Category: Investor Relations

Six Challenges for Investor Relations

Investor relations is broken.  It isn’t the people, it is the process.  Most senior executive see it as a department designed to help the company put their best foot forward.   The skills needed are someone who is good with powerpoint, knows numbers and can talk to analysts all day long without going crazy.   I think this definition misses six key challenges for Investor Relations.

Challenge #1 Investors have no time

Investors are limited by time and attention.   Investing is based on financial reports which are both long and redundant, and the amounts of disclosure are not improving investor knowledge (read this).  The SEC and the FASB have turned a simple financial statement into a career generating stack of paper.  A typical 10k runs 100+ pages and is stuffed with disclosures, reconciliations and accruals.

A typical financial model will go back 10 years and ideally, all the 10k’s & q’s should be read from the entire history.  Most are not.  I bet that fewer than 50 people outside the company conceivably completely read any 10k document.  Most analysts look at changed pages from the previous document, skim the management discussion and update the models with the key data.  If you own 50 stocks, your reading load might be the same as knocking off three books a week in SEC filings alone, not including the other material you read to know what is going on in the economy.

Time pressure causes investors to look for shortcuts to the intellectual rigor of a complete and detailed review.  Pattern recognition conserves time and brain power.  Investments are selected that are similar to past successes.  Investors classify stocks by lots of methods (growth, value, etc) to eliminate the time memorizing details about every company.  The intellectual demands to obtaining, sorting and absorbing the material means that complicated stories are often ignored or missed. Complicated analysis, the use of a lot of jargon just make the analysts job harder, and therefore less likely to expend the energy to invest in your firm.

Clarity increases comprehension and makes the job of an investor easier. Easier means better analysis and better communication and a better stock price.

Investor relations has to recognize the time pressure and focus on a coherent set of facts that allow a potential investor to understand the business and make a prudent investment. 

Challenge #2 It’s not just numbers

For the last fifty years we’ve been training executives in quantitative analysis, and today’s MBA’s know how to deconstruct a business.  Because of our emphasis on numbers, today’s executives tend to manage rather than lead.  CEO’s and CFO’s certify that the financial reports to the best of their knowledge do not include misstatements, or are misleading.  Making both CEO’s and CFO’s more involved in the data and detail.

Investors do not have access to the details of the business, and realistically we can’t share them.  Analysts are trying to make meaning out of disclosures, so they ask a lot of questions about management’s impressions or thoughts (or my least favorite “add some color to the numbers”).   When analysts ask these questions, they are asking for help understanding the bigger picture and cannot tie in the numbers to a direction or theme.

Santa Cruz cows out standing in their field

They are looking for the story behind the numbers.  When a senior management team that generates and lives on numbersis selling to someone who is looking for a story, there is a disconnect.

Humans like stories (see here for Paul Zak’s HBR article) and we remember them better than the numbers.  The story provides structure to our understanding and helps add meaning and relevance.

Investor relations has to communicate a story that makes sense.  It has to be reasonably based on history and explain a direction and purpose for the company.   It is more than the just the numbers.  

Challenge #3 An Outside Perspective

Investors have one huge advantage in valuing firms that senior managers lack.  They have an outsider’s perspective.  Working at a hedge fund meant sorting through 2-3 firms a week.  You hear what the other firm’s have been saying, you can compare this quarters disclosure to the last 15 quarters, you aren’t sitting on half a million options that are underwater.  The outside perspective is very valuable, I have written about it before (see here).  Outsiders haven’t drunk the company Kool-aid, they aren’t convinced of the company’s invincibility and they aren’t incentivized to worship the company mission.  This perspective is valuable to CEO’s and Boards, but the criticism is dismissed because the outside view often is working off of fewer facts and CEO’s reject criticism of their strategic plans.

In a capitalist system, the investment community is the owners of the business, and we should listen to the owner, even if they are sometimes wacky.

Investor relations needs to be a vital conduit about market perspectives on company strategy.  That message has to come back to senior management the board and the CEO in actionable and understandable ways.  

Challenge #4 It can’t be delegated.

Management gets a chance a couple of times a year to tell their stories to the investment audience.  The simplest way to tell of a management team lacks a coherent strategy is if they can’t get the message across in the 25 minute talk they give before the break-out session.  If in 25 minutes you can’t get the message across to the 40 or so MBA clones that make up the ranks of stock analysts, how did you get that message across to the 10,000 high school graduates that make up your workforce?  Whenever I hear jargon and business-speak when a senior executive is discussing strategy, I know that strategy is dead on arrival when it gets to the front-line worker.

