Here’s How The Economic Cycle Affects The Way Investors Value Your Stock

Ian Roundell is the head of IR at Credit Suisse.

As an economic cycle progresses, being able to understand the main focus of investors can help you maximise the effectiveness of your communication with the investor community. Investor relations at any firm should be a key catalyst in actively managing the valuation multiple. This makes IR an integral part of the strategic planning process to ensure its activity and related communication are positively aligned to what investors are evaluating.

The key to maximizing investor valuation is to understand how fund managers view – and therefore might value – your particular company. That appreciation is vital to understanding how the investment community is evaluating your company at any point. It also sets the context for what the focus of your company’s communication should be at all times during the economic cycle. 

In basic terms, investors tend to value up – or discount – a company from the industry standard valuation, normally comprising a price earnings multiple. A premium or discount will be applied based on how that company is addressing the various share price drivers it considers in its model.

During a down market, investors will more likely discount a valuation from the industry standard based on how a company is managing certain specific financial factors. It is important for executive teams to communicate how they are managing these factors. 

It is particularly important to understand that investors apply a varying degree of severity in their discounting, depending on which factors are in play:

1. They will look at your profit and loss account specifically focusing on cost and revenue management

2. They will review your balance sheet specifically focusing on asset and liability management

3. They will form a view of the quality of your management team 

4. They will consider the general over-arching economy in which your company is operating.

The inability of a company to properly manage its costs is discounted the least, whereas the impact of any material macro-economic factors affecting the company are discounted the most. These factors would normally have a global impact on the whole industry but can occasionally have different impacts on different companies from country to country or from region to region.

Economic downturn share price trends 

Fund managers normally identify a specific share price range for every company they own or may potentially own. Companies that best manage the finance-related aspects of a company’s development in a down market will usually achieve the best short-term share price performance. 

As the market begins to recover, these firms are usually the first companies to see an increase in their share price. Normally the reward for managing each financial factor well is an increase in the company’s share price moving quickly toward the top of the share price range assigned by the market, which – as a rule – does not differ that significantly from fund manager to fund manager. 

A company may have done particularly well and out-performed its competitors during this phase. This represents a superior performance in its ability to manage and communicate those performance aspects most affected by a fund manager’s application of valuation discount factors. 

What may happen after that period of out-performance, however, is often surprising for the executive team and the board. This is the point at which fund managers commonly switch out of precisely those shares that have performed best. They will take another look at those companies offering the greatest share price uplift opportunity, even though these companies may still be lagging in their ability to manage the discount factors.

The picture for the executive gets worse as the team watches the laggards’ share prices actually starting to increase. Over time, the value gap that originally existed between the ‘good’ and ‘bad’ companies eventually closes. This is a typical trend that is observed when markets are recovering and represents a very effective trading strategy.

Moving into recovery

There is also some good news, however. Once that gap has closed, fund managers normally return to evaluate those best-managed companies that led the sector out of the downturn. At that stage in the cycle, the initial recovery phase, fund managers become more focused on the factors that are more important in a growth market. 

Investors now begin focusing much more on earnings creation and start to screen companies that demonstrate a differentiated growth strategy. Fund managers will pay a premium on the shares of those companies that can demonstrate tangible plans with the best prospects of delivering on superior growth. They will, therefore, consider the following criteria:

-How your company manages internal talent and develops people

-How your company is increasing the depth of products on offer by adding to its current range 

-Which new product lines and innovations your company is introducing as it starts to enter the new growth cycle

-Which new markets your company is considering for potential penetration

-How your company is managing its brand 

-What your company’s opportunities are for any inorganic acquisitions.

Boosting the premium

In terms of premium, an investor would give the highest premium to an acquisition initiative. But this does not mean a company should simply go down the acquisition route, because fund managers expect companies to exhaust the other less risky potential growth opportunities first. 

A fund manager will be asking the following questions: is the company’s potential for making best use of its employees maximized? Has the company fully extended its existing product range? Is there any potential to launch new products? Next, the company will be evaluated on its efforts to enter new markets. Only then would it be rewarded for initiatives aimed at enhancing its overall brand management. 

Jumping straight into an acquisition before benefiting from all the synergies on the above list would not generally tempt an investor to award a high premium. Investors expect a company to work through these initiatives sequentially. As the company demonstrates positive results from each initiative, investors generally award an increasing premium. 

Fund managers would argue that companies going the acquisition route without first seeking internal synergies have not fully taken advantage of the opportunities available within the company. Once a company has leveraged all its internal opportunities, the next move is likely to be an acquisition, for two reasons:

1. By that stage a company should already be on a high premium share rating and can therefore use the value of its shares to acquire a lower-rated company

2. Once into the post-acquisition phase, the company has demonstrated its ability to implement growth strategies and can apply these same initiatives to a newly acquired company.

At the start of the growth phase, earnings are not necessarily the driver of share price progression. Multiple expansion, or an increase in the company’s price earnings multiple, is where companies can improve their valuation. IR has an important role to play in this phase because it has the knowledge and know-how to lead a P/E multiple-increase strategy as opposed to a traditional earnings-led strategy.

Going for growth

While your company is waiting for the growth phase to occur, it must demonstrate that it has the right initiatives in place to deliver that growth. Your company will need to convince fund managers it is actually delivering on those initiatives. To achieve this aim, the effective communication of those initiatives becomes critical.

It is one thing to say, ‘Our company has the best talent.’ But every other company will be saying the same thing – so how can you introduce an initiative into your company that fund managers will be inclined to believe? 

Number one: it has to be tangible. In aiming to convince investors about your initiatives, it becomes increasingly important for investor relations to be involved in the strategic planning process. But the ensuing strategic plan must also describe new initiatives that fund managers will recognise and appreciate. 

This process involves creating a strategic initiative with tangible benefits understood by fund managers and for which they are willing to pay a premium. This assumes there is good evidence the initiative should deliver superior revenue growth.

Several of these initiatives may not necessarily be core. Take training, for example. Training all your people and having personnel development plans in place are fine objectives, but these initiatives will not really demonstrate to a fund manager, in any tangible way, that your people are better – as in, more capable – than the competition’s. 

A cut above

So how does a firm develop and manage initiatives that demonstrate, for example, that its people are better than the competition’s? An important part of the answer lies in involving investor relations professionals in both challenging and advising strategic planners, support functions and senior heads of company operations. 

Many people, particularly in support functions, struggle to make effective business cases and overlook measurement criteria to prove positive outcomes. Even some of the most valuable internal initiatives fail to mention how they relate to the external world. And very few explain how they will increase the share price.

Investor relations has a key role to play in understanding economic cycles and communicating effectively to the investor community at each stage. But the profession can add even more value. This is not done by simply justifying what investors want to hear in terms of awarding a premium on a company’s multiple. It is also done by having a much more prominent role in strategic planning and designing internal initiatives so the company can provide the all-important evidence investors are seeking.