In the U.S. capital markets, common wisdom suggests that public companies are struggling more than ever to attract capital they deserve - that more than 1,200 of the 6,000 companies listed on U.S. exchanges get no coverage from security analysts, and coverage is anemic for another 1,000, with only one or two “Street” analysts providing research. Research indicates that over 50% of the companies that trade on NASDAQ and some 20% of those listed on the New York Stock Exchange get little or no equity research coverage.“’Consensus estimate’ may be from one analyst .. More than half the 8,416 public companies have no analyst coverage” Ashwani Kaul, chief spokesman for Reuters Estimates
One might assert that these numbers alone are sufficient to merit some rethinking in how corporate investor relations interface with their investor constituency.
Perhaps not. So let’s follow the money. As a “Wall Street orphan,” a company may now seriously consider taking a draconian step and revert to a private company structure in the hope of resurrecting one day in the public markets. Oftentimes, its stock price may stagnate for a protracted length of time or, worse still; enter a death spiral leaving in its place a “shell company”. The burden of Sarbanes-Oxley , now well publicized, is sometimes cited as one reason for companies now considering the delisting route as well as a reasonable explanation for staying private longer. It’s also clear that while Sarbanes-Oxley related costs may be less for a smaller company, they are unlikely to decline proportionately with a company’s revenues. The net effect of this is that small companies are disproportionately affected by compliance costs.
To compound this particularly U.S. epidemic of stymied capital, these Wall Street orphans pay relatively more for capital from new investors or from their institutional lenders. Wharton School research finds these orphans pay roughly 140 basis points, or 1.4 percentage points, more for their new money per year than those that have a recognized Street following. Put another way, on a $100 million capital issuance, the markets extract $1.4 million each year from companies with little or no cover compared to those that do – a not so incidental cost of doing business for a “Wall Street orphan.” While it is true that analyst coverage is only one of the factors tied to cost of capital, data does show that of those 10% of companies with good, credible coverage from 5-6 analysts, the cost of capital is significantly less.
With uncertainty about the use of trading soft dollars (a means of paying brokerage firms for their services through trade commission revenue) for traditional marketing services, it is unlikely any attractive economic model for equity research will emerge anytime soon. And, at least over the last 5 years, the trend has shown no sign of a reversal. Given the new restrictions on sell side research, and the way that it is now perceived within the markets overall, the demand for investment banking led equity research from the buy side has dissipated. This leaves open the challenge of creating an alternative commercially viable model for equity research. The situation is further exacerbated by the fact that there are now more companies globally seeking a public issue on a U.S. exchange, all competing for coverage.
Know that the lion's share of sell-side research is stale. EPS estimates are a commodity, price targets are for retail and many if not all of the big houses outsource model creation to companies like EvalueServe in India. So if you can outsource it, it must be a commodity. No? With the only thing of value in today's capital market today is the connections an analyst has to the company. However, as one IR Director told me recently Reg FD limits much of the stuff they learn and can disseminate. What remains special and untouchable is industry overview reports; they are really the last piece of value left for identifying firm and market forces; so that a professional can determine what he should be looking for and generally what catalysts will make an equity move. Analysts used to have insight . . today, they have hindsight.
A report by Booz Allen titled Saving Sell Side Research highlights key threats to those who lack the vision and adaptability to change with the market - massively declining research spend due to competitive forces, more robust performance measurement metrics, and a squeezing of the middle (being neither a high-quality, focused boutique nor a global behemoth with the resources to deliver a superior global product). This report outlines three specific prescriptives to the sell side, assuming a rational business case can be made for keeping research at all:- Delivery Model Streamlining (more efficient resource allocation, "rationalize" compensation, increase outsourcing)
- Offering Redesign (expand coverage of small/mid caps, add expert networks, quality models, performance metrics, add a degree of client exclusivity)
- Differentiated Service Levels and Pricing (calibrating levels for small, mid-size and large firms, hedge funds, etc.)
An emerging global financial data standard, called eXtensible Business Reporting Language (XBRL), is pushing ahead to help alleviate the issue of accurately communicating company financials with the potential to do much more than help analysts and the regulators.
The concept is simple. Think about the adoption of barcodes or Universal Product Codes (UPC) for products, and the deployment of RFID (radio frequency identification devices) tags embedded with barcodes in the supply chain and retail environments. Now think about how the same industry gained massive value through more accurate tracking of goods leading to fewer errors, lower inventories and even better-stocked shelves, which lead to lower costs, satisfied customers and higher revenues. Making error rates and inefficiencies - and their financial impact visible and therefore correctable was the fundamental commercial potential of barcoding. Now, think of XBRL in financial reporting as the ability to “barcode” the individual financial concepts (such as Operating Profit, Interest Expense, etc.) so that they can be picked up in a consistent and accurate manner downstream from the preparers of financial data.
