Treating Investors Like Customers

The collapse of Enron and other recent financial scandals have created a crisis in investor confidence. Shareholders are more skeptical now and are subjecting management actions to increased scrutiny. Companies need to find ways to restore their credibility and reconnect with their investor base.

Traditional investor relations (IR) isn’t up to the challenge. In most large companies today, IR is an administrative staff activity that emphasizes “push” marketing programs consisting of CEO speeches and outbound investor communications. It is a one-way conduit that provides required disclosure and interprets the company’s outlook in ways that management would like the market to embrace. It is rarely a genuine dialogue based on sophisticated insights about how value will be created.

There is a better way—and, paradoxically, most good companies already have the right analytical tools at hand. Seen from the perspective of the financial markets, a company’s ultimate product is its equity. So companies need to start applying to their shareholders the same kind of strategic disciplines they typically apply to customers.

Treating investors more like customers does not mean employing misguided, and increasingly discredited, techniques for “managing earnings.” Nor does it mean that corporate executives should let investors determine business strategy any more than they should let customers determine product strategy. What it does mean: developing a detailed process for ensuring that a company’s strategy is informed by the perspectives and requirements of its investor base, and then working over time to create alignment between strategy and shareholders. There are four basic steps.

Investor Segmentation

Customer segmentation is a fundamental building block of business strategy—and also of investor strategy. Different classes of investors have different appetites for growth, profitability, cash-flow generation, and risk. The first step is to conduct a segmentation of your core investors and develop a fact-based view of why they have chosen to put their money with you.

Remarkably few companies take this step today. Many companies have only the most general idea of the types of investors that own their shares, and they often misunderstand the investment criteria those shareholders use. Executives may believe that their company trades at a discount to its true value—but they rarely go to the trouble of quantifying the sources of discount or understanding investors’ reasons for valuing the company the way they do. Developing a detailed segmentation requires systematic and continuous fact gathering, starting with the different types of institutional investors that own the company and the expectations of each group. What is the dominant investor segment—aggressive growth, deep value, or one of the various styles in between? How good is the fit between the objectives of current investors and the company’s strategies and performance outlook? What is the peer set that investors use to evaluate relative performance? (Often, it is different from a company’s traditional productmarket peer group.)

Until senior executives know what matters most to their key investors, they can make strategic moves that destroy value rather than create it. That is what nearly happened to one company with a strong brand franchise and a long history of delivering modest, but profitable, organic growth. Senior executives were concerned about how the company was going to meet investors’ expectations. They assumed that sustaining the company’s unusually high price-earnings ratio (P / E) required the company to grow more rapidly.

Management was well down the road toward a new acquisition and a major geographic expansion when it discovered that these big strategic bets were precisely what its core investors did not want. The company’s institutional investors were dominated by “growth at a reasonable price” (GARP) shareholders. They were looking primarily for stability—consistent above-average earnings growth but with very low risk. They were eager to see aggressive reinvestment to protect and grow the main franchise, but not an expensive acquisition and a potentially risky global expansion. The company’s plan ran the risk of alienating its major investors, thereby destroying its P/E multiple rather than saving it.

Dialogue and Discovery

The best customer-oriented companies work hard to understand their customers’ points of view. They don’t rely exclusively on market research and focus groups; they go toe-to-toe with actual customers to hear their unvarnished opinions and uncover their latent needs.

Similarly, the best investor-oriented companies don’t view communication with investors as an exercise in sales hype, nor do they rely exclusively on analysts to reflect the views of the capital markets. Instead, they engage directly and nondefensively in a continuous dialogue with both current and potential investors. Senior managers—and not just the CEO or the IR staff—take the time to personally understand investors’ attitudes and requirements. Some companies even rotate line managers through the IR function because they have learned that direct exposure to investors helps those managers think more like investors when they return to running their own businesses.

The advantage of developing a rich understanding of investors’ views is that it can be a source of valuable insight about strategic tradeoffs facing the company. Investors often have information and perspectives that managers lack. They meet regularly with management teams across a wide range of similar companies. The most sophisticated develop powerful models to explain what drives the valuation of their investments. Fair disclosure requirements may limit the depth of information that management can divulge. But there is no law against asking investors good questions and listening carefully to their answers.

In a series of intensive discussions with key investors, the CEO of a global consumer-products company heard some highly negative views about the viability of the company’s European business. The company had plans to grow the business, but investors believed that it needed to be fixed or—more likely—sold. The feedback was a catalyst for productive internal questioning about the strategy that the management team was pursuing. Rather than viewing a change in direction as a failure, management came to see the move as investors would. Executives began redirecting resources to the core in order to build advantage and value there.

Investor-Oriented Business Systems

The most sophisticated customer-oriented companies build their brand around a distinctive experience that delivers value to the customer—and then organize their business systems so they consistently deliver that experience in every interaction. In the same fashion, once a company knows what its share- holders really value, it can start building the internal systems necessary to deliver the kind of performance those shareholders want and to predict and communicate results in a way that avoids negative surprises and builds credibility over time.

Clearly, more transparent financial reporting—down to the level of the individual business unit—is essential. But while necessary, it is not sufficient. Increasingly, investors aren’t just looking at earnings per share; they are looking at how those earnings are generated. A company must also articulate a compelling business logic for value creation, including details about sources of competitive advantage, operational economics, and portfolio strategy. What drives value in the business? What specific operational drivers are most likely to generate the next round of improvements in shareholder value? What are the criteria that senior management is using for the allocation of free cash flow?

Finally, this value-creation logic needs to be reflected in a company’s management processes. Business plans should explicitly address the priorities of the investor base so that, when achieved, they do not disappoint. Controlling systems need to capture strategic and operational milestones that are important to investors, and to provide early warning signals to line managers so they can take corrective action in time. And executives, including business unit managers, should be compensated for performance along the dimensions most important to the dominant investor segment.

The key challenge here is alignment—not only between company performance and investor goals but also among the various internal systems of the company. Avoid the situation we found at one company, where business plans called for 5 percent growth but incentives in the sales-force-compensation system kicked in at 9 percent—and expectations built into the stock price required growth rates of 14 percent. Such misalignment is a recipe for negative surprises that can wreak havoc with a company’s stock.

Migration to the Right Investors

Of course, there are situations when the imperatives of a company’s long-term strategy and the needs of its current investors will conflict. Once a company has developed an indepth understanding of its investor base, it can identify such disconnects, analyze their causes, and prepare to migrate to those investors that make the most sense given the company’s strategy.

Just as some customers are more profitable than others, some investors are more attractive than others—whether because of their time frame (long horizon, low churn), investment objectives (more in tune with future direction than with past portfolio), or interdependence (insiders, employees, and alliance partners). Cultivating these aligned investors will help the company migrate toward an owner base that supports the long-term strategy and will reduce unnecessary volatility as short-term investors move into and out of the stock.

When companies treat investors like customers, they do a better job of factoring investors’ goals into the development of corporate strategy. The result is better alignment between strategy and shareholders, and superior value creation. In the long term, that approach is the only real solution to the crisis in investor confidence.