Blame the Super Bowl theor y, or the rise in bond prices, or unexpectedly high

corporate earnings, or takeover talk, or the U.S. election factor any reason will
apparently justify pushing North Amer ican stock mar kets to new records. Why
even SEI Financial Ser vices Ltd.s 1995 survey of 2,500 pension por t folios, with
more than $200 billion of assets, has noted that 55 percent of act ive equity
por tfolios had a median return of 15.0 percent, marginally exceeding the 14.5
percent total ret urn for a passive investment in the Toronto Stock Exchange ( TSE)
300 Composite Index, and that doesnt happen ver y often.
All the while, household name stocks like Coca-Cola Co., with record earnings,
record case-sales vo lumes and record mar ket share , h ad a total ret u rn to
shareholders of 46 percent, and War ren Buffett and Charlie Mungers Ber kshire
Hathaway Inc. stock was up again by better than 60 percent. Even though the 1996
market may not be a repeat of 1995, most successful investors will appreciate that
shor t-term stock-market correct ions and longer-term retractions are inevitable,
and sound funding st r ategies are essential in both buoyant and challenging times.
The principal fact ors effect ing t he cost o f capit al
The bond mar ket has been ver y st rong, rebounding from a hor r id 1994 to rack up
double-digit r eturns in 1995. While mar kets d ont usual ly make such huge gains
two years in a row, the economic backdrop that helped produce the remarkable
ret urns low int erest rates, low inflation is still ver y much in place and will not
be dislodged easily.
Fu rt h er m ore , t he financial sys tem is flush wit h inve s tm ent capit al as
governments at all levels struggle to balance their respect ive budgets,aiming to pay
down outstanding debt positions over a protr acted period of time. As the U.S.
Federal Reser ve and the Bank of Canada are almost cer tain to shave rates, much of
that money will find its way back to the st ock and bond mar kets.
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As such, we feel quite confident that the capital markets will afford the
opportunity for Nor th American cor porations to fund shor t-term debt obligations
and to raise additional equity at ver y advantageous pr ices, in anticipation of
further growth and well in advance of the next bear market cycle. As is always the
case, the best-known and respected credits will pay the least for additional
infusions of capital.
Whereas governments and corpor ations have had to go through the painful
process of downsizing, r ightsizing and other reorganizational changes in order t o
reduce unit costs and improve productivity, very little if anything has been done to
offset inexorably expensive under writing charges. Given as Canadas big banks
have a 70 percent share of the domestic investment business, effect ively limiting
competition, these fees are not likely to moderate in the near term. So the real
challenge for CEOs must be to find an innovative way to offset these expenses and,
thereby, reduce the cost of capital.
The vit al r ole of t he CEO
In Capital fo rm a tion stra tegies for the 1990s (1988) we ex a m i n ed the ra ti onale for
Wa r ren Bu f fet ts unpara ll el ed su ccess as Berk s h i re Ha t h aw ay In c .s peerless CEO and
con tro lling shareh o l der. For the record , Bu f fett is the most su ccessful inve s tor in
Nor th Am er ican history. O n ly Mi c ro s oft fo u n der Bi ll Gates is we a l t h i er. Berk s h i re
Ha t h aw ay In c . is curren t ly [Febru a r y 1996] qu o ted at abo ut $32,400 per share . Th e
New York Stock Exch a n ge ( NYSE) listed stock trades at an adva n t a geous 35 percen t
prem ium to book va lu e . Most CEOs can on ly dream of re aching su ch hei gh t s !
To re-interate Buffetts modus oper andi: he prefers to invest in well-financed
companies that demonstrate above-average returns and generate substantial free
cash flow. They must be involved in sound businesses that are highly focused, low-
cost franchises and led by a CEO skilled in capital allocation who has developed a
concise statement of corporate objectives and financial parameter policies that
describe where the company is headed and how it hopes to get there. The
executives must be paid through carefully tailored incentive plans and all the
employees should be encouraged to become shar eholders.