All presentations should be practiced prior to being given.  If we work for the investors, what message do we send when we arrive at our meeting and our report is fumbled and ill prepared?  I’ve never believed the stats about how much of meaning in a conversation is non-verbal, but I respect it is very high.  Stumbling through a presentation reduces personal and firm credibility.

Investor relations is the responsibility of the CEO and CFO, and hiring a director or VP does not absolve you of the responsibility of being prepared, practiced and ready when reporting to the investors. 

Challenge #5 – Authenticity = Credibility

George Burns was quoted “sincerity – if you can fake that you’ve got it made”.  Senior executives think of IR as a something that can be faked.  After reviewing 100+ companies a year for 12+ years, I’ve seen a lot of pitches.  Figuring out what the management team does and doesn’t know is how we made money.  If you state that you are #1 in something, you’d better be prepared for us to check.

Most Investor relations staff get the compliance problem.  All the numbers are verified, everything is properly sourced.  Then the CEO or CFO make an off-hand comment that will end up on a transcript and will be fact checked.  I’ve written before about the average experience of stock analysts (see here).  New analysts spend a lot of time reconciling cognitive dissonance, which is a fancy way of saying, does management “walk the talk”.

I’d rather a management team was perceived accurately, even if that perception was negative, for example as aloof or uncommunicative, rather than as something they are not.

Investor relations stands for authenticity and accuracy.  Senior executives aren’t clones, and should be respected as individuals.  Don’t write speeches full of bafflegab and resist the use of jargon. 

Challenge #6 – Everyone is an Investor

Most companies incentivize with stock options and most stock option grants are small.  Outside of a relatively small circle of high paid executives, most option grants hold little perceived value.  They have a cost, but the perception is that they don’t have any value until they are vested and are deeply in the money.  The staff needs to hear the story as much as the analysts do.  Vendors may make million dollar commitments for a new product line and they need to hear your strategy.  Customers, especially when they are making a commitment to a product, need to know whether the company is viable.

The reality of today’s connected society is that the number of people who “care” about what IR has to say is much greater than before, and those listeners have much more influence the firms success.

Investor relations material should be prepared for all the stakeholders, based on their needs.  The delivery of employee oriented material may be through HR, but that disclosure should be focused on the key story and theme set by the strategic plan. 

Conclusion

Investor Relations needs to play a bigger role within your firm. Helping develop the strategic plan, communicating a coherent story with numbers that provide clarity and understanding.  It is time that IR is more than someone who talks to analysts and comes up with a quote.

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Dr. John Zott is the principal consultant at Bates Creek Research & Consulting.  I am the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and I comment regularly on issues that affect growth businesses.  If you are looking for a CFO for your consumer company, or are a former student, colleague or would just like to connect – reach out.

 

 

 

 

 

The Better Way to Define Growth vs Value

I often read arguments about which is better, investing in growth or value stocks.  Unfortunately much of what is written on the subject is simply wrong. By definition, value stocks have low market to book ratios and growth stocks often have high market to book ratios.

However, there isn’t a lot of difference in the sales growth rates between growth and value because sales growth isn’t what defines them.

The defining factor is in their return on invested capital (see here by Jiang Koller 2007).   The process is simple, firms with great opportunities to invest at above average rates of return (high ROIC), receive capital, invest and grow.  So why don’t growth companies have more sales growth than value companies?   Because many high ROIC firms don’t have attractive places to invest capital and many low ROIC firms don’t need outside capital to continue to grow.

Bennett Stewart in his book “The Quest for Value” defined firms into three basic categories, X firms had returns near the cost of capital, Y firms had returns above the cost of capital but had limited options for investing capital, Z firms also had returns above the cost of capital but had many options for investing capital and grew quickly. Stewart also said there were X-minus firms that didn’t earn the cost of capital and pre-Z firms that grew quickly on outside capital with the thought they’d have a Z level of ROIC later.  I like this approach to classifying firms – it is clearer about the status of the business and adds clarity to strategy.

Return on Capital Opportunities
X-Minus Below Cost  N/A
X Near Cost  N/A
Y Above Cost Limited
Pre-Z Below Cost Many
Z Above Cost Many

X and X-minus, Low ROIC

Firms with returns equal to the cost of capital (and even less than the cost of capital) or “X and X-minus“ can still have sales growth, but they won’t get the high valuations (market to book ratio) of the high ROIC firms.  These firms grow because they retain earnings, which even if low, they can reinvest in the company.  With low interest rates, firms can borrow to continue to grow.  A CFO I once met said that as long as he could borrow at 4% and invest at 7% he was going to continue.  The market cost of capital is higher than the bank cost of capital and consequently the firms stock price took a nose dive (although the bankers LOVED him).

