by Ananth Raman
There is plenty of evidence to show that investors can and do trade stocks more frequently than they did decades ago. This by itself is not a surprise; after all, the costs and effort associated with trading stocks have gone down dramatically. Not surprisingly, some investors would seek to benefit from the combination of lower transaction costs and opportunity to make money from the fluctuations in prices.
Asking them not to profit from such opportunities is likely to (and possibly should) fall on deaf ears.
Moreover, I fail to see any argument why such short-term traders, by themselves, destroy value for the economy as a whole. Clearly, some of these traders could get very rich even while others lose money, but these trades — unless they influence operators within companies — amount to little more than robbing Peter to pay Paul.
Indirectly though, these short-term traders can destroy value. How? Put simply, short-term trading — and the fluctuations they cause or exacerbate in short-term prices — can influence managers to make decisions that are not in their firm's long-term best interest. This conclusion draws on two arguments, each of which needs to explained briefly.
1. The short-term price of a stock can differ from that implied by the firm's long-term valuation.
A firm's long-term value should correspond to the present value of future expected cash flows. However, investors at any given point in time might have limited information on aspects of the company's operations and this could bias their expectations of future cash flows.
Some types of information are not revealed to investors because managers either do not want to or are not allowed to reveal the information. Equally importantly, the average investor might be limited in his or her ability to understand the firm's operations fully and hence, his or her expectations of future cash flows might be biased. Consider, for example, the average investor's inability to understand the subtleties of fashion design or scientific research.
2. Operational decisions at the firm are often influenced by the short-term price.
There are many reasons for managers not to ignore the short-term price. The obvious one is that they are often compensated with stock options, whose value is based on the firm's current stock price. However, there are many other reasons too, and I suspect these other reasons might be more important drivers of managers' decisions. A low stock price can make the firm vulnerable to a hostile takeover, for example. Moreover, in many cases, managers have bemoaned to us the "hell we got" from their boards when the stock price fell. It apparently takes a courageous and confident board member to second-guess the market!
These short-term decisions have the potential to destroy long-term value. During the last few years, I have interviewed numerous managers and often asked them why they failed to invest in projects that — at least in their assessment — would have created long-term value. Usually, these were investments in basic R&D, customer service, and employee skills that in the short-term investors would find difficult to understand and value appropriately. (Admittedly, these investments are also in domains that are close to my heart.)
Under pressure to manage the short-term stock price — and at times meet short-term earnings target — many managers told me that they had abandoned sound projects with good long-term value because these investments would not help, and could often hurt, their stock price. Compounded over many firms, such under-investment in otherwise worthwhile projects compromises society's long-term progress. It might even be at the root of national competitiveness (or lack of it), and the economy's (in)ability to develop projects with longer gestation periods.
It is true that the root cause of the frequent underinvestment in worthwhile projects might be investors' desire to profit from short-term price fluctuations. That said, investors' short-termism per se does not destroy long-term value. Instead, the critical question to ponder is: How can managers make optimal long-term decisions even when the stock price does not reflect true long-term value?
My Summarized Reply:
My experience on this subject has been one of a consultant or as a strategist. In both cases, an observer, thus in proximity of these pressures. In my operating role, I am a degree of separation away from worrying about stock price based on my actions. i.e., I know I need to deliver good results - in if all my fellow managers do the same, it should reflect on stock price.
With that caveat stated, here are a few observations on this topic.
1. Day to day management is less about stock price and more about operating results.
If I have good expense discipline and drive the sales force (wholesale or retail; internal or external) to full-potential performance, then by definition I am contributing my full weight in terms of operating results to the company's bottom-line.
However, there are problems with only focusing on the above.
2. Day to day management is incremental, not quantum.
Day to day management with keen focus on operational results, leaves no room for innovation. However, in my experience innovation cannot be done centrally away in some remote facility (say, like the Xerox facility of yore). I think innovation should be part and parcel of every business.
But there is inherent tension - because focus on operating results is all consuming. And if we don't innovate, we will be overtaken - when and not if will be the scenario.
In my world the biggest challenge is 'Retirement Income'. The demographics have tipped-scales such that we have to move from 'asset accumulation' to 'asset distribution' - the industry is just not ready to do this. However, the first big firm to do this will dominate this category. So I am caught in this tremendous challenge of producing operating results quarter after quarter, but knowing fully well that if I don't invest in this next generation solution, the entire business can be taken away.
3. Key to managing public markets is assurance that you are doing both
I fully agree with you that communication - artful, thorough, frequent is key. And when one watches CEO interviews, it is clear that there is a normal distribution in this regard (However, I would be interested to know if there is a correlation between CEO communication skills and stock price).
Perhaps 2 other elements are key. First that the company is generating consistent operating results. My favorite example of this in my industry is Northern Trust. It is impressive how consistent they have been since the mid 80s (at least that is how far back I have tracked them).
The other is to show where one's next set of growth is coming from. Netflix has been signaling quite clearly in this regard. However, I think the market punished them due to the first reason above - i.e. faulty communication. Also, faulty execution.