He insists that a business can obtain the best financial results by managing both
sides of the balance sheet, thereby obtaining the highest-possible return on assets
and the lowest-possible cost on liabilities. He abhor s paying capital gains taxes,
trading commissions, under wr iting fees, and merger and acquisition charges.
Just as most successful investor s never lose t rack of the fact that the biggest
losses tend to result from owning securities in companies with poor balance sheets,
Buffett advocates a fund-first, buy-or-expand-later funding policy, even though
such a st rategy almost always penalizes near-term per share results.
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We must also all learn from Buffett that it is not necessary to do ext raordinary
things to achieve extraordinary results. Rather wed all be wise to stick to pr inciples
that are simple, old and few.
In terms of investor relations, while the Omaha, Nebraska, phenomenon much
prefers to stay at home, the Berkshire Hathaway Inc. annual and quar terly r epor ts
are easily the best-read anywhere in the world. The annual gener al meet ing is
attended by thousands of investors. Two books documenting his unparalleled
success are on the best-seller lists more than a year after they first appeared in
bookstores. Each provides answers to questions you probably did not know to ask!
The crit ical role of t he invest ment dealer research analyst
Dating back to the founding of Rappor t, we have steadfastly supported the notion
that informed investment dealer research analyst sponsorship is the pr imar y
objective of all successful corporate invest or relations programmes. Twenty-plus
years later, and having been r etained by about 275 TSE-list ed entities, we continue
to insist that such is the case today. The pr ime object ive remains the realization of
relat ively superior stock price, cash flow and earnings multiples performance
during both bull and bear markets, as Warren Buffett has so ably demonst rated.
The September/October 1995 issue of the Financial Analysts Journal had an
ar ticle titled The anatomy of the per for mance of buy and sell recommendations,
reaffirming our long-held advice. Of the 21,387 changes in r ecommendations that
met inclusion criter ia,about 55 percent were buys, 33 percent were holds, and only
12 percent were sells. These percentages are similar to those repor ted elsewhere.
The most obvious lesson to be learn ed from t his U. S . s tu dy is that spon s ors h i p
by t he more high ly accl a i m ed inve s tm ent de a l er re s e a rch analys t s , pr i m a ri ly coveri n g
i n s ti tuti onal inve s tors , the magn i tu de of ch a n ge in the recom m en d a ti on and the
p l acing power of the re s pective firm ,a ppear to have tem pora r y pr i ce pre s su re ef fect s .
It is the size of the com p a ny being recom m en ded , t he strength and perva s iveness of
the recom m en d a ti on , and wh et h er or not the spon s oring bro kera ge firms also advi s e
i n d ivi dual inve s tors , that determines the perm a n ency of s tock pri ce ch a n ge s .
So, if you are ever to realize an up tick in your resp ect ive and r elative cash flow
and earning multiples, you must st rive to achieve a b road base o f full-ser vice and
bout ique investment dealer resear ch analyst sponsorship. If not, youll remain but
an aft er thought in the capital market ball game.
Why is t rading volume so import ant ?
Wh ereas inve s tors seek safet y of pri n c i p a l , i n come and lon ger- term capit al
appreciation, the 165 member firms of the Investment Dealers Association of
Canada measure success in ter ms of merger, acquisition and underwr iting fees,
How to reduce the cost of capital
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agency t rading commissions and securities inventor y gains and losses. Is it any
wonder that conventional Bay St reet wisd om suggests t r ading volume is the fuel
for st ock pr ices?
Even so, the Financial Analysts Journal of November/December 1994, in a study
t itled Evidence that t r ading volume sustains stock pr ice changes, suggests that
one possible reason may be that increased tr ading volume reflects a greater
likelihood that the demand for a stock or iginates from informed as opposed to
uninformed or liquidity-mot ivated trading. Consequently, investors interpret high
volume as an indication that the demand under lying price change is informed. The
presence of informed t r ading, in turn, implies that pr ice changes are less likely t o
reverse. Conversely, investors interpret low volume as an indication that the
demand under lying a pri ce ch a n ge is uninform ed or liqu i d i ty - m o t iva ted .
