Signalling in Investing

A male South China tiger scent-marking his territory
A male South China tiger scent-marking his territory

The world of investing is a rich arena to study various kinds of signalling. Commonly, signalling is done by insiders to communicate the quality of the company to investors.

From MIT,

If a signal is costly to produce in the domain of the quality being signalled, it will tend to be reliable. In the animal world, the prototypical example is the immense antlers that signal the strength in an elk. Carrying such antlers is very costly in terms of strength; a weaker elk cannot afford to expend so much of its strength on this display, and thus must have smaller antlers.

A common example in the human domain is owning an exotic sports car as a signal of wealth. Buying and maintaining such a car is very costly in terms of money. A poorer person could not afford to spend so much on this display and thus must make do with a more basic form of transportation. Such signals are relatively less costly for the honest signaller who has the quality than they are for the dishonest mimic.

In Corporate Finance, theories such as the pecking order model, capital structure substitution theory (css), trade-off theory, market timing hypothesis and others exist because of the presence of asymmetric information, taxes and incomplete contracts.

However, in this post I would just like to skim through a few simple examples:

1. Dividend smoothing happens because companies want their dividends to appear less volatile than earnings. Dividend signalling hypothesis states that when management increases dividend, this signals their confidence in the company to be able to maintain the higher payout in the future. A dividend cut on the other hand, signals an almost desperate need for cash preservation.

2. Share repurchase is when the company buys back its own shares. From the Wikipedia,

Aside from paying out free cash flow, repurchases may also be used to signal and/or take advantage of undervaluation. If a firm’s manager believes their firm’s stock is currently trading below its intrinsic value they may consider repurchases. An open market repurchase, whereby no premium is paid on top of current market price, offers a potentially profitable investment for the manager.

That is, they may repurchase the currently undervalued shares, wait for the market to correct the undervaluation whereby prices increase to the intrinsic value of the equity, and re issue them at a profit. Alternatively, they may undertake a fixed price tender offer, whereby a premium is often offered over current market price, sending a strong signal to the market that he believes the firms equity is undervalued, proven by the fact that he is willing to pay above market price to repurchase the shares.

Note though that this signal is somewhat weaker than the dividend increase given that the company can halt the program with few repercussions.

3. Another one, and this is not in the textbooks – the announcement of a ‘Turnaround Plan’ by the CEO, which usually contains stages or phases, including fancy sounding titles for the plan. The wider the scope of the plan, the higher the share price can rise if investors are impressed enough and the plan is credible. The CEO is signalling that they have the will and the means to see the plan through, e.g. the ability to renegotiate debt and pension obligations, or willingness to divest or close down underperforming units. This though may take a few years to see through.

More examples include:

1. Barclays decided recently that a “new set of skills” were required at the top. From the BBC,

Mr Jenkins has been Barclays’ chief executive since 2012. The bank said a search for his successor was under way. Barclays’ chairman John McFarlane has been named executive chairman until a new chief executive is appointed. In a conference call, Mr McFarlane said the board had decided the firm needed to change its strategy in order to boost revenue growth. Barclays needs to be “leaner and more agile” to improve the firm’s capital performance, he said.

Investors welcomed the news of the change, sending shares in Barclays up more than 2% in London.

This is an especially strong signal given that there was not much pressure on the CEO following good business performance.

2. A well-timed insider’s purchase could signal confidence. However, it could also stem from management’s desperation. From the Wall Street Journal,

Sprint Corp. Chief Executive Marcelo Claure purchased more than 5 million shares of his company’s stock this week, less than a month after the company reported weak full-year results amid struggles to keep customers.

Shares of Sprint jumped on the news, recently rising 6.8% to $5.10 in midday trading. The stock has fallen about 41% over the past 12 months.

Unlike insider selling, which is mostly driven by management’s desire to diversify and not poor business prospect, a significant purchase (if funded appropriately) doubles up on the already high exposure and aligns incentives even further. Caution is needed for a signal such as this. A CEO can behave irrationally as to produce a misleading signal.

All the examples given above highlight an element of cost to the signaller. If today’s signal fails to materialise into future better performance, the financial or reputational loss would be greater than without the signal. This is what makes it costly and therefore credible, and that is why it literally pays for investors to monitor these signals closely.

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