What do we know about the influence of the IR?

Transcription

1 What do we know about the influence of the IR? Corporate Governance Spring 2017 Markus Mäkelä Olli Uotinen Amir Wafin

2 Contents 1. The definition and role of investor relations Definition of Investor Relations Goal of Investor Relations 4 2. Information asymmetry and IR 6 3. Role of Investor Relations Officers Investor relations and firm market value Measuring the Quality of Investor Relations Effective IR correlates with higher market value Higher market value effect is associated especially with large firms Investor Relations and Steering Analysts: Case AT&T References 18 2

3 1. The definition and role of investor relations In modern market based economies where the ownership and the management of a firm is separated accounting information has two important roles. First role of accounting information is to enable the potential investors, both equity and credit, to evaluate potential investment targets. Firms are complex institutions which s value depends on various firm specific factors. This first reason for accounting information arises from the assumption that firm s managers typically have a better understanding on firm s current and future performance than the outside investors and therefore have the ability to value the firm with greater accuracy. This information asymmetry should encourage to disclose financial information for better capital markets efficiency. Second role of accounting information rises from the separation of management and ownership. Once the investors has made a decision to invest in a company he/she needs means to monitor the use of their capital. Disclosure of accounting information leads to improved monitoring and reduced agency problems. (Beyer et al. 2010). 1.1 Definition of Investor Relations To communicate this accounting information to different investors firms must have an infrastructure to create and disclose this information. Investor relations can be seen as the interface between firm s management and the investor community. A common definition for IR is that it is a strategic management function that integrates finance, communication, marketing and security law compliance with the aim of providing the most effective communication between a company and its stakeholders. Investor relations operations can be conducted though to public disclosures such as earnings announcements, annual reports, general press releases and direct communication between the firm and the investor community. Beyer et al. approach IR from three different aspects: voluntary disclosures, mandatory disclosures and analysts s reports. All public companies are required to provide certain amount of disclosure on their operations to meet the capital market regulations. 3

4 To increase the credibility of the firm in the eyes of outside investors firms often provide additional information in the form of voluntary disclosures. Voluntary disclosures include management earnings forecasts, strategy and new product announcements, press releases, board presentations to analyst societies, management s discussion and analysis, conference calls, road shows, internet sites and other corporate reports. 1.2 Goal of Investor Relations The ultimate goal for investor relations, similar to all the other functions in a firm, is to maximize firm value. Bragg (2010) divides this ultimate goal of maximizing firm value to five supporting goals. 1. Alter perception of the company If a firm has been historically compared to peers with low valuation multiples the IR department should try to reposition the firm so that its story is aligned with different peer group with higher multiples. 2. Increase analysts coverage Analyst s opinions is one of the major factors affecting he reputation of the firm in the eyes of the investors. By attracting a boarder analyst s coverage, and especially favorable analysts reports, the firm is likely to increase its stock s trading volumes which often results to higher valuation. 3. Increase geographic coverage If the ownership base of the firm is limited to a narrow geographic area, the potential of acquiring new investors is also quite limited. Limited ownership base also results in low trading volumes and possibly poor share performance. 4

5 4. Reduce stock price volatility Bragg argues that having institutional investors as owners who frequently trade large blocks of stock might result in undesirably large stock price volatility that has an negative impact on share price. 5. Manage existing investors By managing the current shareholder base with high level of communication the company can build long term relationships with investors. 5

6 2. Information asymmetry and IR Information asymmetry was first studied by Akerlof (1970). His example from a used cars market has become a classical reference for the problems arising from asymmetric information. The problem in his example is that the buyer of a used car does not know whether a car is good or bad. The seller, however, has superior information about the quality of the car. For the reasons stated above, a good car has to sell for the same price as a bad car, because the buyer cannot tell the difference. He is ready to only pay the price of an average quality car. This leads to an adverse selection problem the sellers of lemons (bad cars) receive the difference between the true price of a bad car and average price, and the sellers of good cars lose because they only get the average price that is lower than the true price of a good car. Thus, only bad cars are offered in the market and arguably the average quality of goods along with the size of the market decline. Chang et al. (2008) aim to develop an understanding of the effects of a well-developed investor-relations program by observing the effect of its use of the Internet for information disclosure and information asymmetry. They find that firms with high investor-relations scores, proxied by a checklist that they created, have more analyst following, higher proportion of institutional investors, higher market capitalization and higher trading volume. Vice versa, firms with low scores on investor-relation activities were seen in the sample to have less analyst following, lower institutional holdings, lower stock price levels, lower trading volume, and smaller market capitalizations. The endogeneity issues between disclosure policy and information asymmetry limit the authors from making general conclusions, but the results of their study would imply that there is a negative relationship between information asymmetry and disclosure quality, a conclusion that is supported by many in the research community. Beyer et al. (2010) review the recent literature related to the financial reporting environment of companies. They concentrate on the three main decisions that shape the corporate information environment in capital market settings: 1) manager s voluntary disclosure decisions, 2) disclosures mandated by regulators, and 3) reporting decisions by analysts. In setting the scene, the authors start with a thorough discussion on the reasons for accounting 6

