Why do some smaller cap companies succeed in attracting and maintaining the positive attention of the investment community, where others find themselves prey to its worst vicissitudes? Often the answer is simply that the former represent good, consistent investment prospects, while the latter offer repeated disappointment to investors who quickly become disillusioned with their managements.
But the reasons are not always so obvious. Some smaller company managements get on the wrong side of the Street unnecessarily; others succeed in making a virtue out of their mistakes or shortcomings, using them to help build a lasting rapport with the Street and to create positive expectations for the future.
In Street Smart, the second quarterly survey focusing on IR issues affecting small and mid-cap US companies, Janet Dignan attempts to identify what it is that differentiates the Street-wise from the naive, the corporate grown-ups from the children.
Street Smart
‘Don’t quote me on this, for heaven’s sake. But if I had read Secrets of the Street1 before our IPO, I don’t think I ever would have gone through with it.’ So says the CEO of a small-cap company in the computer industry that came to the market for the first time just over two years ago. ‘It’s not that I regret doing the IPO, but I’d have been put off if I’d had any real idea of what the Street was like. It would have seemed so alien. Now I regard it as a continuing challenge and I’m happy with being a public company. We thrive on it. But the Street is a crazy place by anyone else’s standards. It’s another world.’
There are no doubt many other small and mid-cap CEOs across America for whom these comments offer an echo of their own sentiments. But for each of them, there are probably several more who would prefer not to be reminded of the mess they got into when, their navety still hopelessly intact, they allowed themselves to be led by the hand of a careless investment banker into the mouths of a horde of waiting wolves. Those wolves, having made what they could from their prey, spat out the bones – with ne’er a thought for the individuals involved, the future of their business or even the greater good of their country’s economy.
Harsh it may be; surprising it is not. After all, any half-savvy CEO should know that people who work on the Street are in this game for themselves and themselves alone. CEOs seeking evidence of altruism towards their companies should go look for it somewhere else – and stop wasting the time of people too busy rushing from one panic to the next to bother about airy-fairy notions like fair play or honour.
Indeed, the single most crucial thing for a management team taking their company public for the first time is to accept – rather than resist – the fact that the Street is motivated by self-interest, a self-interest that is best satisfied by finding a short, or at least reliable, route to getting rich quick. The companies whose shares are bought and sold by the people who work on the Street are merely a means to that end; they are never an end in themselves.
Knowing this helps focus the mind of CEOs, CFOs and other corporate officers on the fact that the best way of keeping the Street happy is to collude with it: if an investor – or its proxy, the sell-side analyst – perceives that your goal is to help it make money, and that you are likely to be able to realise that goal, then the chances that it will stick with you will be vastly improved.
In short, it all boils down to getting Street-smart – learning how the Street works so that your information flows can be structured and disseminated to meet its needs. That, in turn, boils down to focusing on the future and on the management of risk, because that’s what the Street does; establishing trust; understanding how different investor groups approach stock selection – and stock sales – so that their behaviour can be anticipated and so that the appropriate types of institution can be targeted and dealt with effectively; and being aware of the traps which are waiting to catch the unwary.
‘There’s no mystery to this IR stuff,’ says Jim Prout of Taylor Rafferty Inc in New York. ‘Some smaller companies think they are trying to scale Mount Everest. But a big part of the US market is interested in them: they just have to find the most likely candidates, have the confidence to go forward to those people with the information they need and, above all, to follow through.’
So much for the big picture. But what does this mean for day-to-day investor relations at a small or mid-cap company? ‘Companies have to get over certain mental hurdles in dealing with the Street. Otherwise they get very frustrated in terms of their investor relations,’ notes Ted Pincus, chairman of the Financial Relations Board in Chicago, whose firm counts several hundred small and mid-cap companies in its client list. ‘They find themselves selling in the bargain basement of p/e multiples of seven, eight or nine times earnings, when the S&P 500 is selling at 16 times earnings and many companies are selling at p/e multiples in the 20s and 30s. And they can’t understand why.’
Pincus says this is a product of the most common mental block among CEOs and CFOs, which arises from an almost unshakeable belief that if they run their company well, making good profits, then the financial community will beat a path to their door. ‘Even those that know they need to go out and tell their story often labour under the misconception that they just need to provide a very good description – to anyone that will listen – of the company’s operations, describing in detail its products, how it makes them and how it sells them,’ he says.
