Assessing managers is more art than science for shareholders
• You have ploughed a packet into a company, but how much can you trust the management?
Company management is supposed to act and think like the owners of the company. Unfortunately, that’s not always the case.
Assessing the quality of management, in particular the extent to which they can be trusted to put shareholders’ interests above their own, is more an art than a science, and each investor has to find his or her own way of doing so. For some, seeing the CEOis a must. Others settle for a phone call, and yet others don’t feel any need to talk to anyone as the company’s performance will eventually tell them all they need to know.
But assessing management through their results takes a while and by the time suspicions are confirmed, it’s often too late. On the other hand, as Simon Taylor of Judge Business School wrote in a letter to the Financial Times: “Investors may claim that they learn something more subtle than actual facts from the CEO’s tone or demeanour, but it’s unlikely. Perhaps those with advanced psychological training or with a background in the CIA or MI5 might be good at this, but the average investor or broking analyst, armed only with Body Language for Dummies and with the usual raft of human biases, is likely to learn nothing.”
Not everyone agrees. Baruch Lev, professor of accounting at NYU’s Stern School of Business, maintains: “Executives’ narrative and tone colour many investors’ decisions and account for most stock-price changes in the wake of financial reports.”
“If I see a company executive tense up with a question or glance at his chief financial officer, I’m picking that up,” says Adam Grossman, an analyst at Boston-based Middleton & Co. While a lack of openness may be the main reason, it’s not the only reason that a meeting with management might not yield the results an investor is hoping for.
“Most people ask questions that will generate the answers they want to hear,” says James Montier at GMO. “Much of the information provided is noise … corporate managers are just as likely as the rest of us to suffer from cognitive illusions.”
Perhaps more so. Though CEOs set expectations, they are often overly optimistic about their company’s prospects. They believe their own story.
When things are going so badly that they have to lay off half their staff, they are more likely to want to talk about the opportunity to restructure that will help achieve the “tremendous opportunities” available.
Asked about the potential of a rights offer to reduce share value and they’ll want to talk about the “exciting prospects” renewed liquidity now brings.
Managers seldom admit they have fallen short of their goals, so they characterise setbacks as temporary. “When was the last time anyone arrived at your office and started to confess they were a dreadful business with disastrous management, and had little hope of ever actually improving?” asks Montier.
“The real danger,” says Eric Heyman at Olstein Capital Management, “is that a compelling narrative delivered by a charismatic CE may overshadow financial data that could serve as an early warning sign of shifting fortunes or trouble ahead.”
“Giving more information to investors generally, and doing it in an honest and understandable way, is good business,” says Lev.
“That’s not a loose assertion. It has its roots in the economic theory of information asymmetry. When one party to a transaction knows more than the other, someone suffers — and it’s not whom you might think.
“When sellers have information about the quality of a product that buyers don’t, the sellers are actually the primary losers, as suspicious buyers drive down prices or abandon the market altogether … managers who are distrusted face a substantial share price discount, a higher cost of capital and a more volatile stock price.”
But building trust may have less to do with sharing information than it does with doing it in what Lev calls an honest and understandable way.
One of the more reliable measures of trustworthiness is how management deals with bad news; how quickly it’s passed on and the fullness of the information provided. As far as that’s concerned, the timing and wording of trading updates is especially telling when it comes to differentiating between those that deliver bad news openly, at the earliest opportunity, and those that are out to bamboozle.
In terms of the JSE listings requirements, management has no choice but to publish a trading statement as soon as a reasonable degree of certainty exists that the financial results for the period to be reported upon will differ, by at least 20%, from those of the prior corresponding period. Good news updates are seldom difficult to grasp or slow in coming out. But bad news updates can be so sparse or convoluted and issued so close to the release of the results as to be worthless.
Simmers once issued a trading update an hour ahead of its results. Thabex issued a trading update that warned of an “estimated” headline loss of 61c-84c per share in the morning, with the results in the afternoon.
First in line when it comes to questionable announcements though are those that provide only partial information, usually the good news without the bad. For example, the trading update that announces the company expects earnings and headline earnings per share to be significantly higher than that of the previous corresponding period, but fails to mention that it will still be reporting a loss.
Then there are those that manage to meet regulatory requirements without divulging anything useful. Bonatla Property Holdings, for example, issued a trading update that informed shareholders earnings would “differ” by more than 20%. What it didn’t bother to say was whether that would be 20% up or down on the prior corresponding period, though it wasn’t hard to guess.
IF I SEE A COMPANY EXECUTIVE TENSE UP WITH A QUESTION OR GLANCE AT HIS CHIEF FINANCIAL OFFICER, I’M PICKING THAT UP