Theoretically the right choice for these firms would be to return capital to the investors so that it could be invested at higher rates of return.  However, CEO’s and CFO’s rarely think that they should return capital, and it is often the board or an activist that pushes the issue.  This is the agency problem, where management and shareholders aren’t always on the same page.   Management incentive programs have to be carefully drawn to balance growth and return to shareholders.  Too much on sales or profit growth, then the capital becomes “stuck” in low performing investments. Too much on return to shareholders and the management team underinvests and damages the firm long term.

X and X-minus firms shouldn’t grow, but they do by retaining cash and investing in projects that generate weak returns.

“Y” Firms – High ROIC, Constrained by Operations

Most firms with good ROICs that are constrained by other the factors are called Y” firms by Stewart.  The firms have good returns on capital but are limited in how fast they can invest.  My rule of thumb on retailers was that sustained unit growth rates above 25% always and everywhere resulted in a blowout.  Over a 15 year period every retailer who grew at this rate, blew up.  Eventually the growth retailer I was with that grew at over 25% a year for 7 years blew up too.   The causes of the blow ups vary, but usually it was a lack of talented staff, poor controls or the firm continued to grow after returns declined. All problems that could be foreseen.

Growing at 25% a year for a retailer means opening a lot of new locations, and you need to locate, hire and train a staff. Growing during a downturn when good talent was being laid off helped ease some of the hiring pressure.   Although central office and distribution staff grew at a fraction of the sales growth rate, every year staff count would need to grow at 15% or better to keep up.

Growing fast also stresses controls.  Ebay used to reorganize 3-4 times a year because as the company grows, the management challenges, controls and processes have to be updated.  Nothing is static.  What you could get by with at $100m in sales won’t work at $200m in sales.

If you are successful managing the growth, the best markets will eventually be addressed and you reach the point of diminishing returns where further investment turns the above average returns to average returns.  (See here for a recent discussion of this same phenomena by Fisher, Gaur and Kleinberger).  Niche retailers run into this but also big firms such as Wal-Mart, Home Depot and Best Buy.  (This was a great source of short ideas, as there is nothing like a management team with their foot mashed on the growth gas pedal while new store returns are tanking.)

A great deal of consumer product firms are constrained by opportunity. They cannot further invest at similar ROIC levels.  New strategies (panini’s at Starbucks?) often decrease profit rate and require large investments in process and product that don’t generate a solid return.

A lot of auditing and consulting firms are extremely profitable, but as long as they can capture new clients at full rates.  You can follow a low price strategy, but in the end, you end up with low priced customers and low returns of capital.

Growth can destroy shareholder value – that is what I call dumb growth.  Capital allocation requires discipline and a set of metrics and standards that are appropriate to the strategy.  Investments must earn their cost of capital.  But there are often strategies that offer lower (but still above average) ROIC’s, that should be explored.  The Ansoff Matrix I mentioned earlier can be of help looking for opportunities.

“Z” Firms Grow Fast

A great deal of internet software and services qualifies as “Z”, above average returns, with lots of above average places to invest capital.  Sales growth is a function of reinvesting profits and raising outside capital.  This was perhaps captured best by the HBR article in 1996 by W. Brian Arthur “Increasing Returns and the New World of Business”, where he outlines the shift from decreasing returns on capital (like a retail chain that over expands) and increasing return on capital (the internet) where more users increase the value of the product.

A firm with attractive places to invest capital and is unconstrained will grow quickly.  Ebay grew over 60% for a dozen years, although they’ve grown 5% over the past five years. Eventually that happens to every “Z” firm, they reach diminishing returns (yes, even Facebook) and growth slows.

“Pre-Z” Fast Growth and Low ROIC

There are a few pre-Z’s that have gone public, Snapchat lost $520m in 2016, and $380m in 2015.  Revenue in 2016 was less than “cost of revenue”, so the customers paid actually less than it cost to deliver the service.  They are growing fast, and losing money fast. Maybe Snapchat’s numbers improve although usually great growth companies make money right away.

Amazon has survived for years where the return on capital has been paltry, with the thought at some time it will turn for the better (and perhaps it has).  Amazon’s operating profit from 2011-2015 totaled to $3.8b (no interest, no taxes) but the asset investment has grown $35.7b.  In 2016 operating profits were $4.2b, more than previous four years added together.   Amazon continues to invest to grow market share, and as long as they’ve got the cash and a 185x p/e they can continue.

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Dr. John Zott is the CFO for Carlson Wireless Technologies, and Principal consultant at Bates Creek Consulting. John is the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and comments regularly on issues that affect consumer businesses. If you are a former student, colleague or would just like to connect – reach out.