Friday, February 21, 2014

CEO Candor

Rittenhouse Rankings is an attempt at quantifying the honesty and transparency of firm management.  Rittenhouse claims to be able to capture significant alpha by investing in firms with the highest scores.

I think this is an interesting idea, because even if these excess gains mainly come from avoiding unforeseen negative shocks to specific stock positions, you could say they come from a vulgar kind of market inefficiency.  If the market really is naïve and tends to buy into management obfuscations and overstatements about short term performance, then some of this alpha could come from mispricings among firms based on this inefficiency.  In other words, honest management causes their share price to decline.  This decline reflects a higher required return, and that return is showing up as alpha in the Rittenhouse portfolio.  Put yet another way, you could imagine this as a factor, with returns being a function of smallness, low market to book, momentum, and management honesty.

I would have hoped that markets would be functional enough that management honesty would create reputation, which would increase a firm's share price over time, manifest through a lower required return that would reflect a firm's earned reputational capital.

But, at least, if this is in an inefficiency, that means there are profits to be had for the discriminating speculator.

My experience has been that this is frequently an issue that can be very lucrative.  Micro caps that are coming off of extended periods of poor operating and share price performance, with managed turnarounds and conservative, honest management, can be very satisfying positions to own.  Frequently, these stocks will languish with very little trading volume, even after the turnaround becomes quite clear.  I used to own shares in Onyx Acceptance Corp, which has since been bought by Capital One.  They were a sub-prime auto loan firm, and they had really taken a hit in the 2000-2002 time period.  They made very extensive public reports of their monthly loan performance, so with just a little work, an investor could get a good idea of the differences between the expected values of their loan portfolios and the book values.  For some time, the market was discounting their book value, even though their new loans were clearly setting up to exceed book value.  Management would report perfectly honest, transparent results, with the tone of a palpable yawn, and take a part of their compensation in options.  Those were fun quarterly reports to get.  It was like knowing a secret hand-shake.  Management was putting it all out there, but they weren't cheerleading.  It just took a little patience to wait for the market to catch up.  It surprises me how those type of opportunities seem to be available to individual investors.

While management candor is good for share buyers, I don't know that we can always say it is good for existing shareholders or management.  There are a lot of agency issues here.  On this kind of topic, in addition to conflicting goals between shareholders, management, and other stakeholders, there are conflicting goals between long term shareholders, short term shareholders, and potential new shareholders.  And, while stock options might be associated in the popular mind with short term hucksterism among management, stock options may sometimes encourage management candor, at least for management that expects to have some permanence.

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