"INVESTORS may claim that they learn something more subtle than actual facts from the CEO’s tone or demeanour," writes Dr Simon Taylor of the UK’s Judge Business School in a letter to the Financial Times.
"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 more likely to learn nothing. CEOs, often chosen for their presentation skills rather than ability to run a business, are well rehearsed in their lines and so are quite adept at fooling investors."
Not so, says Baruch Lev, professor of accounting and finance at the NYU Stern School of Business. "Executives’ narrative and tone colour many investors’ decisions and account for most stock price changes in the wake of financial reports. Giving more information to investors generally, and doing it in an honest and understandable way, is good business.
"And 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. Corporate managers who don’t share relevant information face a substantial share price discount, a higher cost of capital and a more volatile stock price."
Prof Lev adds: "Furthermore, interacting with investors is not only about giving information. Information flows both ways: executives can learn from investors, too. Stock price movements around earnings announcements reveal a lot about investors’ growth expectations and their perceptions of management’s credibility. Short sellers often signal serious operating and accounting problems that managers need to fix. Wide bid/ask spreads and a large variability in analysts’ forecasts both point to investor uncertainty about the future course of the business."
The idea that company managers and investors can have a mutually beneficial relationship has, unfortunately, taken a beating of late. In response, some in the corporate world and at business schools have advised managers to pay less attention to shareholders — who, after all, are just one class of stakeholders, and may not be the most important.
Most investors focus on the short term, and catering to their whims interferes with long-term growth and wastes valuable management time, goes the claim. Managers should do their thing — run the business — and investors will fall in line.
"But disengagement from the market isn’t really an option," says Prof Lev. "The heads of publicly traded companies can’t run their businesses without reference to the capital market. The market determines a company’s cost of capital and therefore affects its future growth.
"Capital markets play important monitoring and governance roles in managers’ compensation and careers. Share price patterns serve as beacons, guiding highly qualified employees to join, stay with or leave an organisation (no one enjoys holding underwater stock options).
"The key for executives is not to ignore Wall Street but to be smarter in their dealings with it — to start with a clear sense of the strengths and weaknesses of investors. In one caricature prevalent in the corporate world, those who buy and sell stocks are skittish, myopic ninnies. Whereas, in the view that has long held sway in academia, they are cold-blooded, all-knowing information processors. During recent years, though, researchers have begun to develop a more nuanced view: On the whole, investors are neither incompetents nor automatons."
To dispense with the "myopic ninnies" claim: several studies have shown that investors are more interested in companies’ medium- to long-term prospects than in what is happening today. According to a report by Tom Copeland, Aaron Dolgoff and Alberto Moel in Accounting Review, long-term forecast revisions have a powerful impact on share prices — consistent, they say, "with an interpretation that shareholder returns in the current year are primarily related to expectations about long-term performance".
But investors aren’t all-knowing either, as shown by Columbia University’s Gur Huberman and Tomer Regev, who studied the impact on a company’s share price of "news" of a cancer drug in The New York Times that had already appeared elsewhere. Their conclusion was that "enthusiastic public attention" induced a permanent rise in share prices, even though no genuinely new information may have been presented.
In a similar vein, research shows that investors suffer from what behavioural researchers call "limited attention" — a restricted ability to process and analyse vast amounts of information, in this instance data relevant to companies’ values.
The upshot is that investors are somewhere between naive and all-knowing. They care a lot about what drives a company’s long-term growth — but they need help understanding what those drivers really are.
"That’s where guidance, pro forma earnings statements and the narrative and tone of managers’ communications come in," says Prof Lev.