Therefore, pr ice changes accompanied by low volume are more likely to reverse,
because they result from some tr ansitor y effect unr elated to information; that is,
pr ice changes are mo re likely to be tempor ary when volume is low. Thus, volume
distinguishes stock price changes caused by information effects from pr ice changes
induced by liquidity effects.
Once again, the absolute key to improving t rading liquidity and realizing
longer-term price changes is constr uctive investment dealer research analyst
sponsorship and an informed investor audience. The corollary is also t rue the
greater the t r ading volume, the greater the likelihood that more resear ch analysts
will follow the respective companys for tunes. So, if you have been told your st ock
lacks liquidit y, the best way to rectify the situation is to proact ively broaden the
base of infor med sponsorship, or r emain under valued for many years to come.
Prospect us forecast s are fraught wit h failure
As outlined in The Rapport corporate new issue marketing st rategy (1983) there are
said to be eight parameters that should account for syst ematic mar ket valuation:
(1) the markets r equired rate of return for business risk; (2) the markets risk
evaluation or confidence factor ; (3) nor malized net operating results; (4) the
dividend policy; (5) the target capital st ructure; (6) the capital sp ending forecasts;
(7) the rate of inter nal growth; (8) and the acquisition policy. For the purpose of
this discourse we will focus on project ing the rate of internal growth,cash flow and
earnings per share forecasts as they are the most important guideposts for investors
in buying securities.
As r epor ted in The Globe and Mail Repor t on Business on March 1, 1994, the
Ontario Securities Commission (OSC) staff recently published a 1990 to 1991
sur vey t racking the a ct ual operating results of selected public companies that had
previously used future o rient ed financial infor mation (FOFI) in connect ion with
5
prospectus dist ribut ions. According to the OSC, 77 percent of established firms
sur veyed over-estimated their profit. Moreover, 62 percent over-estimated profit by
more than 20 percent. The equivalent over-statement statistics for start-ups was 82
percent and 75 percent! Needless to say, the pious underwriters inevitably blame
management and the endorsing auditors when an issuer fails to meet its forecasted
cash flow and earnings targets. All the while it is the misled new-issue investor who
must suffer the dire consequences of disappointing financial results.
What can be done to r ectify the dilemma? To our way of thinking all thr ee ar e
to blame, but particularly so the underwr iters, who almost always insist on the
higher-number forecast in order to show how relatively cheap the new issue is in
terms of its r elat ive cash flow and earnings multiple. In our experience, the only
way to mitigate the situation and not disappoint your loyal, long-term investors is
by seeing to it that there is a broad base of well-informed investment dealer
research analysts to keep the over-zealous corpor ate finance reps in check. It wont
happen other wise.
Prospect us dist ribut ions v ersus pre-empt i ve offerings
While weve got the underwriters on the run, a word or two is in order about the
relative cost of prospectus distr ibutions versus pre-emptive special-warrant and
pr ivate-placement offer ings.
In this regard may we refer you to an Amer ican study by the Securities Industr y
Association titled SEC Rule 415: Benefits and Costs for Equity Issuers (1984). It
concluded that prices of shelf-registered issues performed significantly worse than
the market price of non-shelf issues around the announcement date of the
offering. The negative perfor mance of stock pr ices of shelf issues was four to twelve
t imes greater than savings in issuance costs, suggesting that pr ice stabilization
act ivities of an underwr iting syndicate may be of ver y significant benefit to issuers
of equity securities, short and longer term.
So the next time underwriters suggest that a special-warrant issue or pr ivat e
placement is faster and less expensive than a rights issue or public offer ing, tell
them you know better than to believe their balderdash. By the same token, why
should your long-term individual investors be precluded from participation? After
all, it is the successful individual investors, not the in-and-out performance-
pushed instit ut ional p or tfolio managers, that will ultimately d etermine the share
pr ice, cash flow and earnings multiples. They are also managements most loyal
suppor ters, as War ren Buffett has long ap preciated.
