The first decade of the 21st century was the worst in recent stock market history. If that wasn’t enough to discourage investors, they had to endure a parade of corporate accounting scandals and embarrassing managerial pay abuses and stock options manipulations. Not surprisingly, investors’ resentment of public companies and their leaders is at an all-time high.
And not just in the United States, as many stock markets around the world fared even worse than the U.S. Parmalat, SpA (Italy), Satyam Computer Services Ltd. (India), Olympus Corp. (Japan), Nortel Networks Corp. (Canada) and SinoTech Energy Ltd. (China) — a partial list — prove that accounting manipulation isn’t “made in America.”
Nor was the failure of managers and directors of the financial institutions that collapsed in the recent crisis restricted to the U.S., as evidenced by similar mishaps in the United Kingdom, Germany and other countries. Investors worldwide have ample reasons for indignation.
In contrast with the recent noisy but harmless Wall Street protests, shareholders’ resentment isn’t benign. It is seriously detrimental to companies and their managers. Investors are deserting equities in droves, seeking safety and higher returns in fixed- income securities, precious metals and other alternative investments.
Moreover, investor activism is on the rise. Investors push hard for legislation enhancing the monitoring of managers and restricting their authority and control span.
“Say on pay” legislation in the U.K. and the U.S. mandates an annual shareholder vote on managers’ compensation. The Sarbanes-Oxley Act (2002) and the Dodd–Frank Wall Street Reform and Consumer Protection Act (2010) — tightening regulation, encroaching on managerial authority and encouraging whistleblowing — are among the costly outcomes of investors’ resentment.
Managers clearly need to respond to this crisis of confidence, but such response is seriously hampered by deeply rooted managerial myths and misconceptions about investors and capital markets. For example:
▪ Most managers believe investors are short–term oriented, obsessed with quarterly earnings, and all that is needed to mollify them is to regularly beat the consensus earnings estimate by a penny.
▪ Managers are also convinced that the widespread criticism of their pay is unjustified, motivated by envy and misinformation. Hence, what’s required to allay the concerns is just better public relations.
▪ Or consider earnings guidance. It is widely believed that guidance is a capitulation to investors’ short-term approach as well as enhancing litigation exposure. Accordingly, “don’t guide” is the pundits’ advice.
It should be no surprise that these and many other managerial beliefs — shaping their capital markets actions and communications — are refuted by solid evidence, yet they prevent an effective response to investors’ resentment. So, to regain and maintain investors’ trust and support in corporations and their leaders, it’s crucial to bring clarity to investors and capital markets and outline a coherent capital markets strategy to win investors over. Here are the components of such a strategy.
It’s Not the End of the World
Who is afraid of missing analysts’ earnings consensus forecasts? Chief financial officers are. A 2005 comprehensive survey showed that most CFOs consider missing the consensus so detrimental to the stock price and managers’ credibility that they would even sacrifice certain future growth to avoid the calamity by cutting research and development, information technology expenditures or postponing advertising.
And yet investors are much less concerned than CFOs with the quarterly earnings game. While in the past beating the consensus by a penny or two boosted the stock price, in recent years, research shows, beating the consensus triggers investors’ yawns.
Almost two-thirds of public companies either meet or beat the consensus by a few pennies — a practical impossibility without earnings management, given the complexity and uncertainty of the business environment.
Many executives “manage” either reported earnings and/or analysts’ forecasts (termed “walking down” the forecasts) to beat the consensus. As a result, the earnings game is hardly taken seriously anymore, and missing the consensus will often cause just a temporary 2-to-3 percent price decrease, as long as the business fundamentals are intact.
Operating Instructions: It’s nice to beat the consensus, but it’s foolhardy to avoid missing it because of self–inflicted wounds, like cutting R&D and IT, or by earnings management.
Most importantly, as soon as the CFO realizes the company will miss the consensus, he or she should release a public warning to investors, detailing the reasons for the setback as well as the corrective actions being taken. If the fundamentals are indeed intact, provide supporting evidence (continued customer growth, ample order backlog). If growth slowed down, report honestly and outline the business plan aimed at rejuvenating growth.
To Manage or Not to Manage Earnings?
Don’t even think about that. Memorize the following statistics: 93 percent of the executives whose companies were targeted by the U.S. Securities and Exchange Commission or the Department of Justice for reporting improprieties lost their job by the end of the proceedings. Many were criminally charged and indicted. And with the new Dodd–Frank enhanced incentives and protection of whistleblowers, the likelihood of being caught cooking the books is high and the consequences dire.
Operating Instructions: Earnings management isn’t only ethically wrong; it’s also a gross miscalculation. Most earnings manipulations “borrow” from subsequent quarters — front–loading of revenues, costs switch to the future — requiring ever larger manipulation, thereby rendering earnings management an unsustainable proposition.
Accordingly, avoid the temptation of “borrowing” just a penny or two of earnings from next quarter to make the numbers. What starts small ends up inevitably as a big manipulation. Cannibalizing a couple of pennies from next quarter’s earnings, leads to cannibalizing four-five pennies from the following quarter.
Soon the situation spirals out of control. For those who doubt this, read the troubling 2009 letter of the CEO of Satyam, the major Indian IT company, to the board, disclosing a massive fraud that started small yet mushroomed to a “tiger I couldn’t dismount.”
Kill All the Lawyers?
How many times has it been said that shareholders’ class-action lawsuits against companies and their managers, alleging misreporting and other improprieties, are numerous and rising, often meritless and very damaging? The reality: Federal lawsuits statistics show that there are relatively few shareholder lawsuits every year — about 220-230 annually, against 5,500 U.S. public companies, and this number isn’t rising.
