Listen Or Look

For most of my career, I have been a devoted practitioner and advocate of personal contact between financial analysts and companies’ management teams. This is the only way to understand the real drivers of a business’s sales and profits, as well as a company’s competitive position and strategies.

Over the past fifteen years, however, the quality of these contacts has deteriorated. First, concern about leaking “inside” information has led to a shrinking number of “authorized” spokespeople merely reciting pre-packaged corporate stories. This is particularly true at large, bureaucratic companies. Then, in apparent contradiction, an unhealthy partnership has developed between financial analysts and corporate managers, to concoct “consensus” estimates that will 1) satisfy the “Street”, and 2) be easily matched when actual earnings are ultimately reported.

The contradiction, of course is only apparent, since the prepackaged corporate information usually makes it difficult or impossible to deconstruct the actual progress of earnings, and analysts are loath to do so anyway. One thing we should have known all along, however, is that corporate earnings seldom are as consistent or as predictable as they have been made to look in recent years. The inescapable conclusion is that, while auditors and accountants presumably had little role in producing the estimates, they often were instrumental in massaging, or even fabricating, the reported results. That’s the shocking tale the media have recently “discovered”.

The problem with getting too close to companies – especially when the CEOs are smart and charismatic – is that we lose our critical sense. We tend to embrace corporate “stories” rather than analyze cold facts and data. This is true of analysts, but even more so of the ultimate groupies, financial journalists, who for several years did nothing but report whether earnings missed, matched or beat the “Street consensus”. Very often, this was done without even mentioning whether earnings were up or down against those in the prior year, so you obviously could also forget about learning whether earnings had been calculated on a consistent or comparable basis. The media can be dangerous to your investment health.

The realization that being too close to companies could be dangerous has driven me to a paradoxical about face. I recently have been lobbying my partners (with some success) to have at least one member of our analytical staff forbidden to even talk to corporate managers. That analyst would have to derive an opinion of a company’s stock solely from the study of several years of financial statements.

In addition, our analysts have done a good job calling on competitors, suppliers and customers of companies whenever feasible, but a significant part of their industry intelligence has also been gathered at conferences organized by financial institutions. This is a great way to exchange ideas with other analysts, but one seldom hears critiques by professionals at such gatherings. Industrial conferences do exist, where manufacturing managers, supply managers and engineers gather to discuss products: although these reunions are much more expensive to attend and more technical, the information exchanged is relatively free of corporate financial promotion and thus more substantial. From now on, our analysts will also attend more of these.

In other words, while in the past I have considered it a distinct advantage to be close to the managers of companies we studied, I now believe that it will be a distinct advantage to perform one’s analytical work at some distance from the groupthink they generate.

The irony, in all this, is that I am finding that the reverse to be true in less sophisticated markets.

Asian managers, in particular, are less experienced at communicating with investors. I remember one of my first visits to China with my colleague Soun Chhoa, only six years ago or so. A “director” of the finance department at one company we were visiting smugly asked us which broker we were with. When told that we were not brokers but shareholders, the man erupted into a panic, ran out and came back within half an hour with several members of the company’s top management. These people had never received a visit from a shareholder. Things have been changing fast, however.

It is true that the financial statements of companies in China or Southeast Asia are sometimes suspect, often lacking in relevant information and that they tend to present data that are difficult to compare from one period to the next. But I have found that most good managers are quite willing to explain the figures and to add meat to their financial statements – if asked. Of course, there can be a huge disparity between good and bad companies and some managers can’t or won’t answer. But, if you don’t get the answers, you don’t have to invest.

Altogether, I have found that regular contacts and periodic checks on the consistency of management stories over time can bring a level of comfort that I did not expect at first. In fact, I would say that, for the best companies, my comfort is now equivalent to that which I get from the packaged information distributed by America’s slick communicators.

In Japan, we recently lived through an episode that shows how management appraisal may be more useful than statement analysis in less-than-transparent contexts.

Tokyo Style is a Japanese apparel manufacturer and retailer. Their record is poor, as for most old-line retailers in Japan, but their balance sheet is stellar. Cash, net of all liabilities, recently exceeded the company’s total stock market value: a value investor’s dream, except for management. Until recently, Tokyo Style management even refused to meet with analysts, although they had regular meeting with minority holders considered part of the control group.

A local portfolio manager with an activist bend attempted to first, convince management to return excess cash to shareholders in the form of dividends and share repurchases and then, to start a proxy fight along the same lines (we voted in favor of its proposals). The ado forced the management of Tokyo Style to communicate with shareholders and even, for the first time, to meet with them in person. However, that was only to tell them (my interpretation):

-         “What we do with our cash is none of your business;”

-         “We never gave money back to past shareholders, who do you think you are to deserve any;”

-         “We don’t need the cash in the business, which is not making any money, so we’ll use it to buy real estate, which at least is a business we know nothing about.”

With such convincing arguments, they won the vote and shareholders got nothing. Sometimes, in Asia, a value investor is better off appraising a company’s management than the assets on their company’s balance sheet.