According to comments made by the SEC Chairman, the inefficiencies in the flow of financial data from source to consumer accounts for an error rate approaching at least 28% - a not so inconsequential number when you realize how much capital moves in real time based on these numbers. So, how does XBRL make a difference? By adding context information to financial data, XBRL brings about a raft of efficiencies that put more control back in the hands of the company – the IRO, the CFO, the Treasury and the CEO and gives the end consumer (analysts, media journalists, professional and retail investors, etc) access to a robust, reliable, and noise-free pipeline of information from which they can develop their earnings forecast models in a fraction of the time.
“Zero Defect” Financial Data
With the rapidity of information flow in today’s capital markets, it is becoming more important than ever for the investor relations function to pay special attention to the Street – dealing directly with the needs of brokers, broker networks, equity research companies, analysts and other groups of stakeholders. In this highly fluid and dynamic environment, a top priority of the IRO function is to continuously build differential information in ways that persuade the “investor” that adding this company to their investment portfolio is better than adding some other company. Put simply, building a compelling value proposition for a “buy and hold” decision. It is more important now than ever before for the IRO to be in the driving seat. IROs need to be able to push information out as directly, as accurately and as rapidly as possible to a targeted audience of existing investors, potential investors as well as key stakeholders and analysts.
Added to this mix are two other trends, the impact of Regulation Fair Disclosure (Reg FD) and the rise of alternative investment funds. On the first point, there is some justification for the outcry that Reg FD has resulted in less exact details of disclosed company numbers. Some go as far as to explain the volatility of stock performance with the reduction in information flow through the analyst community with less one-to-one contacts taking place. Reg FD has been used as a disincentive for companies to do anything more than the bare minimum with corporate earnings deteriorating with the rise in pro forma reporting. On the latter point, the rise of alternate investment funds (such as hedge funds) and greatly increased application of more sophisticated algorithmic trading models that look deeper into the financials points to a direction of automated trading that is fraught with inherent risks without the provision of a “zero defect” data stream. XBRL ensures a “zero defect” data stream – there is no conversion of data, manual or systematic, to help the data to be processed by different types of consumers and their corresponding systems.
In summary, we have companies disclosing less information as a result of Reg D, fewer analysts funded to cover companies and help them get Street exposure and large funds with major overhangs in search of the right investment. XBRL makes the argument for easier and faster access to company financials alleviating the information asymmetry caused by some of the inefficiencies in the market and regulatory rulings.
Moving away from “one size fits all”
There is clearly a well established and growing multi-billion dollar market for the consumption of high quality financial data as demonstrated by firms such as CompuStat, FactSet, Bloomberg, Thompson Financial, Reuters and others. Each of these data aggregators differentiates itself against its peers by trying to get access to corporate information as fast as it is disseminated to the SEC and from the wire distribution companies, adding value to the data by bundling it with their key search words, filters, analytics, productivity tools and research news so that they gain a higher market share of the data consumers in the industry. Each of these product vendors provides some unique value to its customer base and serves a very valuable function in the efficient operation of today’s capital markets.
Over the years, each of these data aggregators has developed, their own “prism” of public company based on some analysis of key information that may be more characteristic of a specific industry sector. So, for instance, one vendor may have a list of 500 financial data points they generally look at and report based on “as reported” company information. In addition, by industry sector, they may drill down further to track specific industry information – peer comparisons. So, in practical terms, data aggregators parse the data from the companies to fit their data structures. Analysts, Street journalists and other data consumers then use this data to drive their revenue model – justifying a price to earnings and a stock price either above or below the current price – leading to a bullish (buy, hold) call or a more cautionary recommendation.
The downside of this approach is that there is always room for approximation and data interpretation since information is lost in the passage from the IRO to analyst via data intermediary. So, companies send a “round hole” in, and without their control or knowledge -- a “square peg” gets out to the investors. A data integrity issue is perpetuated -- one that can only be remedied by placing more control of the original data into the hands of the publishers of the data – the companies themselves. Enter, a flexible tagging system that takes account of the uniqueness of financial reporting – XBRL.
One standard: Many uses
IROs from all public companies should be encouraged by the validation of XBRL in the market (see www.xbrl.org/showcase/) and efforts by the SEC to persuade companies to adopt XBRL for external reporting. Although the SEC has not mandated XBRL filing at present, it is a strong advocate of adoption not only to help its own analysis but to greatly improve the efficiency of US capital markets overall.. Advocates of XBRL believe that 2007 will be the turning point in terms of headway in both the public and private sector.
Issuers from large companies can help overcome accuracy and efficiency hurdles that slow or impact hedge fund assessment of their performance. Issuers from smaller companies that struggle to get sell side coverage can use the SEC’s voluntary filing program to get noticed. Corporates that find that their unique attractions are getting buried in a sea of standardized infomediary data can make themselves stand out.
Posts
