Memo to the CEO: Decouple from Financial Markets
In today's Financial Times, Anant Sundaram and I make the case for CEOs to decouple from financial markets.
A lengthier (unedited) version of that article appears below:
Memo to the CEO: Decouple from Financial Markets
During the past year, stock price volatility has averaged twice the long-run historical norms. Indeed, at its peak in Fall 2008, it was three times. The recent upswing notwithstanding, this volatility has been accompanied by dizzying stock price declines. For instance, this past year, measured from peak-to-trough, GE was down 83%, Apple 59%, Intel 52%, United Technologies 51%, and Procter & Gamble 41%.
Managers face a conundrum. While many are intent on creating long-run value for their investors, this level of volatility makes them question whether and how the fundamentals of their business are reflected in stock prices. They are throwing up their hands at the seeming futility of their decisions.
Why this frustration? Value is simply long-run cash flows discounted to the present at the rate of return that investors expect when they provide a firm with capital (‘cost of capital’). But while managers have control over the former, it is markets that influence the latter. Cash flows are a function of revenues, costs, and investments. The life of a manager revolves around getting the most out of these. But cost of capital is primarily affected by the stock market.
Finance 101 tells us that cost of capital is set by (marginal) investors who hold diversified portfolios: diversification eliminates firm-specific risks, thus leading investors to price a stock on the basis of risks from how much it covaries with the market as a whole. Other determinants of cost of capital, such as the risk-free rate of interest and the market risk premium (or, the average price of risk) are also influenced by the market, not the manager.
The result? Individual stock prices become inescapably linked to movements of the market. If the market swoons, chances are high that an individual stock will too. As we have witnessed recently, this can happen irrespective of what managers try to do to influence future cash flow prospects.
So, what is a manager to do? We believe it might be time to re-think conventional wisdom regarding the relationship between firms and financial markets. CEOs should perhaps start to think of ways to decouple their long-run strategies from the short-run mood-swings of financial markets.
To achieve such decoupling and yet maintain focus on long-run value-creation, CEOs should consider taking any or all of the following six specific actions: jettison quarterly guidance, reduce dependence on external capital markets, focus on the individual (and not institutional) investor, retool/rethink compensation, innovate via adjacencies rather than breakthroughs, and finally, invest/acquire counter-cyclically.
1) Jettison quarterly guidance. CEOs have had a simple bargain with the market. Provide the market regular updates/information on the outcome of strategies, and the market will, in turn, process the information and reveal ‘fair’ prices. But this bargain may have broken down.
In many companies, the earnings guidance cycle has become an unfortunate treadmill of managing for the next 90 (in some instances, 45) days. If markets rewarded those who provide guidance differently from those who don’t, a manager might go along. But the recent downdraft made little distinction between companies that fed the market with information and ones that didn’t. Moreover, analysts seem to have become lazy: few develop valuations based on actually going out and talking to customers, channels, or competitors. Rather, they appear to have the idle expectation that data are handed to them on a platter. Perhaps we should let analysts do their homework – if they want to value a business and make investing recommendations, they should pound the pavement, gather primary data, and analyze it. In other words, we should let them earn their investing recommendation stripes. Coca Cola, Berkshire Hathaway, Google, Alcoa, Goldman Sachs and McDonalds have all stopped guidance. Others – for example, GE – are moving to annual guidance.
2) Reduce dependence on external capital markets. The need to go out and make the case to external capital markets for why a strategy deserves funding is viewed as a source of managerial discipline. But that view assumes the market will believe the company’s business case, that liquidity will be there, and that the investment bank will be there to provide underwriting when needed. We have seen that these could be somewhat naïve assumptions.
Perhaps companies should shift their focus more to internal cash to fund growth. They should focus attention on cash flows, i.e., the cash that comes in versus the cash that goes out, rather than accounting earnings. They should rethink their payout policies. If they can create more value by reinvesting rather than paying out the cash, they should do so, despite the fact that the action is likely to result in a negative price reaction in the short-run.
One oft-cited risk of having too much cash is the increased likelihood of a hostile takeover. But that risk may be overblown. The past two decades have seen few hostile takeovers. Moreover, a beaten-down stock price is probably a worse takeover threat. The financial slack the company has built up by focusing on internal cash will enable it to quickly raise external capital to defend itself, if needed.
It is not an accident that the tech quintet of Apple, Cisco, HP, Intel, and Microsoft are riding out the recession with collectively over $100 billion in their coffers. Or that, in the past six months, GE has increased its cash position from $13 billion to almost $50 billion.
3) Focus on individual and not institutional investors. A majority of the shares of large, publicly traded companies in the US are owned by institutions. But it is perhaps time to develop, manage, and communicate the firm’s strategy as though its primary investor is an individual. Why? Individuals churn their portfolios less than institutions, i.e., they have longer horizons. Second, managing for ‘institutions’ could create a recipe for confusion. Institutions include everything from pension funds (longer horizons) to hedge funds (short horizons) to statistical arbitrageurs (horizons measured in minutes). They include the longs (who want the stock price to rise) and shorts (who want the stock price to fall). If a firm manages for institutional investors, for which institution should it manage, and for what horizon?
