20 January 2013

A CEO's Search for Market Efficiency

One of the longest running MBA discussions is on whether capital markets truly price a security at its intrinsic value.  Whether you believe in market efficiency or not, erratic stock prices make it difficult for publicly traded companies  to manage for the long-term.  CEOs and Boards must balance its efforts between quarterly earnings targets and long term planning for company sustainability.  As most already know, these generally come in conflict.  So how can companies effectively manage these two opposing forces?  
First off, earnings don't mean as much as market expectations.  In an illustrative example, let’s say a company projects earnings of $10 per share and trades at the market P/E multiple of 15 for a $150 stock price.  If the company misses earnings by $1, the stock not only drops to reflect this miss, but also does  the P/E multiple oftentimes.   If the multiple drops to 12 in this example, the stock falls to $108 (12 x $9).  What’s interesting is that of the $42 drop in price, only $15 of it relates to the drop in earnings as the remainder results from a lowered expectation about the company's future.  An earnings miss means problems on the horizon to the market, whether or not it is actually true.  What's even worse, events or speculation outside the scope of a company's performance can affect the price significantly.  Ironically, while management teams almost solely focus on delivering on the financial budget, it is often outside forces such as an analyst upgrade or downgrade that really moves the price.  

So CEO's shouldn't worry about earnings or the stock price, right?  Of course they must. CEO pay is often tied to stock performance through options, equity grants, and other forms of compensation.  And if he or she can't deliver the short term earnings expected from analysts,  the CEO won't be around to benefit from some of those packages (but we can't lose sight of those healthy severance packages).  It seems counter-intuitive for shareholders to reward short-term results when a properly executed long-term vision should matter more, but patience is not a characteristic of the stock markets.  Bottom line, CEO's are expected to deliver every quarter and build a sustainable future with long-term stock appreciation at the same time. 
A few companies have been able to deliver on both fronts.  Jeff Bezos’ charisma and Amazon's sales growth allows it borrow at ultralow interest rates and command a high P/E despite an unproven earnings record.  Google’s search engine business continues to blow out earnings allowing it to invest in self driving cars and computing eyeglasses.  While very few have a cash cow like Adwords, even declining companies such as  Intel and Cisco can leverage their balance sheets and cash flow stability to delve into riskier investments that might produce a better future for them.  Building a day to day story still is step one.

Financial transactions are a  common way that companies attempt to influence stock price dynamics, but with mixed results.  Companies  that buyback their own stock do so at the highest prices.  Dividend payouts are good, but the market places little value on them (and can in fact lower stock prices due to reduced growth expectations of the company).  Many companies from Burger King to most recently Dell look to going private transactions as a way to generate value.  These transactions are usually highly leveraged and have other issues that may or may not make for stronger concerns over the long term.

Investments in innovation and new companies are another way to look to the future without impacting current results.  Spinoffs like Microsoft's home grown Expedia and EMC's divestiture of  VMWare were not only financial home runs, but also allowed these new ideas to thrive outside of the scope of a larger parent company with competing incentives.  Incubators such as ATT Foundry supports startup ecosystems while keeping the incumbent plugged into developing technologies.  Large companies can also benefit from innovation-based acquisitions, like Google's Android, to potentially develop a strong pipeline for the future.  Certainly there is more variability in the returns on these investments (which markets hate), but there is more upside in the long-run. 

In an ideal world, Management could manage companies for the long-term if markets were efficient.  But even if they are, its hard to chart a clear path to do so when quarterly earnings and outside forces seem to matter more.  Perhaps companies need to hire a psychologist to help manage market expectations.  Or perhaps companies should just stay on the sidelines like tech companies are now doing according to a recent WSJ article.  But if a company is poised to remain in the public realm, perhaps they need to develop a poker face by talking eloquently about mundane topics such as capital expenditures on the one hand, and invest in futuristic cars that drive themselves on the other hand.

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