4. How aggressively is the portfolio being managed?
I have taken to gardening recently (let's say yard work!). But I notice that the garden really responds to one's toil. And the key of course is weeding. (In writing, weeds are typos!)
In my observation, bigger companies accumulate absurd levels of unrelated businesses an business units and labrynthian functional lines. Part of the C-suite responsibility is to aggressively prune - particularly during good times - and in my perhaps provocative view - even if that means sacrificing good revenue - such pruning will focus the company and shore up the balance sheet.
I also believe the stock market will reward this behavior
5. The myth of Private Equity (PE) manager's long term view (?)
This is just a speculation. I believe that public markets are a good judge of a company's health and promise overall. The quarterly pressure is good discipline. But a good manager will be able to signal to the markets and achieve fair valuation if he/she can demonstrate: i) operating discipline ii) organic innovation iii) aggressive pruning and iv) communication savvy. Also, the public company is not going anywhere - so its valuation is in perpetuity.
The public company manager has long terms goals hidden under the noise of short term pressure.
The PE manager can invest for the longer term and not worry about short term pressures. But the goal of the PE manager is to get the company ready for liquidation (sale or going public or MBO). Which means that the PE manager is able to take aggressive 'dressing-for-sale' actions that a public manager perhaps does not readily do.
Thus, the PE manager on the other hand has a short term goal hidden behind the veneer of long term behavior.
This last point I am just speculating for debate since I don't have PE experience. But seems plausible, at least for arguments sake!
2 comments:
Bravo. I am always puzzled about why articles like this, which tread old ground, are written more tightly including only what is needed and then including sufficient qualifiers.
For instance, in Ananth's article his point #1 about misvaluation is unnecessary. There is no need to keep arguing that the stock price is often wrong -- but more important, it is unnecessary because he really needs to be saying "stock price is wrongly priced due to the specific piece of information that the manager is pondering about." That is, would it not be better to say that the starting point is what should you do "if the market price diverges from what it should be given what you say AND you believe it is because the market misunderstands what you are doing?"
There is also a deeper scientific issue here. The key assumption in his #2 is that the manager knows what is right and the market does not. If so, as you point out, more effective communication is one of the right responses. You could read the case "Banc One" written by an erstwhile colleague of his, Peter Tufano. It discusses exactly this situation.
The alternative view is that the market has learnt what the manager has to say and does not like it. Here, the manager can assume he is the omniscient Brahmana and that he simply knows better because the market misunderstands, misperceives, or is otherwise incapable of understanding regardless of all communication strategies. Then the manager can do what Ananth says, but the manager should be made aware that this is the assumption he (or she) is making. That is, the manager is the lord himself. Reading Ananth's article, this is an absolutist interpretation he pushes and argues for.
But this can lead to errors too. And I don't mean just the possibility of managerial incorrectness. I mean the danger of a wrong mindset. There are always -- and most of the time -- situations of ambiguity. In these situations, using Ananth's methods leads to a mindset in which the manager all the time assumes that the market is wrong. With all due respects, this is a fatal prescription for hubris and arrogance in which the manager might play the fiddle of his favorite projects when the company is burning.
I would also argue that advice to ignore the market all the time induces another wrong mindset. Managers are trustees of money that others invest. Is the advice to ignore the market an advice to disregard what the people putting in money have to say? Managers can choose to do so, but then capital providers can equally do what they like with their money: facilitate a takeover in which the managers are displaced and a new set will do what the money providers want.
The article would be accurate and useful if it were more nuanced. A one-sided view in which the market is always wrong is as incorrect as the other sided Chicago view that the market is always right. Most importantly, it should clarify that "wrong stock price" is a conditional statement based on assumptions about what the market is seeing and causal links tying them to managers' actions.
Good food for thought. I liked the way you compared aggressive management of portfolio to yard work which makes me think of a person who used to live in our development. Back in 2002, NJ experienced a drought spell due to which conservation of water was strictly advocated. Watering of lawns and Car Wash at home were part of the curfew. The lawns were dying but the weeds thrived. One day, this guy lamented "My wife complains that our lawn is full of weeds and I don't maintain it. I don't get it. At least the weeds make my lawn look green. I don't know what she is fussing about!". We all had a hearty laugh! Imagine if this guy is a portfolio manager!
I can't agree anymore on the importance of communication. Reminds of this one man - Alan Greenspan. Whenever he spoke, the markets listened! Unfortunately, those days of "irrational exuberance" (quoting his own words) are long gone! Not sure if you watched Jon Corzine testifying before Congress yesterday about how he had no clue about where all the money vanished! Pitiful!
I consider myself a dormant investor. In my experience, I've seen that short term has provided more returns than long term - counter-intuitive to the concept of stock market! But I admit that this experience pertains to the 90s. Now the rules of the game are very different. Perhaps it's high time I went with a professional rather than managing portfolio on my own.
Post a Comment