7 information demand. The demand for this information by company outsiders arises for two reasons. These problematics are referred to as the valuation problem and stewardship problem. In the context of financial reporting environment, information asymmetry between capital providers and company insiders will result in the capital provider s underpricing firms with high profitability and over-pricing firms with low profitability, potentially leading to market failure. The authors classify this as an ex-ante demand for accounting information, referred to as the valuation problem. Second, the ex-post demand for accounting information arises from a separation of ownership and control, which results in capital providers not having full decision-making rights. To solve the ensuing agency problems, both implicit and explicit contracts often use accounting information such as the use of resources, decisions taken and generated return on investments. Investors value such information ex-post and require a lower rate of return ex-ante when they can rely on such information. This problem is referred to as the stewardship problem. The authors agree that these two reasons mean that the information environment tends to develop endogenously. But they put out an interesting question: If the corporate information environment arises endogenously to resolve valuation and stewardship problem, then why is disclosure regulation needed in capital markets? In some instances, the lack of voluntary disclosure of private information by the company insiders can lead to sub-optimal situations, and thus disclosure regulation is required to ensure a functioning capital market. Simply put, when managers do not voluntarily disclose all their private information, there is room for disclosure regulation in capital markets. The discussion above would imply that information environment will be shaped by: 1) The extent to which each of the conditions of the unraveling result do not hold (explained in detail below) 7

8 2) The availability and cost-effectiveness of alternative mechanisms or information from other sources than the firm itself that strive to help mitigate the valuation and stewardship problems 3) The magnitude of stewardship problem compared to that of valuation problem. The unraveling results The unraveling results identify conditions under which firms tend to voluntary disclose all their private information. These conditions can be, according to the authors, 1) disclosures are costless; 2) investors know that firms have private information; 3) all investors interpret firms disclosure in the same way and firm know how investors will interpret that disclosure; 4) managers to to maximize their firms share prices; 5) firms can credibly disclose their private information; and 6) firms cannot commit ex-ante to specific disclosure policy. Essentially, the unraveling result is a consequence of investors reacting to the management s decision not to disclose any information that would cause the investors to revise their beliefs about firm value downward. Consequently, managers have incentives to disclose their information in order to distinguish themselves from other managers with less favorable information, and this leads to the unraveling of any information that is being withheld. However, the unraveling results do not directly suggest that firms always fully disclose their private information. The theory implies that in many cases one or more of the six conditions presented above do not hold and rather describes why less than full disclosure is likely to occur. Additionally, in some cases circumstances may exist where manager s incentives to voluntarily disclose information are insufficient even though additional information would improve overall social welfare. When the information can be seen as public goods, this can lead to a free-rider problems. In these cases, regulation that mandates the disclosure of certain type of information will be required and be even desirable. Consequently, disclosure regulation will be highly dependent on the type of information that a firm either voluntarily discloses or what has been produced by other market participants. Thinking beyond mandatory 8

9 and voluntarily disclosures, other information intermediaries also shape the information environment. The authors highlight the impact of the decisions made by sell-side analysts. They list the following decisions made by analysts that should impact the corporate information environment: 1) whether to follow a firm and how many firms to follow 2) how much information to acquire and produce 3) what kind of reports to issue; and 4) to what extent they issue reports that diverge or are less precise from the analyst s private signals and beliefs. 9

10 3. Role of Investor Relations Officers One of the main responsibilities of an investor relations officer is to communicate what the company is doing and how it is doing it to investment community. Investment community includes for example institutional investors and stock analysts, who make analyses for other investors. According to Brown et al. (2017) public earnings conference calls are the most important way for investor relations officers to communicate company s message to investors. Investor relations officers are also in a central role in many disclosure-related activities, such as conference calls, press releases, and other informal interactions with the investment community. (Brown et al., 2017) The main role of investor relations officer in conference calls is to create a script for the call and prepare a list of possible questions the investors and analyst are going to ask and to be prepared to answer the questions. Investor relation officers can sometimes receive ideas of what investors are possibly going to ask from stock analysts and the investor relations officers often do call-backs with these sell-side analysts after public earning conference calls to be able to convey the company s situation to them. How the company manages these conference calls is one of the most important ways to determine investor relations officer s job performance, unlike company s ability to meet or beat the consensus analyst earnings forecast, which is not a very important determinant of investor relations officers performance evaluation. (Brown et al., 2017) From investor relations officer s point of view, private phone calls are seen as even more important way than for example SEC 10-K reports to convey company s message according to the study conducted by Brown et al. (2017). This indicates that investors prefer personal discussions over written material. Even though social media is often seen as an important communication channel these days, less than 2% of investor relations officers responded in 10