In fact, it decreased during 2001-06, rising moderately thereafter in the wake of the financial crisis. The median settlement amount — more than 90 percent of shareholder lawsuits settle — is a modest $10-11 million in recent years. Most importantly, studies show that most lawsuits aren’t frivolous. The typical target company used very aggressive accounting, restated past earnings and its executives had an unusually large share of their compensation in stocks and options — a strong earnings management temptation.
However, while the overall frequency of shareholder lawsuits is quite low (3–4 percent per year), in certain industries it’s rather high: electronics and software, telecommunications, health care and drugs.
Not surprisingly, in the wake of the financial crisis, financial services firms are frequent targets of shareholder lawsuits. Note that the targeted industries, characterized by volatile demand, frequent technological disruptions and difficult–to–value assets (intangibles), are all conducive to investor disappointments and lawsuits.
Operating Instructions: For those operating in this danger zone of lawsuit-prone industries, there are lawsuit-immunization measures to take. Avoid by all means earnings management and even aggressive accounting, such as the early recognition of sales or costs capitalizations. Refrain from trading on inside information and the excessive allocation of stock options to executives. And warn investors well ahead of disappointing news.
Life Beyond GAAP
Should companies disclose information beyond what is legally required? CFOs understandably are wary: Aren’t U.S. generally accepted accounting principles — the current reporting framework — enough of a burden already, they ask? Indeed it is, but both casual observation and rigorous research indicate that GAAP reports provide a decreasing share of investor’s information needs.
Space doesn’t permit a comprehensive discussion of the deficiencies of current accounting. Suffice to say that investors embrace non–GAAP information that augments the shortcoming of financial reports.
For example, it was documented that investors respond to pro forma earnings more strongly than to GAAP earnings, evidently viewing the former as more relevant.
Furthermore, various types of voluntary disclosures, such as about the product pipeline of pharma and biotech companies, customer acquisition costs and churn rate of telecommunications and Internet services providers, or same–store sales and order backlog if retailers, trigger significant stock price reaction upon announcement.
And earnings guidance — another non–GAAP disclosure — has a significant impact on analysts’ forecasts and stock prices. Such investors’ reactions to voluntary disclosures would not have occurred if GAAP information satisfied their needs. It is important to note that the disclosure of non-GAAP information doesn’t benefit investors only. Companies and their managers gain, too.
Such disclosure enhances transparency and therefore decreases stock price volatility and the firm’s cost of capital, and it strengthens managers’ credibility in capital markets as well as mitigating lawsuits. Remember, disclosure of relevant information isn’t a zero-sum game.
Operating Instructions: What should managers disclose in non–GAAP information, and when? The general rule is to disclose when investors’ uncertainty about the firm’s operations and its future prospects is high. Thus, companies with complex business models, such as drug and software manufacturers, should disclose information about their product pipeline. A drug’s success in Phase III clinical tests, for example, is more relevant to investors than beating the earnings consensus.
Similarly, subscription-based companies (telecom, media, Internet services providers) should regularly disclose key business model data, such as the number of new customers, the churn rate and the cost of acquiring new customers.
As a rule, provide the main data requirements of analysts’ valuation models. If concerned about the competitive harm of such fundamental disclosure, consider that many pharma, Internet service providers and energy companies, all operating in highly competitive industries, regularly provide extensive non–GAAP information without any competitive harm.
Communicating Effectively With Investors
What makes a successful conference call? To provide the answer, this author conducted an extensive study of quarterly conference calls with a group of Ph.D. students. Successful calls were defined as those that came in the wake of bad news — a missed consensus estimate — yet turned the stock price trend to positive from the start of the call to the end of the day. No mean feat.
Call transcripts were read carefully, comparing them with calls that didn’t change the negative price trend due to the consensus miss. The following was learned from the hundred of effective and ineffective conference calls examined:
▪ Effective calls have more analysts and investors participating than ineffective calls, more questions asked and more answers given (some questions receive multiple responses).
▪ In effective calls, managers’ initial discussion and questions and answers are lengthier than in ineffective calls.
▪ Effective calls are characterized by more quantitative responses (a higher numbers-to-words ratio) and by fewer “big picture” terms, like growth, strategy or competitive position, than ineffective calls.
▪ Buzz–creating calls (those that generate a high volume of trade) contain more negative terms, such as abandon, abolish or write–offs, and fewer reassuring, buoyant expressions, like hopeful, or resurgent growth, than less effective calls (recall that all the calls examined followed a disappointing quarter).
▪ Finally, and importantly, effective calls contained more prospective, quantitative guidance than ineffective calls.
Operating Instructions: To enhance the effectiveness of conference calls, increase the number of participants and foster a lively Q&A session by providing new, insightful information on the business and its future course in each new call.
Don’t be overly cryptic, bland or defensive. Whenever possible, provide numbers in lieu of vague narrative. Following a disappointing quarter, don’t sugarcoat the situation. Face the situation honestly, don’t minimize the challenges and provide relevant details and performance targets for the corrective actions being taken. The objective of an earnings call is to provide relevant information to investors, not to escape unscathed.
Regaining investors’ trust and support should be at the top of managers’ agendas. There are no shortcuts or magic tricks to achieve this task. It requires a substantial shift in managers’ conception of investors’ needs and the workings of capital markets, and a persistent execution of a capital markets strategy, based on honesty, relevant information sharing and smart communication with investors.
Baruch Lev is the Philip Bardes professor of Accounting and Finance at the Stern School of Business, New York University.
This article first appeared in Financial Executive magazine.