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Allen's Theory of Value

by RiskRewardNews on Oct 11, 2009

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Presentation to National Investor Relations Insittue (NIRI) and Financial Executives Instittue (FEI) in Columbus, Ohio making the business case for business ethics

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Presentation to National Investor Relations Insittue (NIRI) and Financial Executives Instittue (FEI) in Columbus, Ohio making the business case for business ethics

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Good afternoon and welcome. I’m pleased to be back in Columbus in the fall. I spent four years here as an undergrad as OSU so Columbus is a special place in my life.Thanks to John Hyre, the NIRI Columbus board and the FEI Columbus Chapter for bringing me here today and thanks to all of you for attending.It’s been an interesting year, hasn’t it? And I believe the next few years are going to be some of the most interesting in any of our professional lives. And I want to leave time to hear your thoughts, questions and observations.I’d like to do three things with you today.First, I want to give you my very simplified view of the capital markets, what I call the Allen Value Model – with apologies to my finance professors at Boston College.Second, I want to take a brief, idiosyncratic and highly selective tour of the past 60 years on Wall St., paying particular attention to the past 20 or so years.Third, I want to open a dialogue with all of you about what I call the business case for ethics in business.Before I begin, let me share a little background and some of my own experiences as it relates to what we are going to be talking about.First, a little about the NIRI ethics council which I am currently chairing. The council is an advisory body to the NIRI board of directors, made up of former NIRI board members and it provides advice and input to the board on any issue of professional ethics referred to it by the board. To date, this has mostly involved NIRI members sanctioned by the SEC or courts, and thankfully it’s rarely been called upon to fulfill that role. Of interest to all of you -- the seven ethics council members are available either individually or collectively to any NIRI member on a confidential basis for advice. Finally, we review the NIRI professional code of ethics, which all NIRI members affirm annually when they renew their membership. For more information on the council, check the NIRI website. I’ve been in IR for nearly 25 years, in large cap, mid cap and small cap tech companies in all kinds of circumstances, from rapid growth, to significant strategic challenges and changes, management turmoil and turnover (8 CEOs and 9 CFOs), activist investors, lawsuits, M&A, spin-offs, crises and restructurings. Prior to that, I was a journalist in New England, and then went into public relations in government and industry. Through that career, I’ve made a few observations:Markets matterIR mattersCredibility and integrity matter
Six months ago, I set off on a new venture, returning to my journalism roots, but with fatter Rolodex and a set of experiences different than anything I could have imagined. I launched RiskRewardNews – an online conversation about changes in the capital markets and how companies communicate their risk/reward profile in the 21st century. I also do IR and communications consulting for companies and entrepreneurs. If you’re interested in seeing my website/newsletter or learning more, I’ve got some information on the tables.
My first IR job was with Digital Equipment Corporation – DEC – in Massachusetts, starting in 1985. During the decade I was there, DEC moved into #2 behind IBM and on a track to rocket past them. #30 on the F500, DEC was highly followed with more than 20 sell side analysts. It was considered a real bell weather stock and a core position in institutional portfolios. It was highly liquid and there were people who made a comfortable living and career just trading in DEC options – I know – I met some of them.Let me describe our quarterly earnings release process at that time: 1986. First, we were a tech company and so used the latest in technology. We would schedule the release and reserve the one fax machine in the building, to ensure we had unfettered access to it on that day. At the anointed hour, we would fax the release to the Dow and then after the several minutes it took for the fax to go through we’d fax to Reuters who had been calling every 30 seconds to scream at us because we’d given it to the Dow ahead of them. The next quarter, we’d reverse the order and get screamed at by the Dow. Once the headlines went out across the wire, we’d start getting calls and would return them in order, two or three secretaries, the Director of IR (my boss at the time) and me…. Reading the P/L and balance sheet line by line over the phone. The analyst would take the numbers down line by line. 10 hours a day. It sometimes took three days to return all the calls. The analysts and PMs would go away and ANALYZE the numbers, come back with questions, we’d discuss, answer their questions, discussion their assumptions and models – all very pre-REG FD you understand.Then the analyst would write up their reports, send them to the printer, and drop it into the mail. About a week to ten days after we pushed the send button on that fax machine, the views on DECs quarter were generally out and broadly known.