11 the study that social media is very important to conveying their company s message to investors. Furthermore, almost 66% said that social media is not important for this purpose. For some reason, investor community ignores social media as a communication channel. If the study had asked about the importance of communication channels to other stakeholders than institutional investors, the results would probably have been completely different. (Brown et al., 2017) Table 1: Survey responses to the question: How important are the following for conveying your company s message to institutional investors? Source: Brown et al. (2017) Another responsibility of investor relations officers is to work as corporate gatekeepers, controlling the access of outsiders to senior management. This is an important role due to Regulation Fair Disclosure (Reg FD), which mandates that all publicly traded companies must disclose material information to all investors at the same time. Hence, investor relations 11

12 officers have to make sure that management does not accidentally disclose any additional information to some investors. Investor relations officers are also responsible for keeping the management up to date on what investors and analysts think about the company, which helps management to prepare for meetings and public conference calls. In practice this means that investor relations officers have to analyze markets and analyst estimates about the company on a daily basis. (Brown et al., 2017) 12

13 4. Investor relations and firm market value 4.1 Measuring the Quality of Investor Relations Unlike some other firm characteristics there isn t a single uniform way of measuring the quality or effectiveness of firm s investor relations practices. In recent literature different approaches to measuring the quality or effectiveness of IR. Many studies have relied on the Association of Investment Management Research Corporate Information Committee (AIMR) firm disclosure quality ratings. These ratings include separate ratings for the firm s 10-K, quarterly reports and investor relations programs. (Agarwal et al. 2008) Agarwal et al. (2008) use IR magazine ratings of investor relations as a measure for IR activities. They use these best overall IR awards as a proxy that is used for evaluating whether a company s IR function is effective. Chang et. al (2008) use a checklist of investor relations activities to formulate a disclosure index. The checklist items were weighted based on their relative importance to the investor relations function based on the findings by Bushee & Miller (2007). 4.2 Effective IR correlates with higher market value The role of effective investor relations is to avoid undervaluation of the firm by providing sufficient information to potential investors and analysts. If a firm does not have effective communication towards investors, it is obvious that firm is undervalued, since investors cannot receive enough information to make accurate valuations. There are several studies showing that market value correlates with efficient investor relations. Bushee and Miller (2012), using data between 1998 and 2004, investigate whether the initiation of IR programs by hiring external IR agencies is related to an increase in firm disclosure levels, media coverage and analyst following. In addition, they are interested to see if these programs lead to attracting more diversified institutional ownership from different geographical locations, and the market-to-book ratios serve as an indicator of firm valuation effects. Their results find a connection between hiring an external IR agency and the described phenomena above, but unfortunately their sample size is limited to very small firms and only to 210 observations 13

14 altogether. According to Agarwal et al. (2016) effective IR reduces information asymmetry between the company and investors, which can be expected to lead to a reduction in investors cost of capital as the increased transparency would be viewed favorably by the market. Thus, a higher market value for firms with effective IR can be justified. Also Karolyi and Liao (2015) have studied how effective investor relations program affects company and they found that firms with active investor relations programs have in general higher Tobin s q, greater analyst following, improved analyst forecast accuracy, and a lower cost of capital. Chapman et al. (2016) found in addition that companies with in-house investor relations teams have lower stock price volatility, higher analyst forecast accuracy, and faster price discovery, which means that investor relations programs may help the market to assimilate information about the firm. 4.3 Higher market value effect is associated especially with large firms The single most significant contribution of Agarwal et al. (2016) study is that both small and large firms, classified as having effective IR, have significantly higher market valuation multiples than those that are not seen as having effective IR. However, they found some evidence that effective IR is associated with higher market value especially in the case of large firms compared to small firms. This is contrary to their predictions, which are based on previous studies. For example Merton (1987) had argumented that the benefits of effective investor relations are greater for small firms, since those firms generally have more information asymmetry between managers and investors or small and large shareholders. 14