In practice, this amounts to only a small part of what needs to be done. Managements have to understand the fundamental fact that, from the Street’s point of view, information is valuable because – that is, if – it reduces risk. Since risk is about the future, retrospective expositions of a company’s business are not much help to analysts and institutions preoccupied with what lies ahead. They may want to know what companies do and how they do it, but only in so far as this is relevant to the future.
After all, if a company has done well in the past, or is doing well now, that does not amount to an investment story for today: some other inspired or well-informed investors will already have made the profits out of that. And prospective new investors are not about to take for granted the idea that there will be more profits to come from buying the same company’s shares; on the contrary, their presumption is more likely to be that future success has been discounted in the current share price already and that they had better look elsewhere for a bargain. Street-wise companies know all this, so their meetings with investors only focus on the current or past position when it helps explain implications for the future; rather, they concentrate in their discussions with investors on exploring what next year and the year after will hold.
The worry for companies faced with talking about the future – disclosure problems and the fear of class actions apart – is that it involves nailing their colours to the mast. But the danger of failing to do so is far greater. ‘Investors need to know the investment story,’ confirms Pincus. He says a company should tell them what management’s goals and standards are; what its growth strategy is; its competitive position; its market share and how it plans to improve it; and the timetable for diversification or expansion or whatever else it is planning. ‘Companies should really go public with the business plan that they normally keep in a three-ring binder on a shelf – instead of leaving investors to assume that such a plan exists. You need to prove that it exists by laying it out – both verbally and in writing.’
In response to such urging, companies often plead trade secrets or confidentiality – arguing that they don’t want to reveal information that might help their competitors. Analysts don’t buy this line any more, however, dismissing it on the grounds that information is so available and fast-moving today, that most of it has to be in the public domain, whether companies like it or not.
Companies in turn may dismiss this kind of demand from analysts, noting that the Street has a boundless thirst for knowledge. But the key thing is to disclose not just more information but the kind of information that analysts actually care about. One common cause of a souring of relations with the Street arises from companies attempting to dictate to analysts what they need – an approach destined to cause irritation among an already arrogant fraternity. For the record, typical complaints from the Street concern failure to break down numbers adequately by operating division; insufficient information about risk and potential losses; a lack of detail about margins; and a failure to disclose receivables.
Having disclosed the business plan and future strategy to the Street, a company is then obliged to come back year after year to explain how it is working – or, if it is not working, to explain how and why it is being changed. Again, this seems alarming, but it is a crucial part of building trust with the investment institutions and the sell-side. It also gives companies a chance to educate the investing public on their industry. And to show them the depth of understanding within the management team, to create confidence in that team’s ability to read its market, to respond flexibly to the unexpected, to manage changing circumstances and to rectify mistakes.
Management may be nervous of admitting to mistakes, for fear that this will alienate investors. But even the Street knows that people make mistakes; and it also knows that what differentiates the good management teams from the bad is the capacity to admit to them and rectify them. Wary companies should note the words of Alden Stewart of Alliance Capital Management, who is responsible for a fund currently valued at $15 bn . Quoted in this issue (see Fund Management Profile, page 99) Stewart says: ‘I don’t want to own a company that has never made a mistake.’
Similarly, if companies are to impress the Street, they must have the courage to talk about the downside risk, as well as the upside. Ideally they should take the trouble to explain to investors the relationship between variable and fixed costs, demonstrating how quickly each can be reduced, and what could be done to lower the break-even point, should that become necessary.
This is all part of taking into account the way the Street works, which involves constantly assessing and reassessing risk. Being one of the Street’s key preoccupations, and any company that fails to warn of prospective danger, especially where it knew – or should have known – that things might go awry, is risking jeopardising its relationship with investors for a long time to come (as well as a string of lawsuits).
Companies must highlight potential upside, too, of course. They should show, by reference to the numbers, where there may be room in future for improved margins; or what would happen if sales grew by a factor of X, leaving the analysts to come to their own conclusions as to what might be achieved.
A CFO or CEO who has the courage to pinpoint weaknesses, explaining existing shortcomings and the plan for putting them right, may succeed in sending the audience away with three positive perceptions: that management is straight both with itself and with investors; that management is competent; and, most crucially, that there is some real upside in this stock. In other words, the assembled analysts or investors will leave the meeting with a real investment story.
This may not be a course for the feint-hearted, but it’s an approach that is far more likely to pay off than trying to disguise downside risk or pretend that weaknesses and problems simply do not exist. It also shows the Street that management understands what investors need to know – and is willing to tell them.
