What do these three quotes have in common?
“If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”
“When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.”
“For investors as a whole, returns decrease as motion increases.”
Aside from the obvious point that all three declarations advocate long-term investing, the common thread tying them together is their source. Indeed, these are excerpts from Berkshire Hathaway shareholder letters which, more notably, are penned by legendary investor Warren Buffet.
Given Mr. Buffet’s unprecedented success and candor as it pertains to his investment process, one may assume that investors would largely follow his lead. This assumption, however, would run in stark contrast to reality. The fact of the matter is that capital markets have moved away from a long-term mindset and more towards a focus on short-term results. This trend has been well observed by market participants and academics alike, yet the question as to what will serve as a catalyst to reverse the trend remains.
To this end, it’s worth highlighting a recently released white paper by The Generation Foundation and KKS Advisors focusing on the impact of regular Earnings Guidance. Thorough examination of the topic leads to the following conclusions:
• Many companies practice regular earnings guidance because they perceive guidance to bring capital market benefits in terms of analyst coverage, reduced volatility, and a lower cost of capital. Those benefits though are just perceived rather than real.
• Costs, however, are very real. Regular earnings guidance seems to be associated with myopic behavior decreasing investments that allow the firm to remain competitive in order to achieve short-term capital market targets.
• Perhaps the most worrisome part for a senior leader of a company is that regular earnings guidance attracts short-term investors. While this is not necessarily a bad thing in every case, there are many instances where a short-term oriented investor base has put pressure on the firm to maximize short-term earnings rather than the long-term value of the firm.
• Studying leading companies that have moved away from earnings guidance, the authors derived a framework and several concrete steps that CEOs can implement to move away from the practice. These steps are also designed to help minimize any confusion and uncertainty about the move among capital market participants.
In assessing the debate around the impact of regular Earnings Guidance, the authors, George Serafeim and Gabriel Karageorgiou, first provide an overview of the evolution of the issue and regulatory milestones that shaped reporting practices. Notably, Earnings Guidance popularity increased rapidly in 1996 following the extension of the Safe Harbor Law that protected companies from legal liability in performance forecasts. Following the relaxation of regulatory rules, “companies aimed to increase their transparency and provide the market with additional information while exploring new communication channels that would attract the market’s attention.”
Thereafter, Serafeim and Karageorgiou discuss the perceived benefits and actual costs associated with Earnings Guidance. On the cost side: the risks associated with incentives to manage earnings, the likelihood of attracting a more short-term oriented investor base, increasing analyst herding, and the link between managers’ financial incentives and short-term performance of their firms. On the other hand, the authors address the perceived benefits in that Earnings Guidance reduces information asymmetry, increases visibility, reduces stock price volatility and lowers litigation risk. They conclude that “the perceived benefits are either not justified by the empirical evidence (i.e., reduction of stock price volatility, increased analyst visibility) or do no justify regular adoption of the practice (i.e., information asymmetry reduction, lower litigation risk exposure).
It’s one thing to identify an issue; it’s another to provide a potential solution. Serafeim and Karageorgiou aptly anticipate the question “If not Earnings Guidance, then what?” They discuss alternative forms of communication that would benefit investors and other stakeholders including Integrated Reporting. As part of this, Integrated Guidance should be provided by which management discusses how various forms of capital (i.e., financial, intellectual, human, social) are enhanced or depleted.
In recognizing that eliminating Earnings Guidance may be perceived as a negative signal (sign of uncertainty), the authors propose a seven-step process that CEOs can use as a roadmap in ending Earnings Guidance, while minimizing the risk of being perceived negatively. Furthermore, the study offers recommendations for other organizations in the capital markets, such as sell-side brokerage houses and asset managers. Finally, the study offers case studies whereby large, well-respected companies either ended the practice of Earnings Guidance (i.e., Coca-Cola and Unilever) or chose not to provide it in the first place (i.e., Google).
Michael Shavel, CFA, is the Research & Business Analyst at Cornerstone Capital Inc. and a former Research Analyst at AllianceBernstein’s Global Growth and Thematic team. [/groups_member]