What an analyst wants from you.
The investment process is electric. The financial analyst first studies the industry. Indeed, he may have worked in the industry. As he investigates a company, he interviews suppliers and competitors, studies market research, obtains industry statistics, and reads the trade press. He visits the company--at the corporate, group, and division levels--goes to company meetings, and often surveys customers. He interviews management, sometimes test the products, and looks at the economic scenarios that his own firm develops.
At Lehman Brothers, we expose our industry analysts to our economics people by having monthly "sector" breakfasts. It's here that the analysts tell the economist what they're seeing in the real marketplace. The economist uses this "bottoms up" information, and the industry analysts get the broader, "top down" view from the economist. The analysts then model the financial statements and identify the key valuation drivers for the stock. For example, does the stock trade mainly on asset value, cash flow, or earnings? If earnings, which earnings? This year's, next year's, "normal" earnings?
Stocks are valued in different ways. Looking at the price/earnings ratio is not the only method. In the last few years, we've seen a massive shift away from valuing a stock using the private market value back to valuing it using traditional methods--earnings, dividends, and their growth rates. A smart analyst will likely kick the idea around with his coworkers to see how they fell about the stock.
When an analyst finally formulates his investment thesis, we have a meeting of our investment policy committee. The analyst will pitch the idea; the members of the committee ask questions and continue to help refine the idea. If they're convinced it's a good pick, the analyst will recommend it the next day--or sometimes even the same day.
The analyst's dilemma
From your vantage point at a corporation, you see only one part of the analyst's job: the final output. What you may not know is that an analyst has many forces pulling him in different directions as he tries to make the correct investment recommendations. (See the figure at right.) Of course, he'd like to be pursuing the truth, which translates to: Is the stock going up or down? But he's also pulled by other influences, such as:
* The investment policy committee members may have insights (and prejudices) that affect the analyst.
* Investment banking. The analyst requires a good deal of discipline and clear thinking to separate his investment judgment on a stock from a corporate relationship that his investment bankers may have, especially if he helped create the relationship.
* Traders. A good analyst will have a strong relationship with the trader who is dealing in the stocks he follows and will respect that trader's opinion.
* "Shorts." The short sellers are clients, too! If the analyst recommends a stock that some clients are shorting, those clients get angry.
* "My companies." The management and the investor relations personnel at the companies being researched are a very powerful force on the analyst. This force is expressed when the analyst refers to the industry that he follows as "my companies." An analyst will get calls from the investor relations manager complaining about the analyst's recommendation to sell the stock. To mitigate these problems, we advise our analysts to notify the company's investor relations people immediately after he's changed a recommendation and to explain how he sees things a little differently than the company does.
Furthermore, the salesforces, both institutional (numbering in excess of 50 at Lehman Brothers) and retail (numbering more than 8,000 at our Shearson Lehman Brothers division) don't hesitate to voice their opinions. Even the analyst's research assistant will chip in his two cents.
So, you can see, the analyst has quite a balancing act to perform. And sometimes that tug-of-war affects you and your company.
The analyst's real goals
To work well with a financial analyst, it helps to know his objectives. They're simple: to look smart and avoid embarrassment.
An analyst wants to pick good stocks to help clients make money, so they keep coming back to do their business with the firm. This is the best way to look smart. But many institutions will use an analyst and his firm even if the analyst's stock picking is mediocre. Institutional clients very often use an analyst not for their recommendations, but for accurate earnings estimates, product knowledge, competitive analysis, or other insight that are valuable inputs to their investment process. Of course, it's best if the analyst can do it all--pick stocks and be an industry expert.
The second goal of the analyst is to avoid embarassment. The analyst has a glaringly public job. The analyst doesn't want to be the last person to discover something. It's okay to be embarassed along with everybody else--just don't be singularly embarassed. It takes a lot of courage to be the only person recommending purchase of a stock or the only person recommending the sale of a stock. This is simple human nature.
Remembering these two motivations--looking smart and avoiding embarrassment--should help you deal with analysts. Analysts are searching for special insights and desperately trying not to get surprised. What can your company do to make sure your message gets out and make the analyst's job easier? To answer that, let me talk about the best investor relations I ever witnessed as an analysts.
Who's the best?
The firm with the best investor relations program, in my opinion, is AMP, Inc., a $ 3-billion manufacturer of electrical and electronic connection devices based in Harrisburg, Pennsylvania. AMP repeatedly wins a poll of financial analysts in an Institutional Investor magazine survey on top investor relations programs.
