Guidelines on investor communication

An important section in ‘Corporate Valuation and Value Creation' by Prasanna Chandra ( www.tatamcgrawhill.com ) is the one devoted to investor communication. It opens with the quote of Warren Buffett emphasising Berkshire's ‘it's-as-bad-to-be-overvalued-as-to-be-undervalued approach,' as a way to maintain a 1:1 relationship between the intrinsic value and the market price of the share. Such an approach, reasons Buffett, can attract long-term investors who seek to profit from the progress of the company rather than from the investment mistakes of their partners.

To ensure that the intrinsic value of a company is fully reflected in its stock price, the company should communicate intelligently with the investors, explains Chandra. Reminding that share prices are not determined by a polling process in which all investors have an equal say, he cites Bennett Stewart and David M. Glassman, thus: “Stock prices like all prices are set not by average investors; they are set at the ‘margin' by the smartest money in the game. The herd is led by influential investors – ‘lead steers' we call them. They care about cash flow and risk; they are not fooled by accounting illusion.”

Deemphasise creative accounting

The book lays down a few guidelines for companies to effectively communicate with the market. The foremost diktat is to deemphasise creative accounting. “The advocates of the ‘disclosure' view of financial communication believe that the stock market is influenced by investors who assess companies by their reported financial results. Hence they argue that a company must paint a picture of steady earnings growth and cover any deficiencies by resorting to creative accounting.”

In this regard, the author makes a reference to a Wall Street Journal editorial (that spoke of how a lot of executives apparently believe that if they figure out a way to boost reported earnings their stock price will go up even if the higher earnings do not represent an underlying economic change), and informs us of empirical evidence about the contrary effect. That the market is very intelligent in penetrating through the veil of accounting reports and seeing a company's underlying economic performance, and so the efforts to artificially inflate reported earnings or creatively manage the bottomline are futile.

On a related note is the second guideline in the book, cautioning against financial hype. Frets Chandra, that many managers believe the securities of a company should be marketed like any other product; this, in turn, leads to the hiring of PR firms, to sell the story through imaginative advertisements.

This approach, he points out, is guided by the ‘demand and supply view' which assumes that securities can be sold at higher prices by stimulating their demand through high pressure-selling tactics. “The ‘demand and supply view' is not a valid view in a market dominated by rational lead steers. The ‘intrinsic value view' prevails in such a market. If prices rise because unsophisticated investors are momentarily swayed by financial hype, lead steers will sell and align price with intrinsic value. They may even short sell.”

Greater disclosure

The third and final guideline on investor communication is a call for greater disclosure to the lead steers, almost to the extent of making them part of the company's planning process. Towards this, Chandra advises companies to provide lead steers with information about the average operating profit over a business cycle from capital already committed to the business, new investments projected in the foreseeable future, expected rate of return over the lives of investment, target capital structure and financing policy, acquisitions and divestiture strategy, international performance, and management compensation plan. He highlights empirical evidence on how greater disclosure lowers the cost of equity capital; this is more pronounced for small firms which are not actively monitored by analysts.

The author is happy that, driven by regulations and international law, India Inc's track record on disclosure and transparency has improved. Among the healthy pointers he observes are the reporting of material developments within a reasonable time period, the inclusion of consolidated accounts in the annual report, the instituting of a whistleblower policy by some companies to encourage employees to disclose personal knowledge of fraudulent activity without fear of discriminatory action, and the featuring of CEO/CFO certificate in annual reports affirming that the financial statements do not contain any misleading statements.

A book that can add comprehensive value to investors' decision-making.

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