When Good News Is Actually Bad News For Investors

Context and presentation often matter more than substance, at least in the short term. Many public companies have elevated this notion to a perverse art form by announcing news that is actually quite bad for shareholders, but spinning it in a way that makes it sounds as though shareholders should be grateful to have such far-sighted leadership. Being able to separate the real good news from puffery and double-talk is a valuable skill. 

Investors should be on the lookout for these four examples of good news that are usually not good news.

Following the Great Recession and the steady recovery in the economy in the years since then, companies have generally been in a mood to hire and expand rather than restructure and retrench. Eventually, we can expect there will be another wave of corporate restructuring among public companies. Though analysts and institutions often cheer these moves, savvy investors should be skeptical.

Sometimes restructuring makes all the sense in the world; particularly when a company hires a new management team to improve or turnaround a business that has been lagging and underperforming. But what about cases where the management team doing the firing is the same team that did the hiring? Barring a public mea culpa (and perhaps the surrender of some bonuses or salary), why should an investor trust a CEO who is basically saying, "I confess... they did it!"

Restructurings can be very bad for morale, and they eat away at the loyalty between employees and employers. Worse still, the roster of companies that have fired their way to prosperity is rather short. When a shareholder sees one of his or her portfolio companies announcing a restructuring, they should carefully examine whether the moves are aimed at long-term success (rather than a short-term earnings boost) and whether current management really has the skill set to build long-term shareholder value and compete effectively in the market.

(To learn more, see Cashing in on Corporate Restructuring.)

There has long been a notion in academia that there is a "right" capital structure for each company — the perfect balance of debt and equity financing to maximize earnings and returns while minimizing risk and volatility. As readers may suspect, the professors advancing these theories have almost universally never run a company, nor held a position of high responsibility within one.

A recapitalization often means a company that has had a reasonably good record of cash flow generation and little debt will often go to the market and issue significant amounts of debt. This essentially shifts the company's capitalization from an equity-heavy/debt-light ratio to the opposite.

Why would a company do such a thing? To a certain extent, debt is cheap money. Creditworthy companies often find that the coupon rate on debt is lower than their cost of equity and the interest on debt is tax-deductible (equity dividends are not). Sometimes firms will use this sort of maneuver to raise cash for use in acquisitions, particularly in cases where the stock might be illiquid or otherwise unattractive as deal currency.

In many other cases, though, companies use the cash generated by the debt sales to fund a large one-time special dividend. That is great for long-term investors who get the cash payout and leave, but it creates a radically different company for those who remain invested or buy in after the recapitalization.

Unfortunately, many companies recapitalize themselves during periods of peak cash flow and struggle to survive under the heavy weight of debt payments as economic conditions worsen. Consequently, a recapitalization is only good news for investors willing to take the special dividend and run, or in those cases where it is a prelude to a deal that is actually worthy of the debt load and the risks it brings.

(To learn more, see Evaluating a Company's Capital Structure.)

With the popularity (and flexibility) of stock buybacks, special dividends have become less common, but they still do occur. A special dividend is basically what it sounds like — the company makes a one-time payment of cash to shareholders with no particular expectation of making a similar payment again in the near future.

While special dividends funded by debt are dangerous in their own right, there is a problem even with dividends funded by a non-strategic asset sale or cash accumulation. The biggest problem with special dividends is the not-so-subtle message that goes with them — management is basically out of ideas and better options for the company's capital.

Is it better for a company to write a check to its shareholders instead of wasting the money on a stupid acquisition or a new expansion project that cannot earn its cost of capital? Of course. But it would be better still for management to have a plan and strategy in place to continue growing and reinvesting capital at an attractive rate. Though management teams willing to acknowledge that a company has grown as large as it practically can should be applauded for their candor, investors should not overlook the message that a special dividend sends and should adjust their future growth expectations accordingly.

(To learn more, see Dividend Facts You May Not Know.)

What happens when a board of directors is afraid that a company will expose their shareholders to the truth that they could reap a premium by selling their shares in a buyout and management does not want to sell? They initiate a poison pill, or as companies prefer to call them, a "shareholder rights" plan. Poison pills are designed to make unfriendly acquisitions prohibitively expensive for the acquirer, often allowing underperforming management to keep their jobs and their salaries.

In essence, a company sets a trigger whereby if any shareholder acquires more than that amount of the company, every other shareholder except the triggering shareholder has the right to buy new shares at a major discount. This effectively dilutes the triggering shareholder and significantly increases the cost of a deal.

What's really unfortunate about these deals is the embedded paternalism. Management and the board of directors are telling its own shareholders "look, you're not smart enough to decide whether this is a good deal, so we'll decide for you." In other cases, it's simply a conflict of interest — the management or board owns a big slug of stock and just isn't ready to sell yet.

It is true that some studies have shown that companies with poison pills get higher bids (and takeover premiums) than those that do not. The problem is that there is relatively little beyond the threat of lawsuits that shareholders can do to ensure that a board of directors upholds their fiduciary duty to shareholders. If a majority of shareholders wish to sell the company at a given price, a poison pill and management's opinion of the valuation should not be allowed to stand in the way.

News always carries a certain amount of nuance with it. None of the actions listed here are universally or automatically "bad" or "wrong" for a company and its shareholders. The problem is that too often dishonest and self-serving managers try to fool their shareholders into believing that quick fixes are a long-term strategy. Investors should foster a healthy sense of skepticism and make sure that "good news" is really as good as management wants you to believe.

(For more, see Can Good News Be a Signal to Sell? and Evaluating a Company's Management.)