Ben Rebbeck, Executive Director
If there is one consistent thing the financial markets are saying about Brexit, it’s that there are uncertain times ahead for every major economy – and by extension, for the prospects and financial performance of every major company.
When uncertainty reigns, we often hear management or Boards describe disclosure and guidance as ‘Hobson’s Choice’: bunker down and say nothing; or have a crack at guessing a company’s financial performance and risk being shot when you’re wrong. In this context, saying nothing often appears to be the safer option.
This perception also appears to align with approaches to operational risk management. That is, at times of uncertainty and heightened risk, good governance can mean tightly controlling cash flow and exposure to business risks to protect shareholder value in the event a downside risk eventuates. So this means limit rather than extend disclosure, right?
In fact, this is a false picture. There are far more guidance alternatives to consider than just quantitative earnings guidance, such as qualitative or quantitative operational guidance or discussion of strategic risk management alternatives. Each of these can allow the company limit its disclosure to areas that it controls and are far more informative than saying nothing or continuing as if nothing happened.
Lack of disclosure and guidance impacts share price and value
To put the folly of the ‘safer option’ into perspective one only needs to consider the viewpoint of shareholders.
It’s no secret that investors hate uncertainty. This notion is more than just a saying, it goes to the heart of valuation theory and practice. While different investors and analysts use a multitude of valuation methodologies, they all boil down to three core elements: money, when that money is being received and the risks of it not being received.
Consequently, saying nothing about a company’s prospects will adversely impact investors’ perceptions of each one of these three elements and therefore will adversely impact demand for a company’s shares. The outcome: lower share price, higher cost of capital, lower shareholder returns.
For example, over many years and across a number of different surveys institutional investors have been asked to put a value on good disclosure practice. Their responses have remained relatively consistent. Good disclosure adds about a 10% premium to market value, while bad disclosure results in a stock receiving about a 20% discount to market value.
More simply, if uncertainty is a bad thing, saying nothing doesn’t in any way help address the problem.
But isn’t it still safer to say nothing in the face of uncertainty?
No, it’s not safer for either shareholders or directors to pull back on guidance.
Take the GFC as an example. In 2008, economic uncertainty skyrocketed, there were changes to the cost and availability of credit, the threat of a severe economic downturn and unknown impacts from currency movements and tax policy changes. All clouded Boards’ visibility of their companies’ prospects.
Some companies bunkered down, disclosing little about their operations and prospects until visibility increased, while others continued to pro-actively engage with the market.
Then in 2009, when the equity capital markets re-opened for capital raisings, first out of the block with non-dilutive rights issues were those companies who pro-actively maintained disclosure and guidance throughout 2008 and 2009. Later, those companies that pulled back on disclosure during that period were able to access the market, but often via heavily dilutive placements. There was a clear correlation between differences in disclosure and guidance practices and access to and cost of capital .
Boards of the latter group of companies soon felt the heat from disaffected shareholders and an inquisitorial financial media. In some cases this led to campaigns by activist shareholders for board spills and wind ups or capital returns.
So what are the alternatives?
While the outcome of the Brexit vote is known, nearly every other outcome is still uncertain. With the timetable of the European Union’s ‘Article 50’ process taking two years, it’s a fair bet that economic certainty won’t arise in the short term.
In this context, when determining a suitable disclosure and guidance model there is at least one maxim that always holds true: don’t try to give guidance on economic matters over which you have no control – you will get it wrong.
Instead, management and Boards should look at factors that will assist shareholders in coming to their own view of financial performance and value and appreciating the level of influence each factor has on investor opinion.
In 2015, US market research firm Corban Perception surveyed 68 leading financial firms and professionals across industry sectors and regions to determine what disclosure factors are critical to their investment decisions. Only 7% of investors preferred that companies refrain from giving guidance – the overwhelming majority cited strategic and operational measures as critical areas of disclosure in determining their buy/sell decision, including:
- 93% cited execution track record
- 92% strategic vision
- 84% management quality
- 84% sustainable competitive advantages
- 79% effective capital allocation
Notably, none of these directly measure a company’s financial performance, nor are necessarily linked to external economic factors. Investors cited these as the most important financial data points:
- 95% cited performance against growth strategy and initiatives
- 90% margins
- 90% market data, including dynamics, segmentation, share and competitive positioning
- 88% business drivers (e.g., flight hours, housing starts)
- 85% sales
- 76% product portfolio and pipeline
Clearly there is a significant range of choices for any company to continue to provide pro-active disclosure and guidance, while avoiding making predictions on uncertain economic outcomes. Brexit will undoubtedly create ongoing economic challenges and uncertainty for investors, but there’s no need for companies to add to them.