Narrowing the Credibility Gap: Transparency and Managing Expectations

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Narrowing the Credibility Gap Transparency and
Managing Expectations
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Objective

• Managements goal should be to ensure that the
  market value of the company is as close to its
  fundamental value as possible. This involves
  narrowing the Credibility Gap. The size of this
  gap depends on how management communicates to
  investors and investors perceptions of
  managements incentives. The purpose of this
  session is to examine when managements claim are
  viewed as credible.

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Basic Points

• Managements goal should be to make sure that the
  market value of the firm is aligned with the
  firms fundamental value.
• Fundamental value may differ from market value
  because investors lack value relevant information
  and/or they find management is not credible.
• The credibility of managements message depends
  on making certain the message is aligned with
  strategy and management accountability.
• Corporate governance refers to the set of
  contracts, laws and institutions that protect
  investors from management opportunism.
• Corporate governance in the U.S. (and UK) is
  based on promoting shareholder democracy and
  disclosure. The key institution in US corporate
  governance is the board of directors.

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What is the Goal of Corporate Disclosure Policy

• Long run value maximization versus share price
  maximization.
• If you believe that the market will eventually
  get it right and that there are significant costs
  associated with unpleasant surprises then the
  goal of disclosure policies should be to align
  the market value with fundamental value.
• The starting point for evaluating the
  effectiveness of corporate disclosures should
  begin with assessing whether the current market
  value is in line with fundamental value. That is
  easier said than done.

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What Makes a Message Credible?

• A compelling story has four elements
• Managements goals and aspirations are clearly
  articulated
• Avoid vague or unrealistic goals not grounded in
  industry economics.
• Place the goals in context of comparable firm or
  industry performance metrics.
• Place goals in the context of prior firm
  performance.
• How do goals related to key value drivers?
• Managements strategy for accomplishing goals are
  clearly articulated.
• What are the companys competitive advantages?
• What specific steps will be undertaken to meet
  goals?

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What Makes a Message Credible?

• Indicators of success are clearly articulated
• Specificity and detail are important
• Identify operational value drivers
• Relate operational performance to financial
  performance measures
• What time table should investors expect?
• Management is accountable for achieving goals

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Concerns About Transparency

• Competitive concerns
• Detailed disclosures may alert competitors to
  competitive moves and speed a response.
• Are competitors uninformed? If strategy can be
  easily copied is it a source of value?
• Legal concerns Does transparency increase the
  risk of shareholder litigation?
• Reduced flexibility
• Pre committing to goals may reduce management
  ability to adapt to changing circumstance.
• Is flexibility a way to hide failures?

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Free Rider Problems and the Stock Research
Conundrum

• The information needed to make informed decisions
  about fundamental value is extremely detailed,
  time consuming to collect and requires industry
  expertise to analyze.
• An individual shareholder when making investment
  decisions compares the cost of information
  production to the benefit of production.
• In an efficient market all information is
  embedded in the share price, hence the benefit of
  information stock research is likely to be small.
  
• The conundrum If the benefits are stock research
  are small, why do it? If no one does it how can
  the market be efficient?
• Answers to the conundrum
• Infra marginal profits from timely information
  .large shareholders, analysts, institutional
  investors and hedge funds lead to market
  efficiency.
• Strategic investments Identify undervalued firms
  and take positions to make changes.

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Who Should be the Target of the Corporate Message?

• Large shareholder and institutional investors
• Potential Acquirers
• Sell side Analysts
• Affililiated Analysts Employed by investment
  banks to analyze securities and persuade
  investors that certain stocks are more attractive
  than others. Paid indirectly out of brokerage
  commissions and investment banking fees.
• Unaffiliated Analysts Independent information
  producers (i.e. not affiliated with investment
  banks) paid on either a fee basis or out of so
  called soft dollar brokerage.
• Opinions and managements disclosures are
  summarized in analyst reports.
• While everyone talks about analysts
  recommendations and forecasts (which, in the case
  of affiliated analysts, are undoubtedly biased)
  institutional investors rely on analysts for
  qualitative information and industry expertise.

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Background Whats in an Analyst Report?

• What Academics focus on
• Recommendation
• Prior to settlement typically a 5 point scale
  1strong buy, 2buy, 3hold, 4unattractive or
  under perform, 5sell.
• Now point scale 1buy 2hold 3 sell.
• Target Price What the analyst thinks the stock
  will sell for in twelve month horizon.
• Earnings estimate and growth forecast Some
  measure of earnings over the next quarter, 12
  months and sometimes longer time period.
• Note Until recently almost all coverage was
  initiated with a buy or a strong buy
  recommendation. Indeed, for IPOs in the late
  1990s the majority of recommendations (60
  percent) were strong buys On average target
  prices were set at 155 of the current price.

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Background Whats in an Analyst Report?

• What institutional investors focus on
• Industry knowledge
• Integrity
• Access/Responsiveness
• Details concerning the valuation
• Institutional investors focus on qualitative
  information.
• Analyst reports are a great source of data on
  what the market knows and what investors are
  thinking.