15 5. Investor Relations and Steering Analysts: Case AT&T In April 2013 AT&T reported earnings slightly above the average analyst s estimates, resulting in a positive stock price reaction. During the month before the firm s quarterly earnings announcement AT&T s investor relations officers pushed analysts to look towards comments made by company s CFO Johns Stephens earlier in March. According to comments made by Mr. Stephens some customers seemed to be waiting longer to upgrade their phones. Phone upgrade cycle had slowed down on 4 quarter last year and the CFO implied that he wouldn t be surprised to see that trend th continue in this quarter. This could have a significant impact on AT&T s as distribution of new phones is one of its major sources of revenue. One analyst said that AT&T s IR "is very diligent before earnings releases about making sure that the comments from the executives are reflected in the commentary from the sell side." A week before the earnings announcement analysts from three different research firms lowered their revenue expectations on average of $1b, about 2.5%. Not surprisingly AT&T beat these lowered expectations. When interweaved by The Wall Street Journal Chief IR officer of AT&T suspected that the company beats the analysts expectations about half of the time. According FactsSet database AT&T has met or beat analysts EPS expectations 10 out of 13 last quarters (Q116-Q411). 15

16 Analysis The notion of market expectations management is a typical point of discussion in today s world of IR. Factset and other sources have the habit of quoting the mean and median expectation for company s earnings per share metric, and this is most of the time based on the estimates of the major analysts covering a firm. The same kind of low communicated expectations practice has been associated also with different companies, such as Apple for instance. The issue here, however, is that in many cases market participants correct their estimates based on historic trends of company management deliberately or accidentally lowering/boosting expectations of earnings announcements. In result, regardless of quoted mean and median estimates by Factset and others, the actual market expectations might be higher/lower than what has been reported for investors to see. The market impacts tends to surprise investors in many of these cases, but a careful review of the actual market expectations and historical under/over-estimations by the management may help in explaining the sometimes irrational market reactions. As a function, IR s aim is to mitigate the risks related to information asymmetry between the firm and investment community. We need to remember, however, that firms do not operate in a vacuum. The information that is supplied to the market is a result of inter-company 16

17 interaction and negotiation, and the information can be characterized as a compromise outcome that entails trade-offs and company-specific considerations. Therefore, the reality of companies supplying the market with their own estimates, and thus controlling market expectations, is a much more complex issue to study and draw conclusions from than one would expect. Only on thing is certain. Assuming that companies and the investor community both act rationally, they should both strive to maximize their benefits from IR. This means that companies will e.g. strive to attract more capital, crystalize the investment story in order to have gains in market value and comply with existing regulatory requirements. On the other hand, the investor community will try, to the best of its abilities, to mitigate the information asymmetry problems related to IR, in order to have a fair and realistic view about the company s future earnings potential. The resulting swings in firms market values during IR announcements are the result of both parties deductions and reactions to IR information. 17

18 6. References Agarwal, V., Taffler, R. J., Xijuan, B., Nash, E. A. (2016) Investor relations, information asymmetry and market value. Accounting and Business Research, 46:1, p Akerlof, G. A. (1970). The market for" lemons": Quality uncertainty and the market mechanism Beyer, A., Cohen D. A., Lys, T. Z., Walther, B. R. (2010) The financial reporting environment: Review of the recent literature. Journal of Accounting and Economics, 50, p Brown, L. D., Call, A. C., Clement, M. B., Sharp, N. Y. (2017) Managing the Narrative: Investor Relations Officers and Corporate Disclosure. Fox School of Business Research Paper No Bushee, B. J., Miller, G. S. (2012) Investor Relations, Firm Visibility, and Investor Following. The Accounting Review, Vol. 87, No. 3, p Bushee, B. & Miller, G. 2007, Investor relations, firm visibility, and investor following, available at SSRN: Bragg, Steven M Running an Effective Investor Relations Department. Hoboken: John Wiley & Sons, Incorporated. Accessed May 14, ProQuest Ebook Central. Chang, M., D Anna, G.,Watson I., Wee, M. (2008) Australian Journal of Management, Vol. 33, No. 2 December 2008 Chapman, K.L., Miller, G.S., White, H.D. (2016) Investor Relations and Information Assimilation. Unpublished paper, Washington University in St. Louis, University of Michigan, Penn State University. Karolyi, G. A., Liao, R. C. (2015) The economic consequences of investor relations: a global perspective. Unpublished paper, Cornell University and Rutgers University. Merton, R. (1987) A simple model of capital market equilibrium with incomplete information. 18

19 Journal of Finance, 42 (3), p