All this is to lump the investor community together, however, as if it is a homogenous bunch, which it certainly is not. Rudy Martin, now at Fidelity Investments in Boston but until recently the IRO at Lincoln National Corporation, says that this point was brought home to him in a survey he undertook of 300 investment professionals.
The survey revealed three distinct investor clusters, each with markedly different levels of knowledge and interest. ‘To be Street-smart, you need this kind of information,’ says Martin. ‘It’s like marketing any product: you need a picture of the structure of the market and your position in it. You need to be able to filter out the noise coming from markets that are not your markets. And for that you need to appreciate that there are several markets – not just one.’
With growing companies the profile changes as they develop, which means they will appeal to different groups as they metamorphose from a brand new IPO to mainstream, income-generating Fortune 500 stock – if they ever get that far. Even Fortune 500 stocks have their ups and downs, of course, and history has shown that the stable blue chips of one decade can become the stumbling giants of the next. Who, in the mid-1980s, would have envisaged IBM ever becoming a recovery play?
By and large, smaller cap stocks have more work to do in anticipating which funds are likely to sell out at a particular point, and which ones they should be targeting to plug the gaps. Management teams inexperienced with the ways of Wall Street tend to throw up their hands in horror on hearing that a rising stock price can of itself trigger a sale. For many institutions there will be a fixed price – set at the point when they buy the shares – at which they will sell out to realise profits. Depending on how black-box-oriented a given institution is, the individual portfolio managers may have discretion to override these pre-set limits; but they are unlikely to do so unless they are very confident that the risk of not taking the profits at the predetermined point is offset by the strength of the case for expecting even better profits in the future.
So success can bring its own investor relations challenges. Take the example of Boston Chicken, the Golden, Colorado-based rotisserie chicken restaurant chain which first listed its stock in November 1993. ‘When we went public we went out priced at $20 a share, but the demand was such that it opened at $48.50 and traded as high as $51 that day, before closing again in the upper 40s,’ explains Melissa Marsden, the investor relations officer at Boston Chicken who joined the company about three months after its IPO.
Such a story suggests that the investment bankers – and the independent pricing committee in particular – must themselves have been way out of line with Street sentiment. Indeed, Boston Chicken filed a lawsuit on the subject. But the company’s short trading record meant it would have been hard to justify a higher price, as did any comparison with other IPOs at the time with similar growth potential and risk characteristics, so the case was dismissed. ‘The demand was certainly unexpected,’ concedes Marsden.
Nevertheless, the IPO left the company with an awkward situation in IR terms. When an IPO price sky-rockets like that, the Street assumes that the only place it can go next is down. Worse, it leaves plenty of people out there with a vested interest in seeing just that happen, and the stock with little appeal to the average institution.
Boston Chicken’s management understood this, and its implications. ‘It was certainly the case that most of the institutions who managed to get shares in the offering tended to be flippers, because there was a pretty sizeable built-in return there,’ notes Marsden. ‘So one of the issues was to attract an institutional shareholder base that could get beyond the perception of the company as just a high-flying IPO without much of a track record. In the first two quarters reporting of institutional holdings following the IPO there were probably only a handful – maybe 15 or so – institutions that continued to hold the stock.’
Marsden’s strategy since then has involved actively taking the company’s story out to investors, organising one-on-ones and participating in broker-sponsored conferences. ‘We also run our own field trips and our own meetings which we invite both the buy and sell-side to, in order to make sure they are kept abreast of current developments at the company,’ explains Marsden, who says that as a result of this effort the institutional shareholder base now accounts for around 20 per cent of the equity.
That’s a higher proportion than it sounds, since even following last year’s secondary offering, only 60 per cent of the equity is in the market; the other 40 per cent of the shares are still in the hands of management and officers of the company.
But the retail holding remains strong, reflecting Boston Chicken’s high consumer profile. ‘We have over 600 stores in the US serving rotisserie roasted chicken, turkey, ham and meat loafs, as well as a wide variety of side items,’ explains Marsden. ‘And we have a lot of small individual shareholders who, because they are customers and like the concept of the food, also want to buy the stock.’ Marsden says the company has no real objection to this, noting that shareholders make loyal customers, as well as vice versa. ‘The overlap can work to your advantage. But we do also need to keep attracting the right kind of institutions and to keep broadening that base.’
