts and companies obsess on the income statement, particularly EPS, he notes. Or they go with EBITDA. Working on the theory that true value is in one way or another the discounted sum of future cash flows, he notes that one of the keys to cash flow – change in working capital – isn’t even shown on the P&L, but in balance sheet lines such as inventory, receivables and payables. Earnings releases, presentations and conversations often give short shrift to the balance sheet. IROs need to know and discuss the interplay among the financial statements.
… Both profitability and growth are essential to the way a company creates value, Lehavy says. The point is that it’s profitability and growth – not one or the other. (He points to ROE and growth components in the valuation formulas, but I’m not going to go there in this blog.) Often, companies or analysts talk about a great growth story, but not profitability – or vice versa. IROs should be sure their messages discuss both – and if one is present, but not the other, address the need for improvement as part of the company’s strategy for creating value.
Thursday … The connection between high-quality disclosure and shareholder value is more than just a theory. Michigan accounting prof Russell Lundholm says abundant evidence bears out the idea that companies delivering more and better-quality information earn a premium in market value.
… Lundholm cites studies that show firms with better disclosure attract more analysts (especially true for smaller firms); improve their stocks’ liquidity and reduce transaction costs; reduce volatility around earnings time; lower the cost of equity capital; and increase their stock price. He even offers a study that shows 184 firms that hired IR consultants achieved benefits such as better trading volume, higher institutional ownership, more analyst coverage, more media attention and – the key – increased valuation as measured by price-to-book ratios. Who would have guessed?
… Turning to the nitty-gritty of investor relations practice, National Investor Relations Institute president and CEO Jeff Morgan cites NIRI’s recent interviews with 30 senior IR pros on communicating in a post-Reg FD world. Bottom line: Pursue best practices in transparency, consistency, responsiveness and credibility. These are motherhood-and-apple pie labels, of course. But the verbatims in the July 21 NIRI Executive Alert offer practical ideas on specific behaviors and process changes.
… On when to issue an earnings release, companies have different ideas. Many of the two dozen participants in this seminar seem to converge on a best practice: Issue the earnings release before the market opens, hold a conference call later that morning (giving investors time to digest the release before calling, and media people time to listen to the call and get their quotes before p.m. deadlines), and file the 10-Q later that same day. Not everyone does it that way – so this could be my prejudice, rather than a true best practice.
… Morgan warns dramatic changes in disclosure are looming, including XBRL reporting of financial data as part of SEC filings, replacing EDGAR; increased emphasis on disclosure via corporate websites, encouraged by the SEC; new guidelines brewing at FASB for how to set up financial statements; and a switch from GAAP to IFRS (International Financial Reporting Standards), expected in three to four years. “If any of you think IR is a static profession, it is the farthest thing from a static profession,” Morgan says. We need to get ready for these changes.
… NIRI has undertaken a spate of new studies on key issues in IR practice, with reports to come out this fall – so watch your e-mail inbox (assuming you’re a NIRI member).
Friday … The seminar finale is a freeform discussion of hot topics on people’s minds. NIRI’s Jeff Morgan moderates a panel of three seasoned IROs: Lynn Liddie of Domino’s Pizza, David Prichard of Corn Products International and Ann Sternberg of American Physicians Capital.
… All three IROs interact with their boards of directors in regular ways. A common element is an annual IR presentation to the board on what’s happening with the investor base, capital-market interest in the company and top concerns of shareholders. Other examples: support for specific board committees, quarterly written reports, an online library of board documents, and answering board members’ questions on issues as they arise.
… In an age of litigation and shareholder activism, the panelists say IROs should take care to follow document retention policies and avoid sending e-mails or making notes that might be dragged into a court case. One IRO gets analyst questions by e-mail but responds by phone. In day-to-day work, an IRO suggests, keep a person with all the numbers at your right hand, and a securities lawyer at your left hand. A good mindset these days.
… Success factors for an IRO (how to measure if you’re succeeding) tend to be qualitative, but shouldn’t be fuzzy. We can ask, can we see progress in building understanding of the company’s key messages and strategies, maintaining sound, up-to-date disclosure practices, communicating news (good or bad) in ways that temper overreaction, serving as the CEO/CFO’s eyes and ears in the capital markets, and playing the staff role of ensuring that events go smoothly for senior management?
Quantitative measures can include activity counts like conference presentations or one-on-ones, outcomes of investor perception studies, sell-side analyst coverage, stories in the financial media, or goals for changing the shareholder mix (increasing the percentage of foreign or institutional holders, etc.). IROs are less than unanimous on the value of any given number, and most agree that stock price isn’t the prime measure of success – since the value of the company is driven by the economics of its business more than by IR efforts. IR performance measures must fit the company.
Once again, thanks to NIRI and the University of Michigan for organizing this seminar and enabling me to participate. (We put out a news release for Kansas City and online media on my completion of the program.) Bottom line, it’s a terrific program for IR executives.