How to reduce the cost of capital
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How t o assure informed research analyst sponsorship
While we have commented in this regard for more than twenty years and published
The research analyst challenge (1988), a new benchmark study, Analyst Forecasting
Errors and Their Implications for Securities Analysis, was issued in September 1994
by David N. Dreman, chairman of Dreman Value Management, and Michael A.
Ber r y, Wheat First Professor of Investments, James Madison University.
Comparing a sample of 66,100 consensus year-over-year estimates of Wall
St reet analysts, with repor ted earnings for a large sample of NYSE, Amer ican Stock
Exchange (AMEX) and Nasdaq companies over the per iod January 1974 to March
1991, the study demonst rat ed that management and research analyst estimates
often differ significantly from actual repor ted earnings and quarterly consensus
e a rn i n gs forecasts are even more incon s i s ten t . Fu rt h erm ore , m a ny mar ket
professionals consider forecast er ror magnitude of plus or minus 5 to 10 percent
of actual earnings enough to tr igger a major st ock price reaction.
Messrs. Dreman and Berr ys mispr icing-cor rection hypothesis or MCH
assumes that investors oft en over value the prospects o f the high-P/E t ype st ocks
and under value low-P/E investment oppor tunities, implying that posit ive or
negative developments of the recent past are ext rapolated well into the future,
pushing stock pri ces to exce s s ive prem iums or disco u n t s . As ex a m p l e s , the so-call ed
Internet-related new issues are currently enjoying excessive multiples of cash flow
and earnings while many other technology stocks are still having to cope with
below mean multiples.
The MCH also predicts that negative sur pr ises have demonstr ably different
effects on high-P/E and low-P/E asset classes. Bad news on an unpopular
investment has little effect on investors, as exp ectations are low and such news is
taken in st ride. Conversely, the possibility of unfavourable news for a high-P/E
investment is not as expected and always comes as a surpr ise. When it occurs,it has
a far more damaging effect on the st ock pr ice than is the case for a low-P/E st ock.
As an example to consider, the TSE Oil and Gas Producers Sub-Index topped out
at 5627.80 on September 3,1993. Its 52-week low was reached on January 13,1995,
at 3784.44, reflect ing a 16-month cor rection of 32.75 percent. Notwithstanding all
the bad news that subsequently swirled about and/or emanat ed from the oilpatch,
the sub-ind ex instead rebounded to the year-end level o f 4794.10, representing a
recovery of 26.7 p ercent. While still 14.8 percent shy of its previous all-time high,
the sub-index outper formed the TSE Composite in 1995!
Re ading bet ween the lines, it is qu i te obvious that proactive inve s tor rel a ti on s
programmes have gre a ter impact wh en times are to u gh , wh en re s e a rch analysts and
perform a n ce - p u s h ed inst i tuti onal inve s tor port folio managers are out of s ort s and
wh en most of on es com pet i tors are tending to stay put ra t h er than ven tu re forw a rd
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and face the mu s i c . Fu rt h erm ore , m a n a gem ent should alw ays re s pect t he fact that
su cce s s f u l ,l on g - term inve s tors are wi lling buyers in bu ll and bear market s , provi d i n g
t h ey are kept au cou ra n t a bo ut the com p a ny s financial affairs and pro s pect s .
As fewer than 50 percent of Wall St reet and likely Bay St reet research analysts
consensus estimates are close to the mark, when more than 60 percent of FOFI
prospectus projections are at least 20 percent too opt imistic, one can only come to
one conclusion.
That is this. The responsibility for protect ing and enhancing shar eholder value
and for reducing the cost of capital by assuring informed research analyst
sponsorship, rests with the CEO, and nobody else. Further more, achieving success
in this regard will take perception, perspicacity, persever ance, patience, a bit of
passion and a well-executed in vestor r elations progr amme. If you do not stay the
course, the next bull mar ket cycle may well pass you by.
How to reduce the cost of capital