Marsden attributes Boston Chicken’s success in meeting its IR needs so far, at least in part, to the strength of the management team. ‘Senior management are very sophisticated in terms of their understanding of the Street,’ she says. The chairman and CEO, Scott Beck, was the vice chairman of Blockbuster, who participated both in developing that company’s business and in marketing it to the Street. CFO Mark Stephens has relevant experience too, but from the other side: ‘He has an investment banking background so he’s worked with a lot of other companies to help them in marketing their shares.’ As for other members of senior management: ‘It reads like a who’s who of the restaurant and retailing industries. It’s a young group, but an experienced one which understands the importance of having an open posture from the investor relations standpoint.’
Crucially, that openness has been evident in the company’s statements about its financing needs. ‘We have indicated to the Street that to finance the growth of the Boston Chicken system at the present rate, we expect to be coming back to the market fairly frequently. And we make sure that we adequately explain the company’s future strategy – where we’re heading – because investors need to have confidence that we’re setting goals and meeting them.’
Certainly, the performance of Boston Chicken since the IPO has been impressive. The stock price never did crash back down. ‘Over the six months after the listing it settled in the $36-42 range,’ says Marsden. There’s been a stock split since then but the current price of $22.75 is the equivalent of $45.50. Meanwhile, market capitalisation has risen from around $200 mn at the time of the IPO to just short of $1 bn in the 18 months since.
Explaining the funding of that growth to analysts is a particular challenge for the company. ‘We are a little unconventional in our approach to financing so the process takes a little more walking through with analysts than it might for other restaurant companies,’ notes Marsden. ‘That applies to both the sell-side and the buy-side, but since the sell-side is publishing the models, we need to make sure that we’re comfortable with their assumptions and that they understand how to model our expected results. On the buy-side, we spend quite a lot of time with buy-side analysts – usually before we talk to the portfolio managers – to help them understand the figures. We then arrange for fund managers to meet senior management. That’s especially important in our case because the company is seen as a management play by institutions.’
Boston Chicken has now established relations with many institutions, and built a good following. But for a lot of IPOs it’s hard to justify the resources needed to identify the relatively small number of institutions that might be interested in their stock. In many cases, portfolio managers are restrained from investing in very small companies; and keeping track in-house of the individual managers who specialise in smaller company stocks, or in a particular sector, can be too time-consuming without outside help.
Despite these drawbacks, small-cap companies do need to develop a sense of who they are competing against for capital. Talking to fund managers is key to finding this out, which makes building real relationships with relevant buy-side investors essential. Qualifying the lists of firms and individuals to be approached will surely improve the effectiveness of any IR effort. Help is available from various vendors for this, including sophisticated targeting firms who can identify the different classes of investor and pinpoint those likely to be interested in a given sector or investment profile; and assess when and why particular institutions are likely to move in or out of your stock.
‘One of the main ways that companies miss the boat in dealing with the Street is by believing that the sell-side is still very influential on the buy-side,’ says Chuck Triano of the Carson Group in New York. ‘But the sell-side has a decreasing influence so companies really do need to build relationships with the buy-side.
Triano accepts that many small-cap companies think this will be too time-consuming or complex, but he points out that even rudimentary peer group analysis can be put to good use for narrowing down the targets. ‘If they create a peer group of, say, ten companies they can then judge from the 13fs which money managers are selling and which are buying their counterparts,’ he suggests. ‘That’s a simple way of setting about the task, but they’ll get good ideas about who’s moving in and out of their sector or of other companies with similar financial characteristics to their own.’
Targeting is still difficult for small companies, however. ‘Large companies don’t generally have to spend time identifying the analysts who follow their industry and then make a point of seeking them out,’ notes June Filingeri of IR firm Morgen-Walke Associates in New York. ‘If you’re a major company in a sector, the analysts have to find you. But for small-cap companies there’s a responsibility to seek out the right portfolio managers and analysts in a proactive way.’
Filingeri also believes that senior managements of small companies have a special role in IR: ‘The CEO must show a real commitment to building the relationship with the Street, and this has to be accompanied by strong involvement in the IR effort by the CFO. It takes a lot of time, and in small companies that’s one thing no one really has enough of, so it’s a significant burden.’
One CFO who has made the commitment is Debbie Moffett of Community Health Systems Inc of Nashville, Tennessee, which went public in March 1991. The company had been trading since 1985, but Moffett joined at the time of the IPO as director of finance. Now CFO, she has devoted considerable time and effort over the last four years to building the company’s Street credibility. It now has a good following among healthcare analysts and strong institutional representation in its stock.