This focus, however, must be accompanied by three real changes in the relationship with retail shareholders. Companies should appoint to the board a retail shareholder representative. They should make the annual general meeting more meaningful, and treat it as an opportunity to have a genuine conversation with investors. (One good question might be, what would Warren Buffett do?). Companies should make financial statements more retail investor-friendly, by couching discussions in simpler language, reducing boilerplate content, making their numbers less opaque, and cutting back on the size of the annual report. In this day and age, anyone who needs more detailed data can download SEC filings.
4) Retool/rethink compensation. A great deal of compensation is tied to short-term EPS-related metrics, and rewards managers too much on the upside, and perhaps paradoxically, too little on the downside.
Instead of the increasingly opaque, accrual-based, quarterly EPS-type measures, companies should focus on long-run cash flow-based metrics for incentive compensation. They should do so in a manner that rewards managers for the value-creating investments they make. It is investments a manager makes today that produce value-creating growth tomorrow. If a major investment recommendation is accepted – e.g., a new R&D program, a new product introduction, a new market entry, an acquisition – the manager should be rewarded. This said, could the firm end up rewarding managers for decisions that, ex post, do not turn out as intended? Indeed, that could happen. The key is to get the ex ante incentives right. This, in turn, presupposes that the company has in place a capital budgeting and investment selection process that are effective at sorting the good from the bad.
When compensating managers with stocks/options, companies should benchmark against market- or peer-performance. It is fairer to both managers and shareholders. On the upside, they are rewarded only for value that they (and not the market or industry) create; on the downside, managers are not penalized for market-driven price declines. Consider an example. Suppose a stock is expected to vary one for one with the market – or in finance parlance, it has a “beta of 1”. Suppose the stock falls 5% when the market goes down by 10%. In market-benchmarked terms, the managers created value, and would get an extra payout. On the flip side: if the stock goes up by 10% when the market gains 10%, managers only did what was expected of them, and would get a zero payout.
5) Innovate via adjacencies rather than breakthroughs. Tough economic conditions call for a brutal focus on costs. But playing defense is not enough; companies must also grow. So, how does one play offense during these challenging times? Growth requires innovation: we recommend that companies focus on innovation into spaces adjacent to the core, rather than via breakthroughs. The latter, such as the quest for an electric car, involves bet-the-company moves which have the potential to exaggerate the already high volatility in stock prices. This is because the size of the upfront cash outlays required and the chances of failure are both higher.
Adjacency innovations are likely to be less risky because they leverage existing competencies and offer new products and services to already-familiar customers. And, to the extent that they involve a smaller upfront cash outlay, such innovations are consistent with reliance on internal cash flows, and they obviate the need for massive external financing.
Infosys, the Indian software company listed on NASDAQ, offers an example. Following the dotcom bust, the company, whose traditional business model was to provide software to improve a customer’s workflow processes, decided to play offense and make an adjacency move. Infosys started a new service – consulting – to advise its existing customers on business process transformation, thereby moving up the value chain to command higher fees. With such a consulting capability, Infosys was able to initiate a conversation with its customers about unsolved business problems, rather than uncompleted programming tasks. The integration of consulting and programming has allowed the company to grow rapidly since the dotcom debacle.
6) Invest/acquire counter-cyclically. Investing and acquisition activity has traditionally been pro-cyclical with the market: it tends to surge when market valuations are high, and ebb when valuations fall. This happens for the simple reason that companies go shopping for big-ticket items when they feel rich, rather than poor.
The risk with such a strategy is that one can end up ‘buying high’ in a boom, and go into a defensive mode in a bust. We think that it makes sense to be strategic and contrarian. Decoupling from the short-term influence of external capital markets would imply that it pays to be counter-cyclical in investing and acquiring. Why? Not only are assets likely to be cheaper in a downturn, but equally important, screening mechanisms are more disciplined, and the require-ments for a business case more uncompromising. The focus on internal cash generation and the retooling of compensation structure that we recommended above are consistent with the requisite financial freedom and the right incentives to pursue such a strategy.
Cisco Systems (with its acquisition of Pure Digital, the maker of Flip Video), Johnson & Johnson (with its acquisition of aesthetic medical device market Mentor Corp), and Eli Lilly & Co (with its acquisition of Imclone Systems) exemplify companies pursuing such a strategy.
The paradox of value creation is that, while companies control the cash flow side of the equation, markets control the cost of capital side. When both sides of this coin are well-aligned, it is easier for managers to go about their lives implementing strategy to create shareholder value for the long run. In a situation in which managers’ ability to focus on the long horizon is compromised by a financial market that is tugging in the opposite direction, sensibly decoupling from the market’s mood swings may be the way to go.