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What are the most important qualities of a good
analyst?

• Accurate earnings forecasts
• Timely buy and sell recommendations
• Insightful written reports
• Setting up meetings with management
• Accessibility/responsiveness of phone calls
• Industry knowledge

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Disclosure Issue Should Management Provide
Guidance?

• The case for earning guidance
• Investors want to know/ Provides investors with a
  summary of where the firm is going.
• Guidance encourages analyst following.
• Guidance may reduce litigation exposure.
• The case against guidance
• Promotes managerial myopia via short term earning
  focus.
• May create incentives for manipulations and
  reduce the quality of earnings.
• What we do know is that stopping guidance
• Typically follows missing guidance
• Leads to reduced analyst coverage
• The information environment deteriorates.
• Management doesnt seem any more focused on long
  run returns.

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Corporate Governance and the Credibility of
Management

• The basic problem The separation of management
  from finance.
• The relationship between management and the
  providers of funds is governed by contract and
  laws. The contracts are incomplete the sense that
  they can not completely specify all future
  contingencies. Thus management has residual
  control rights.
• In the U.S. management owes a fiduciary duty to
  shareholders. However, except in egregious
  circumstances the courts do not intervene (the
  business judgment rule). Equipped with residual
  rights and an enormous information advantage,
  management has plenty of opportunities to pursue
  their own self interest in the form of shirking,
  self dealing and excessive perquisite
  consumption.
• Solutions to the management shareholder conflicts
• Incentives to management Carrots
• Compensation contracts
• Options/ownership stakes
• Monitoring and shareholder control
• Board of directors
• Large shareholders
• Hostile takeover
• Auditors
• Creditors
• Underwriters
• Reputation and the managerial labor market

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The Elements of Corporate Governance

• Corporate governance refers to the contractual,
  legal and institutional factors that influence
  how effective shareholders are in exercising
  control.
• The vote and the corporate charter The corporate
  charter (and state laws) lay out the voting
  rights of shareholders (e.g. How many shares per
  vote, supermajority rules, staggered/classified
  boards).
• The free rider problems and voting Relying on
  voting to control agency problems is not likely
  to be effective if shares are diffusely held.
  Shareholder are unlikely to have the incentives
  or information necessary to make the right
  decisions.

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Corporate Governance and the Credibility of
Management

• Governance Objectives
• Information accuracy and accessibility
• Management accountability
• Strengthen the role of independent monitors
• Facilitate shareholder action

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Issues in Corporate Governance

• Some ways in which shareholders exercise control
  (remember one size does not fit all)
• Delegated monitoring through Boards of Directors.
• Outside board members with industry or business
  expertise that serve as fiduciaries to
  shareholders. Concerns about anti-competitive
  effects of transparency can be addressed by
  limiting disclosure to the board.
• An obvious potential problem is board capture by
  management. Note most members of U.S. boards are
  CEOs of other companies.
• Board independence may impair management and
  limit the creation and use of specific knowledge.
• The takeover market.
• A liquid and efficient market for shares implies
  the potential profits from assembling shares of
  underperforming corporations and using the vote
  to oust management.
• Some problems with takeovers as a control devise
• A competitive takeover market limits the gains
  that accrue to the acquirer.
• Effectiveness is limited to significant
  underperformance.
• Takeover threats can be mitigated by corporate
  charter changes .
• Hostile takeover are politicalcorporate raiders
  and layoffs.

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Case Study in Disclosure Policies and Corporate
Governance

• Option backdating and timing
• Options granted to senior executives are
  typically granted at the money. Until recently,
  at the money grants were not required to be
  expensed.
• How can I make at the money options like in the
  money options?
• Grant them after bad news and before good news
  (so called spring loaded option grants).
• Back date the option i.e. with the benefit of
  hindsight choose the date with the lowest price
  in the month.
• SOX requires reporting of option grants within
  two days (although over 15 of options are
  granted with late reporting).
• If option dates are manipulated what should you
  see?
• Pre grant negative abnormal returns
• Post grant positive abnormal returns
• A frequency of option grants on low price dates.

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Case Study in Disclosure Policies and Corporate
Governance

• Is option manipulation a result of poor
  governance?
• Lucky grants declined after SOX.
• Prior lucky grants increase the likelihood of
  future lucky grants.
• Lucky grants are more likely the longer the CEO
  tenure (i.e. the more likely cronyism exists).
• Lucky grants are less likely when firms have
  independent boards and compensation committees.
• Lucky grants are positively related to total
  compensation (the more you make the luckier you
  are!!)
• Lucky grants are more likely the higher the
  payoff from being lucky.
• The puzzle Why go to jail for such a small
  payoff? Earnings management?

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Takeaways

• The goal of management should be to align the
  market value of the firm with the fundamental
  value.
• The message matters in that there are way to
  convey information to distinguish it from cheap
  talk.
• Large shareholders and analysts are typically the
  targets of qualitative information.
• Credibility is enhanced through corporate
  governance. Corporate governance refers to the
  rights and ability of shareholders to influence
  management.