‘Back in 1991 after the IPO, we concentrated on the sell-side analysts,’ recalls Moffett. ‘We had no experience of investor relations so we were developing the programme from scratch, with the help of an investor relations firm called Corporate Communications in Nashville.’
The first goal was to build the company’s profile among analysts, without worrying too much about the institutions. ‘We started out with four analysts covering us, all from regional investment banking firms,’ say Moffett, who notes that these analysts already knew a number of Community Health Systems’ management, since they had been with other public companies. ‘That helped,’ she says. ‘They were at least known in the industry and because of that some of the analysts were familiar with the company before it became public.’
There followed a programme of mailings, meetings, distribution of quarterlies and so on and, as time went by, the programme was brought in house. ‘But we were still targeting the sell-side analysts. A company like ours had the best chance of reaching the buy-side and the retail investors through sell-side analysts. It’s very difficult to keep up to date with changes in the institutions in terms of who the portfolio managers are, who the analysts are – and who’s interested in healthcare today and who is not,’ she says.
The analysts-only approach has changed since the early days of life as a public company, and for the last 18 months Moffett has been working with Morgen-Walke to build credibility on the Street. ‘The programme, the message and the presentations are still created inside the company, but Morgen-Walke has been instrumental in getting our name in front of some of the institutions we weren’t aware of and helping us keep up with the changes within the institutions,’ explains Moffett. ‘We still concentrate on the sell-side too, but the larger institutions rely more and more on their own analysts, so we have relations with both them and the portfolio managers. I now spend two-thirds of my IR time talking with buy-side institutions, the other third talking with analysts.’
Whoever the particular audience has been, throughout the four years of Community Health’s existence as a public company, Moffett’s main preoccupation on the IR front has been to get across the company’s growth plans and to explain the business strategy. ‘Our focus is unusual in that we are involved in non-urban hospitals as opposed to urban,’ she says. ‘Analysts were aware that we were doing something different but, because there were not a lot of other companies with this strategy, I think it took time for them to understand it and to see why it worked.’ This was partly a question of taking them through the detail, but the management team also had to prove that it worked – which, by definition, took time.
In fact, there was another piece to the strategy, which also needed explaining. ‘This was the acquisition strategy,’ says Moffett. ‘Until this year, about half our earnings were expected to come from acquisitions. So we had to prove we could buy hospitals at reasonable prices, to show that we were spending our capital carefully. We also had to prove that we could operate them efficiently; and we had to show that we could evaluate a hospital accurately, so that we really were getting what we thought we were getting.’
Moffett presented both pieces of this strategy to the Street in some detail. ‘We went back and described for the analysts what we had paid for acquisitions in the past and why, as well as the results we had got from them. This gave them some tangible evidence of the kind of analysis we did and the results we could achieve.’
Community Health’s acquisition strategy also has financing implications, of course. The individual acquisitions are usually quite small – in the $20-25 mn range – since it mostly buys one or two hospitals at a time. ‘So we generally use our bank lines of credit for the acquisition at the time of completion,’ explains Moffett. ‘Then, when we have a critical mass of outstandings, we go to the market to replace them with something more permanent.’
In 1993, for example, the group replaced its bank debt with senior subordinated debt sold in the public market. Then in December last year it made an equity market offering. This was a good test of the company’s standing with the Street, which it passed with flying colours.
The offering was prompted by the fact that in October 1994 Community Health had bought 18 hospitals in a single transaction with another public company. Straight after that, it bought two more hospitals, in separate transactions. ‘The market was a bit unsettled at the end of last year, but the offer was still very well received by the Street,’ reports Moffett. ‘We attracted a number of new institutions that had not owned the stock before and we ended up increasing the size of the transaction – to some $85 mn.’
Moffett is sanguine about the time required from her on the IR side and accepts the need for the thrust of the effort to come from senior management. ‘It’s a big job. But one thing I believe the Street responds to is knowing they are talking to someone who is in a position to know the trends in the company, the strategy, and if and when things might change. There is never a point at which the CEO or CFO should be isolated from the IR function altogether, although as companies get larger they may have to bring in assistance at other levels.’
Moffett is talking here about assistance from IR staffers, but that’s not the only kind of help available. For smaller companies, especially, the advent of computerised support has been a real boon, and most clued-up companies have become adept at exploiting blast fax, teleconferencing, voice-mail – even putting out their message on television networks delivering video output to analysts’ and investors’ desks – for IR purposes. All of these can contribute to the speed and efficiency of their communications with the Street.
But there are traps awaiting the unwary with high-tech communications systems. That’s true of all.