What makes AMP so good? The key is that AMP shows analysts a moving picture of what's happening in the firm, not a snapshot. In other words, as the quarter progresses, I can call AMP's investor relations person, who has been with the company since the early 1960s, and he'll give me their best read on the company's revenues and orders. He helps me understand margins and earnings trends for the quarter. All this makes surprises rare when the numbers finally come out. Analysts, of course, must take the initiative to call AMP frequently.
AMP also holds management meetings twice a year in Harrisburg. Present are the top management and executives from all the marketing divisions--automotive, computer, telecommunications, and so forth. At the meeting, they all review trends in the business. Seventy to 80 investment professionals come to this rather out-of-the-way place and always come away with some new nuggets of information.
AMP always will send some of its top people to broker-sponsored investment conferences to give updates on the firm. At all meetings, AMP issues a press release that is a status report on the business. AMP also almost always comments on its Wall Street earnings estimates. This essentially ensures that the consensus is reasonably closely aligned with reality. For example, AMP might say it believes Wall Street earnings estimates are between $2.80 and $3.00 per share and, provided the economy continues to improve and the proposed tax legislation is enacted, AMP doesn't see a strong reason to disagree.
Analysts get very comfortable with AMP, and I'm convinced that's a direct result of keeping information flowing. I'm also convinced, though it would be impossible to prove, that a portion of AMP's premium valuation is a function of the breadth of coverage it receives from both the sell and buy sides because the IR program makes the company so easy to follow.
Your hidden jewels
Your company has some attributes that make it attractive to investors and analysts, but you rarely, if ever, expose them.
These hidden jewels are your management processes, how you run your company. But because financial executives are often running around trying to estimate the tax rate or put together order figures for last week or last month, they rarely have time to promote their management processes. Maybe it's time for a completely different approach to analyst meetings. The kinds of things you should want to show Wall Street and buy-side analysts are these:
* Your sales forecasting process. How do you make your projections? Why do you think revenues will be up 10 percent, if that's unusually high? If analysts know that your firm makes its forecasts through a detailed, bottoms-up approach and you cross check the data, they'll have confidence in your numbers. They'll understand that your forecasting process is solid.
* Your budgeting and control process. How do you roll up the numbers? How soon after a period ends can you do it? How do you regain control when things get out of balance?
* Your capital expenditure analysis process. How do you compute payback periods or ROI? Do you risk-adjust the ROI? How do you allocate capital between divisions? IF analysts understand your thinking in these areas, then if you make a controversial investment--say, you build a large plant you shouldn't have--they may be more willing to support it even if they don't or can't know all the facts.
* Your acquisition analysis. What are you trying to accomplish with acquisitions? What are you wiling to trade off? If, for instance, analysts have known for years that you're willing to trade as much as 10 percent of earnings in the first two years following an acquisition, they'll internalize that and recall it when you make an acquisition that is dilutive initially and won't be surprised and feel embarrassed.
The same philosophy holds true for project management, research and development, and human resource development. If you think your company excels in any of these areas, expose it. By doing so, you raise the analyst's comfort factor, drop the surprise quotient, and get the reputation of being a well-run company. You need to have a program over a year or two that illuminates these assets, rather than just react to the quarters and the pressure of getting the releases out.
An example of a company that does this well is Applied Materials, a $500-million global growth company that makes equipment used to make computer chips. It's an ultra high-tech firm that receives big, lumpy orders, so its business and stock prices are extremely volatile. Therefore, orders and new technology are the usual focus of the analyst meetings. But, at one of the company's analyst meetings, the president switched from discussing the firm's current activities to explaining how he runs the company. He took well over an hour, and it was one of the most interesting discussions I had ever heard by an operating executive. He talked about how he structures the company, describing how he looks at all five product lines as separate business units. Each has to pay for itself, he said, and each has a pretax profit target. He explained how each is funded. He even showed the analysts copies of the budget and sales reports and described how he uses each.
Analysts came out of the meeting with a much better understanding of the company. Most important, many left thinking this company has a very good handle on its business--much better than most.
This article is adapted from a speech Mr. Balog delivered to FEI's Committee on Corporate Finance.
|Printer friendly Cite/link Email Feedback|
|Title Annotation:||includes related article; relationship between corporate executives and financial analysts|
|Author:||Balog, Stephen J.|
|Date:||Jul 1, 1991|
|Previous Article:||Executives should earn their retirement income.|
|Next Article:||Is your accounting department loafing?|