Winning Investors Over. Baruch Lev
Harry Frankfurt who equates his book's theme to the more palatable term hot air, and explains: “When we characterize talk as hot air, we mean that what comes out of the speaker's mouth is only that. It is mere vapor. His speech is empty, without substance or content. His use of language, accordingly, does not contribute to the purpose it purports to serve. No more information is communicated than if the speaker had merely exhaled.”3 Frankfurt goes on to distinguish bullshit from a lie: “When an honest man speaks, he says only what he believes to be true; and for the liar, it is correspondingly indispensible that he considers his statements to be false. For the bullshitter, however, all these bets are off: he is neither on the side of the true nor on the side of the false. His eye is not on the facts at all, as the eyes of the honest man and of the liar are, except in so far as they may be pertinent to his interest in getting away with what he says.”4
Chapter 3 is devoted to truths and lies in financial reporting and their consequences. Here, I deal with a subtler dimension of communication with investors—soft information—and show, among other things, that bullshit often defeats the communicator's purpose, whereas relevant, credible information—details later—will improve investors' perceptions of the company, even in the wake of a disappointing quarter or year. Soft information, not just data, matters, as well as its tone and delivery. Above all, investors' seriously limited cognitive capacity, which economists often ignore, has to be carefully accommodated by the communicator or executive.
Surprise, Investors Are Human After All
Mainstream economists and finance scholars implicitly assume that investors, at least those that rely on information in making decisions, possess a perfect capacity to collect and process that information. They expeditiously read and digest the voluminous quarterly and annual financial reports of companies (including the generally indecipherable notes); attend conference calls and press meetings; read the various SEC filings of companies; learn about new technologies, innovations, and changes in the competitive environment of firms from governmental, research, and consultants' reports; speak with customers and suppliers; and do all this and more on a regular basis for fifteen to twenty companies typically followed by financial analysts and active investors. If investors were indeed able to achieve this physical and intellectual phenomenal feat, how could one explain the following research findings:
On Sunday, May 3, 1998, a New York Times front-page article about a promising drug developed by EntreMed, a biotech company, catapulted its stock price from $12 to $52, despite the fact that “the new-news content of the Times story was nil.”5 The attributes and prospects of this drug were thoroughly analyzed months earlier in scientific journals, and covered by the popular media, including the New York Times, though not on its front page. If investors process information fully and in a timely manner, the New York Times article, which didn't contain any new scientific or commercial information, should have been stale news, exerting no effect on EntreMed's stock price. And yet, the stock price more than quadrupled.
Research shows that pro forma (non-GAAP) earnings prominently displayed in the title or the first paragraph of a company's news release have a substantially stronger impact on stock prices than pro forma earnings reported less prominently in earnings releases.6 However, efficient information processors react only to the content of a message and are indifferent to the order of information release, or where it is placed in the message. And yet …
During the 1990s, managers of high-tech companies fought tooth and nail against the FASB's proposal to expense the value of employee stock options—namely, subtract it from earnings—yet were indifferent to reporting the same information in a footnote to the financial report. Evidently, managers believe that an item affecting net income will draw investors' attention, whereas they will largely ignore the same item disclosed in a footnote a few pages later in the report. But, surely, astute investors read financial report footnotes carefully and can easily subtract the value of stock options reported in a footnote from earnings.7 Managers clearly beg to differ.
A textual analysis of managers' narrative in earnings press releases indicates that the narrative's tone—level of optimism or pessimism—has a significant effect on investors' (price) reaction to the earnings release, beyond the quantitative, hard component of the message.8 Shouldn't hardened, rational investors be indifferent to the tone of a message, focusing only on its substance?
Last, companies tend to release poor earnings news on Fridays because the stock price reaction to Friday's news is significantly more muted than on Monday through Thursday. Indeed, studies have shown that there is a catch-up (delayed) stock price reaction to earnings announcements on Friday, occurring over several weeks.9 It's hard to believe that sophisticated, alert investors are distracted on Fridays by the approaching weekend; isn't fund management 24/7? And yet …10
Surprise, surprise: investors are evidently not the bloodless, efficient automatons populating economic and finance textbooks. They obviously suffer from what behavioral researchers call “limited attention,” namely, a seriously restricted ability to process and analyze the vast amount of information relevant to companies' values. In the Nobel Laureate economist Herbert Simon's words, “the scarce resource is not information, it is processing capacity to attend to information.”11 That's why investors focus on salient cues, information items that stand out in the crowded data mess, such as a front-page New York Times article about a promising drug, devoid of new information, or react strongly to pro forma earnings and restatements flashed in the heading of a news release, while reacting with reserve to similar information buried in the text of the release. Limited attention also implies that investors will use an information item as displayed to them, rather than engage in an extensive modification of the information,12 corroborating managers' belief that when the stock options expense is in the P&L report (displayed information), it will have a substantially stronger impact on investors than a footnote disclosure requiring investors to modify reported earnings.13 These are all important lessons for executives striving to communicate effectively to investors.
A more subtle yet equally serious manifestation of investors' limited attention and constrained information-processing capacity is their frequent failure to draw inferences from the absence of information, such as when a company that used to provide quarterly earnings guidance to investors stops doing so, often because of deteriorating performance.14 Similarly, investors rarely realize in time that some widely touted drugs while under development never made it to the market because the developers kept mum about the failure of these drugs in clinical tests.15 It's the same with companies that announce with fanfare plans for large stock repurchases (usually triggering stock price increases), yet never fulfill the promise. However, since the absent information was apparent (earnings guidance that was subsequently stopped), efficient information processors are expected to notice the change. They don't.
I dwell on the severe information-processing constraints and limited attention of investors because a comprehensive understanding of these limitations is central for designing effective capital-market communications policies. The tone (sentiment) of a message, where it is placed in a news release, when to keep mum, or what works in a conference call are essential components of an effective disclosure strategy to investors with limited attention, as I show next.16
Speak Softly and Carry a Big (Hard) Stick
Investors' limited attention and constrained cognitive capacity naturally sway them toward hard information, which is easily reduced to numbers and thereby made salient, and away from soft information, which is hard to summarize by a quantitative score.17 Moreover, institutional investors—investment managers, banks, insurance companies—prefer hard information, like earnings or sales, because it is easy to transmit across their hierarchies to researchers and investment managers and will be interpreted uniformly by the various employees and executives on the decision-making team. Soft information, such as a description of the competitive position of the company or the strength of its intellectual property, may be lost in translation across hierarchical channels. Soft information is also easier to hype and misinterpret relative to hard data. And yet, soft information or narrative is