Epiroc’s head of IR Karin Larsson presents a strong argument to improving the IR-hedge fund relationship
I have been working as an IR professional for almost 15 years. To my continued surprise, I still meet peers who remain negative around hedge funds.
In fact, they actively seek to minimize interaction. And if they do allow such meetings, they squeeze hedge fund managers into large group meetings, normally led by IR rather than management.
To me, this approach is counterproductive. The role of the IR department is to safeguard a fair valuation of the share by communicating correctly to all relevant corners of the financial markets. I strongly believe that open doors and strong relationships improve liquidity and generally lead to a fairer – and to be honest, often higher – valuation. And this belief is reflected in Epiroc’s own meetings with the hedge fund community.
Since Epiroc was listed, the company has been trading at a premium versus peers (with an average trailing price-to-earnings ratio of 28) and it is well known for qualities such as a large aftermarket and market leading innovations. In the Epiroc IR department, we hold more than 400 meetings and calls with the buy and sell side each year – of which some 20 percent are with hedge funds. Of those meetings led by our CEO, hedge funds join 25 percent.
Hedge funds improve liquidity – and valuation
As hedge funds have all tools at hand, they can strengthen share price moves up or down, especially during uncertain times or when they have strong opinions about the stock.
Here are a few examples of how they do it:
• Amplify the buy: A hedge fund borrows money to buy more shares than they could with cash alone, thereby amplifying trading volume and potentially a price increase
• Make money when share price goes down: A hedge fund might borrow shares from another investor off market and conduct short selling in the market, thereby adding trading volume and potentially a price decrease
• Impact decisions: A hedge fund might hold borrowed shares – not to sell them, but to vote – thereby impacting decision making at the AGM.
Math and statistics are a great lens through which to look at hedge funds. Traditionally, risk premiums have been linked primarily to systematic risk factors such as beta in the CAPM model. However, since the 1980s, a growing number of researchers have shown that liquidity plays a crucial role in both return requirements and pricing. For example:
• In Alternative factor specifications, security characteristics and the cross-section of expected stock returns, Brennan, Chordia, and Subrahmanyam (1998) found that liquidity has significant explanatory power for returns over time. These studies have led investors to increasingly integrate liquidity premiums into their return requirements, especially in discounted cash flow valuation models
• In Asset pricing with liquidity risk, Acharya and Pedersen (2005) developed a liquidity-adjusted capital asset pricing model, where investors require compensation for both the level and risk of the asset’s liquidity. They identify four risk components: own illiquidity, and three types of systematic liquidity risk.
So, we can agree that high levels of liquidity are crucial for listed companies as it ensures shares can be traded quickly and at stable prices, minimizing the risk of share-price volatility.
Hedge funds are an important source of liquidity and can also act as healthy counter-flows during periods of overreaction.
A well-informed hedge-fund manager is likely the first mover to buy or sell your share in times of market exaggerations, which helps to smooth out an otherwise bumpy ride. In times of volatility, liquidity is even more important.
Öystein Fredriksen, associate professor at Linköping University in Sweden – the university with most CFA Research Challenge Champions in Sweden – says: ‘Liquidity is more than market convenience; it is a cornerstone of valuation. The evidence shows that investors require compensation – a liquidity premium – for the risk of being unable to trade efficiently. This premium intensifies during times of market stress when the ability to trade without loss of value is most constrained.’
Hedge funds give important market insights
Hedge funds often conduct thorough due diligence and possess sophisticated analytical tools to evaluate a company’s potential. Their investment decisions are based on comprehensive research and analysis, which many times signals confidence to other market participants. You may be surprised to know how many tone-setting hedge fund managers there are in key (global) financial centers such as London, New York and Dubai.
‘I believe global investment firms are typically well-positioned to attract and retain some of the industry’s top talent with a variety of financial services backgrounds, many of whom are selected for their deep sector knowledge and experience as industry analysts,’ says Chris Buxton, a sector specialist at Millennium with more than 15 years of experience in the global capital markets.
‘In my opinion, good investors also prioritize open dialogue and offer constructive insights to companies and, in the process, in many cases can help company management drive their own positive changes. At Millennium, we’ve invested in our sector specialist team, which works closely with our investment teams to deliver high-quality insights so that company engagements are constructive for company management.’
Thanks to these thorough analyses, hedge funds often identify risks or potential for improvement in investments. This is good! If you build a strong relationship with hedge fund managers, they will also highlight important insights, concerns or hidden potential that you and your management can use.
They are not shorting your stock because they want to be mean; they do it because they see that things could be done in a different way, or they spot a risk in your business that needs to be addressed.
‘Hedge funds are good at spotting risks. They are the only market participants that have a strong incentive and ability to profit from it. Long only investors just don’t have the same incentives and the sell side is just not set up for it,’ explains Erik Karlsson, a hedge fund veteran in London. ‘If I was a CEO, I would listen to what some hedge funds saw as risks in my business, especially if they are disclosed short. In particular, if they had concerns about the quality of my accounts and any risks therein. Sometimes they are right, sometimes they are wrong, but it is worth listening to their thoughts.’
How to successfully engage with hedge funds
My strategy is to be inclusive and proactive towards all institutional owners, including meeting with many hedge funds on a regular basis. This leads to fruitful discussions rather than staler one-way communication about Epiroc. This way, I learn about emerging trends, investor sentiment and potential risks. I am sure that our proactive approach helps us stay ahead of competitors, adapt to market changes and seize emerging opportunities.
That said, there are rather a lot of hedge funds, often with several independent teams. And honestly, many of them want to interact and join meetings too often – sometimes on a weekly basis. This can be less than ideal, to put it mildly. So, what is too often?
It’s all about finding a balance. When discussing the topic with my peer Hanna-Maria Heikkinen, award-winning IR professional and vice president of IR at Wärtsilä Oyj, she notes that ‘it is critical to maximize the audience for your equity story. In practice this means that you need to meet different relevant investors, not the same ones every week. The key to succeeding in investor relations is consistency. You cannot give different messages every week. When you are consistent, investors know that your message does not change every week and we can balance our interests with investor interests.’
Luckily, most large hedge funds are working more efficiently these days, and invite all their teams – regardless of where they are in the world – to meetings, so the logistics are getting easier.
The importance of the sell side
The sell side – and its close relationship with hedge funds – also needs a mention here. To me, the sell side is a much-appreciated part of the financial markets that works as a ‘free-of-charge marketing channel’. I am aware that there are no free lunches, but if you have, say, more than 25 brokers covering your stock with 20 salespeople, the buzz they are creating in the market is worth a lot. If I can support them by taking hedge fund meetings at their conferences, I am more than happy to do so.
Mark Troman, deputy head of EMEA equity research at BofA Merrill Lynch Global Research is reinforcing the message further with this insightful quote: ‘Hedge funds have long been a success story in the investment landscape, often dominating the debate around key stocks. Many have achieved remarkable growth and scale, becoming some of the largest clients for sell-side firms. Consequently, sell-side institutions have experienced a significant increase in hedge fund interactions – both through sector analysts and corporate access, promoting a dynamic exchange of investment ideas, perspectives and market insights.’
As you see, I really believe that engaging with hedge funds on a regular basis offers listed companies, such as mine, many benefits – including enhanced liquidity, improved valuation and invaluable market insights. Enjoy your meetings with (some of) the smartest minds in the world.
Karin Larsson is vice president of IR and media at Epiroc, a global supplier of equipment and related services to hard-rock mining and construction industries. She is also a board member at Genova, a Nasdaq listed property company active in Sweden