Now change was on the horizon. I was one of the first, not THE first, but among the first corporate clients of First Call which you all know, disseminating the press release right to PM’s desktops (or the one fax machine in their building). And we had blast faxing, blast emails, teleconferences. It all seems primitive compared to where we are now with web sites and YouTube. So with that personal history let me play amateur finance prof for a moment--- again with apologies to all the real finance Profs.
SLIDE 4 Price ≠ ValueStock prices, which we all care about, we all learned, can be described as follows:There are lots of assumptions in that statement but it’s essentially a simplified dividend discount model that we all learned, it’s logically consistent and a widely recognized way of thinking about asset PRICES.
Now we move from finance to theology, if you will where great debates occur and if you think about it, why we do IR. So let me introduce Allen’s Value theorem.
Wall St. will ask endless questions, look at lots of information and ultimately is driven to a financial conclusion. They essentially care about three things.The markets you are in, the products and services you offer, and the management team that brings it all together. That’s it, that’s all they care about. Because they are smart and they are trying to get at some projection of future cash flows to try to determine what PRICE they should pay. But what they are really looking at is:
Now like any good finance Prof I’m going to substitute and say that:Price = ValueSo we have:Isn’t that slick?
Now the present value of future cash flows has implicit in it, risk assumptions.Exogenous or market risks assumptions include interest rate, economic, currency.Endogenous, or firm risk assumptions fall under the three things Wall St., cares about: what I call the Markets/Products/Management factors.What are these risks?In your markets, the risk are described by the competitive landscape, are your competitors rational, is the market growing or shrinking, is it regulated, is it mature, etc.In products/services dimension it’s your competitive differentiation, its intellectual property, competing or replacement products and technologies, capital requirements, costs, etc.With management the risk calculation encompasses two dimensions – management CAPABILITY and management CREDIBILITY two very different things. Capability is measured by consistency, predictability, experience, strategic thinking, decisiveness, etc. Credibility encompasses governance, compensation, commitment, transparency, honesty, integrity.
OK. Now we are going to shift gears and take a tour of the last 60 years on Wall St.
As you look over this highly selective list of events, it’s intended to demonstrate increasingly liquid and efficient markets. Liquidity up; friction down.
Now, I want to show you a long-term trend on how long a stock is held – a trend everyone in this room is all too aware of. As you can see, the average holding period for a NYSE listed stock is at a 90 year low – it’s now about six months on average. And that takes into account the trust funds that hold your stock forever as well as Aunt Edna in Toledo whose beloved Earle left her the stock when he passed away and she’ll never sell it. In this context, investor relations is a misnomer. We should refer to the profession as “trader and speculator relations”, or to use another term, croupier in a casino.
Next: we have, again a highly selective list of significant mileposts in the development of modern finance, whereby prices can be modeled and behavior can be modeled.
Now this next slide is what I call the flashing yellow light slide, where we see significant events over the past two decades that have reminded us that models are only models, or as I like to say, the map is not the terrain.
. I’d like to quote Myron Scholes of Black – Scholes who presciently warned an audience at a 2005 conference on hedge funds that: “We make models to abstract reality. But there is a meta-model behind the model that assures us the model will eventually fail. Models fail because they fail to incorporate the inter-relationships that exist in the real world.”I was recently interviewing Bill George, former Medtronic CEO and currently on the board at Goldman Sachs. The interview will appear in my newsletter, but I’ll give you a preview here. He recounted how Gary Cohen, Goldman CEO reported to the board after three of their hedge funds declined by 30% in the recent market meltdown. “We had events that our models showed would happen once in every 10,000 days. We had three of them in this week. Either three black swans came in simultaneously OR the models are wrong.”
