CEOs, it is time to decouple from financial markets

By Vijay Govindarajan and Anant Sundaram
Published: April 21 2009 03:00 Last updated: April 21 2009 03:00

Managers are frustrated. While many are intent on creating long-run value for investors, the recent performance of equity markets makes them question how the fundamentals of their business are reflected in the stock price.
Basic finance theory tells us that a company's value reflects long-run cash flows discounted to the present at the rate of return that investors expect ("cost of capital"). Cash flows are a function of revenues, costs and investments - and the life of a manager revolves around getting the most out of these. But cost of capital is primarily determined by the stock market.
As a result, individual stock prices are tied to movements of the market. If the market swoons, the chances are high an individual stock will plunge too. As we have seen recently, this can happen irrespective of what managers do to influence future cash flow prospects.
What to do? We believe it is time to re-examine the relationship between companies and capital markets. Chief executives should decouple their long-run strategies from the short-run vagaries of financial markets by taking any or all of the following six actions:
* Jettison quarterly guidance. Chief executives have had a simple bargain with the market: provide regular updates and the market will process the information and reveal "fair" prices. But, in many companies, earnings guidance has become a treadmill of managing for the next 90 days. Recent market falls made little distinction between companies that provided quarterly information and ones that did not.
* Reduce dependence on external capital. Having to justify to the markets why a company needs capital is viewed as a source of discipline. But that assumes the market will believe the company's business case, that the liquidity and the investment bank will be there when needed. We have seen that these could be somewhat naive assumptions.
Companies might do better by focusing on internal cash to fund growth. They should concentrate on cash flows - that is, the cash that comes in versus the cash that goes out - rather than accounting earnings. They should also rethink their dividend policies. If they can create more value by reinvesting the cash, they should do so, even if the action risks a fall in the share pricein the short term.
* Focus on individual and not institutional investors. Most shares in the US are owned by institutions. But it is perhaps time to develop, manage and communicate the company's strategy as though its primary investor is an individual. Why? Individuals have longer horizons. Second, if a company is managed for institutional investors, which institution should it care about and for what horizon? After all, they include everything from pension funds (longer horizons) to hedge funds (short horizons) to arbitrageurs (horizons measured in minutes).
This focus, however, must be accompanied by three changes in shareholder relations. Companies should appoint to the board a retail shareholder representative. They should treat the annual general meeting as an opportunity to have a meaningful conversation with investors. Companies should make financial statements more retail investor-friendly.
* Rethink compensation.
Earnings-per-share-related metrics bias managers' attention towards the short term. Companies should instead focus on long-run, cash-flow-based metrics in a manner that rewards managers for the value-creating investments they make.
If using stocks or options, payoffs should be benchmarked against market or peer performance. On the upside, executives are rewarded only for value they (and not the market or industry) create; on the downside, they are not penalised for market-driven declines.
* Innovate via adjacencies rather than breakthroughs. Tough economic conditions call for a brutal focus on costs. But companies must also grow and growth requires innovation: we recommend innovation into spaces adjacent to the core rather than via breakthroughs. The latter, such as Detroit's quest for an electric car, involves bet-the-company moves that can exacerbate share price volatility because the up-front cash outlays required and the chances of failure are both higher.
Adjacency innovations extend existing competencies and offer new products and services to already-familiar customers. To the extent that they involve a smaller up-front cash outlay, they are consistent with reliance on internal cash flows, and obviate the need for large external financing.
* Invest and acquire countercyclically. Companies tend to go shopping for big-ticket items when they feel rich. But the risk is that they can "buy high" in a boom and go into a defensive mode in a downturn. By being counter-cyclical in investing and acquiring, not only are assets likely to be cheaper but screening mechanisms are also more disciplined and the requirements for a business case more uncompromising.

Vijay Govindarajan and Anant Sundaram are professors at the Tuck school of business at Dartmouth

Source: FT.com