Business Models Aren’t Static

Apr 8, 2016
Ideas & Insights

Investment Rationales Shouldn’t Be Either

Balancing Investment Stories with Candid Commentary Builds Credibility

By Chris Plunkett

Business models are not static. Many investment stories will fail – at least temporarily – at some point. They have to – because they are what they are – stories – and rarely do they fully take into account downside scenarios or the various bumps that may surface on what can be a rough road to value creation. That’s why we have investment analysis, a robust SEC filing system, and investor Q&A opportunities, among other tools, to gauge the health of a company and its industry.

The core of the IR practice lies in the ability to develop and deliver an attractive, yet realistic investment rationale. This is the “story” that summarizes a company’s market, competitive position, assets, and business plan. It answers the question: why should I buy this stock? It should dovetail with a set of pertinent yardsticks that an investor can monitor to determine management’s progress in executing the growth plan.

The investment rationale forms the backbone of subsequent communications including earnings release quotes, quarterly conference call remarks and Q&A sessions at major conferences. A good investment story encapsulates the business opportunity and the company’s roadmap to capitalize on it in a very succinct way. This makes it easy for the Street to follow management’s progress and keep abreast of the core financial and operating metrics.

Great business plans can lead to great results, sometimes for long periods of time. But, ultimately something will change to the detriment of a company’s outlook, ROI potential or rate of growth. No business model is perfect. The inherent problem with looking at investment stories – at least in isolation – is that the underlying mechanics of the roadmap for growth will eventually hit roadblocks. Yet, many companies fail to adjust from a messaging standpoint. Their stories are too simple and too optimistic.

On the surface, this seems obvious. But, when all cylinders are humming and management is executing at a high level in line with the business plan, something magical can happen: the company’s share price may increase. Capital appreciation can be dramatic and support subsequent share offerings and M&A activity, among other benefits. In turn, management teams tend to double down on what’s working in terms of messaging. Sometimes analysts do too. After all, when everything is, in fact, going right, why mess up a good thing?

The answer is that while simple investment stories serve a very important purpose, they often don’t account for unpredictable environments. Most investors know this. A big part of their job is to anticipate what can go wrong. However, instead of buying business models and all the imperfections that come with them, shorter-term players often buy nicely packaged stories that fuel share price momentum when everything goes right. They know the ride won’t last, but they plan to get off in time. This partly fuels the frantic quarterly analysis process that is increasingly being questioned these days. If you’re purchasing shares of a company at a valuation that can only grow if all cylinders are humming, then you have to be a bit paranoid. After all, you’re exposed. So is management.

That’s why careful management of expectations is so important. Any solid investment rationale should dovetail with a realistic stance to financial guidance and a candid assessment of what can go wrong. Beyond the fine print of SEC filings, such commentary should be sprinkled into various communications platforms where the story and outlook are addressed in greater detail. That doesn’t mean a CEO has to sound like the end of a pharmaceutical commercial with a list of potential side effects. There’s no reason to communicate doomsday if there are no signs that one is coming. However, a CEO should look to paint a realistic picture when delivering the company’s story to investors.

This may be an unpopular thing to do when the company’s shares are heading up and/or the stock’s valuation is high. But, such an approach will support credibility over time – both for management and for the investment thesis. I can remember an earlier recession where the advertising market was beginning to slow as companies pulled back on spending. At a major investment conference, a CEO of a broadcasting entity claimed his company didn’t plan on participating in the ad recession. It was a clever comment with a strong touch of bravado and salesmanship. But, of course, the company was ultimately impacted by the downturn. At the time of the conference, that scenario didn’t fit into the nicely laid out investment rationale – which had been working quite well. But the environment was indeed changeling. Yet, the CEO failed to adjust his messaging and it became disconnected from reality.

On the flip side, early in my career, I worked with a television syndication company that had a very clear investment rationale and roadmap for growth. It was also a very successful and profitable company that distributed several consistently popular hit shows. Analysts called it a cash machine. But, the company had one major risk element. It was having a hard time developing new hit shows on its own. Rather than glossing over the issue, the CFO addressed it straight on. In the company’s investor presentation he developed a slide on the show development process, including the risks involved. He titled it: “Most New Shows Fail.” How about that? He addressed this part of the company’s plan in a very transparent manner. He also lowered the bar – and in turn raised his credibility.

Most new shows fail – and many investment stories fail as well – at least temporarily. Roadblocks emerge – it’s just a matter of time and a matter of degrees. Good investment stories lay out clear value creation roadmaps. They serve a very important purpose on many levels. But, it’s important to balance growth scenarios with candid insight on what can go wrong and how the company plans to adjust. This is hard to do when everything is going right. But it will come in handy when things turn – in the form of credibility and even conviction among longer-term investors who recognize the ultimate return potential of the company and the solidity of its business.