Remember my MPM factor model? We’ve seen that the exogenous or market risks that the PhD mathematicians modeled and securitized have not succeeded in eliminating risk. In fact, I’d argue that systemic risk has increased. We’ll the risks of investing in the oil industry, or fertilizer, or semiconductors or retailers are pretty well known and knowable. Each market or industry has its own set of discount factors, valuation multiples and investment criteria. Same for the constellation of products and services, new and old that you deliver and that fill our world.
Now two disclaimers here. First, I have been quoted on the record as defending the vast majority of company executives and IRO’s from the egregiously simplistic assumption behind REG FD that EVERY COMPANY was selectively leaking inside information to a few favored analysts. I believed when it was implemented that the assumption was untrue and I believe it today. The difference is that I realize, with First Call, the web and instantaneous communication, we no longer have a week to discuss, analyze and set opinions on how the quarter went. We just don’t. So like any regulation, REG FD was catching up to the reality that information is now instantaneously disseminated and absorbed by the markets. Please note that I did not say the information was ANALYZED, however. Big difference.Second disclaimer: I am not a starry-eyed Pollyanna. I’m a Darwinist. Business is tough. To paraphrase: it ain’t bean-bag. And it should be that way. Two of the companies I used to work for no longer exist as I knew them, though each had created a whole industry and was dominant in its market. I know that strategy and execution matter. I’m also a baseball fan and this is the best part of the season where every game in the play-offs matters and the players all know it’s life-or-death. And they’re all great athletes. Now being from Minneapolis, I’m pulling for the Twins to perform a miracle, and could whine about how the Yankees have all the money and big guns. But you know what? A ball is still a ball, a strike is still a strike, the foul line is the foul line and you have to touch home plate to score. You can slide into second base to break up a double play, but you can’t slide out of the base path into the second baseman.
How many of you remember the Albanian Lek crisis? No? I’m serious — this matters. More than a decade ago, the infant post-Soviet Union Albanian government was thrown into chaos and civil war. Long simmering ethnic tensions exploded into open fighting, spawning a massive refugee crisis. Maybe it would have happened anyway but the precipitating event was the collapse of a government-sponsored pyramid scheme in which citizens lost their entire life savings. They trusted that the system would keep their investments safe. Trust in the capital markets assumes that everyone shares in an open and transparent playing field where risks are known and rewards are shared. It’s an important set of shared assumptions, sort of like understanding that red lights mean “stop” and green lights mean “go.” Without that shared set of assumptions…well, we all could be in trouble.
What about management? One more admittedly selective slice of recent history. Here we see that management – whether on the corporate side or the investment side – occasionally lies, cheats steals. And that, in my mind, increases the risk discount applied to ALL managements and raises the cost of capital for everyone in this room.
Remember I told you at the beginning that I have three basic premises. First, markets matter. The US capital market has been, I believe, a competitive differentiator for this economy we all live in. But there is nothing written in stone that it always will be that way. And we’ve seen recently that in fact it can easily slide into places few of us even imagined 15 months ago. Second, what you do matters. Participating in the market, you communicate the risk/reward profile of your companies, the MPM factors, so that value and price can align, so that markets behave efficiently. Without your efforts, it doesn’t happen automatically. Finally, you each have the opportunity to strengthen it or weaken it based on how you behave in your capacity. I know the real life challenges in dealing with the markets, the conflicts, ambiguous information and uncertainties. But especially in the toughest times, credibility, integrity and transparency are the life-ring that allows you to keep your head above water when the waves seem to keep pouring in over the bow. So I would encourage you, not only to continue to pursue your own career with the personal integrity that has gotten you where you are today, but to insist on it within your organizations, and through associations such as NIRI and FEI, to insist on it for your profession. I’m counting on you.