Short Expectations

by Julia Mezzanine Tranche

The following was contributed last week by our new writer, Equity Private, who has an excellent blog about being an private equity insider. Both He/She/It (“Hsit”), along with Female to Be Named Later (links to her blog), will be contributing at will.

Meta data surrounding “investor relations” has the potential to become a derivative vehicle itself. Investor Relations (“IR”) is a field which has developed into an art and a science due to the importance of earnings announcements and the triumph of the short-term (12 week) focused analyst over the long-term (12.5 week) focused analyst. Below, we outline a system to guide equity strategies in this realm.

Expectation Expectations (Expectation Derivatives)

Relations strategies employed by firms can best be understood on the two axis defined by the continuum between “passive” and “active” on one axis and “earnest” and “obscene f***king fabrication” (“OFF”) on the other.

  • Firms with little communications program are on the “passive” side of the continuum. The likelihood that a given firm will fall to the passive side of the continuum is inversely proportional to the square of the total theoretical mass of the egos of the senior management. (The number for our analysis is 2 and consists of GOOG and the NYSE-listed firm whose IR department spent their entire annual budget at strip clubs prior to the collection of data).
  • Firms with frequent, detailed, descriptive and lengthily communications are on the “active” side of the continuum.

  • Firms with honest, direct and accurate communications are classified on the “earnest” side of the continuum. The number of firms on this side of the continuum is also quite small. (Note: If the definition of “honest, direct and accurate” is refined to omit profanity directed at analysts on investor calls this number drops to zero).

  • Firms with inaccurate, misleading (intentionally or otherwise), obscure, evasive, or immaterial communications are classified on the “obscene f***ing fabrication” side of the continuum. 950 examples of these firms exist among the Fortune 500. (Note: This figure includes 450 off balance sheet “special purpose entities”).

  • Firms with highly active disclosure profiles and highly OFF-leaning disclosure profiles quickly burn reputation capital among analysts and observers. The short term gains initially realized by such firms are quickly lost following discovery of the firm’s true location near the far frontier of OFF. Firms in the first OFF quartile show net losses of -56% compared to other market actors. These losses, however, typically follow a huge wave of gains.

  • Firms with active and “moderately” OFF disclosure profiles perform poorly as well. Throughout their history their only moderate OFF position communicates results below those of the high OFF actors. Since they appear to perform poorly relative to the high OFF participants they are discounted by investors.

  • Firms with passive leaning disclosure profiles also perform poorly. Those with OFF leanings suffer versus active OFF leaners as they are perceived to release “too little good news,” according to one CSFB official who commented on condition of anonymity from federal prison. Those with earnest leanings are characterized as “boring, with too little good news.”
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Efficient Frontier Dangers

Even firms along the efficient frontier of OFF/Active boundaries face perils. Dell(DELL) is classified as an active OFFer. Dell’s carefully crafted investor relations program has had the effect of depressing earnings expectations consistently for years. Unfortunately for Dell, analysts have grown sophisticated; they publish one set of expectations while harboring another set of “double secret expectations” amongst themselves. These “double secret expectations” are generally arrived at among analysts at a quarterly secret meeting in the “champagne room” of Scores.

Dell’s failure to exceed the second tier of secret expectations is punished. In response, Dell began to offer even more depressed earnings guidance based on second derivative expectations (their expectations of the analysts expectations). There are rumors that Sell Side analysts are now developing in the lab a third derivative expectations but shortages of key ingredients such as molybdenum and bullshit have hampered their efforts.

Recommendation:

For investors with longer horizons:
Short firms with investor relations programs

For investors with shorter horizons:
Go Long on newly listed firms with budding investor relations programs and sell immediately after the third quarter of disclosures.

But we expect that you expect that we already expected that you expect this.

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