Monday, May 22, 2006

Getting Off the Quarterly Guidance Treadmill

Much of the blather of the stock market revolves around the significance of quarterly earnings results and whether or not there was a surprise element relative to expectations. CNBC commentators try to provide instant analysis..."Wow, they beat by 3 cents." or alternatively, look skeptically, "Is that before options expense?" Analysts promulgate the game with their comments both in their written reports and in their fawning before managements in conference calls, "Nice quarter, guys!"

In fact, some years ago as academics investigated the relevance of earnings surprise, entire companies rose up to meet the "need" for determining earnings forecasts, and measuring the surprises. Hence, the birth of Zacks and I/B/E/S. The assumption that all of this was somehow pertinent to determining the future trajectory of a stock seemed to drive research and an entire infrastucture of analysis. The accuracy of earnings forecasts became one of the criterion in determining analyst compensation.

Warren Buffett, Mike Jensen, and Jeff Diermeyer, the president and CEO of the CFA Institute agree that companies should get off the earnings treadmill and suspend providing guidance. Diermeyer writes in the May/June edition of the CFA Institute Magazine that there is no problem with quarterly guidance per se, but rather with the value-impairing behaviors it engenders.

He cites four value-impairing behaviors that derive from quarterly guidance:

Because, over the short-term earnings surprises are effective, it is almost Pavlovian for companies to learn to manage expectations. Diermeyer states,"The aggressive management of expectations distracts from the bond of trust between firm and investor. Corporate managements simply did not think their major investors were mature enough to realize that the world is not perfect and that companies and leadership suffered challenges and frailties."

"Quarterly earnings guidance encourages manipulation through accounting chicanery." Though chicanery has been evident in some companies, many more companies utilize aggressive accounting largely because GAAP permits a broad scope of choices and estimates. It is a huge mistake to assume that earnings represent a precise quantum of is real, earnings are merely an words, not Diermeyer's.

"All of the effort that goes into 'making the quarter' wastes valuable management time that could be put to better use in building and maintaining the business." As Diermeyer describes so eloquently, "This problem goes beyond the effort made every 13 weeks to figure out how much product to move a few feet off the company dock or how to change reserve policy to free up reserves." Failing to consider the long term by forgoing the necessary investment in order to preserve the targeted earnings is disingenuous to investors and value destructive in my opinion.

"Finally and perhaps the most destructive of all. such behavior sets a terrible example at the top. In effect, the rank and file....are given the impression that the firm makes their numbers by making up their numbers, rather than competing successfully in the marketplace."

I have commented on the "game" before. Please check, "How to Beat the Quarter- Playing Mouse Olympics." When we as investors fall for this game of extremely low hurdles and somehow attribute a management with prowess or skill for successfully scaling this, we are ignoring the reality of what really drives returns. As I said back then, " Shareholder value is, in my opinion, not created by earnings surprises,
except for an evanescent moment where the hallelujah chorus of Wall
Street ballyhoos the spasmodic 'success.' Shareholder value only comes
from building a business that can generate cash in excess of its needs,
and earn a return on its capital in excess of its cost."

According to the Diermeyer article quoting a recent poll, 76% of my fellow CFAs support companies moving away from quarterly earnings guidance and of those affirmative responses, 95% indicated that when quarterly results are released, companies should also provide additional information on the fundamental, longer term drivers of the business. I couldn't be prouder of my fellow analysts. I do wonder what the 24% who were against this notion were thinking!

The value disciplines that I describe in these posts are inherent in value thinking and investing. Do your own thinking. Understand what the competitive advantage of a business is about. Try to project its longevity. Understand the cost of capital and the potential for return on invested capital. Look for businesses that generate free cash flow.

Earnings surprise is essentially a spasmodic jolt, not unlike a shudder, or chattering your teeth. I suspect that you would not consider seeking medical attention when these things occur to you. Similarly, earnings surprise has little diagnostic value in understanding a business. A penny or two of upside or downside has no more fundamental relevance to a company than a hiccup or a belch have in understanding your gastrointestinal system.

Despite the protestations of both managements and informed investors, this silly game rages on. Skills of managements and the analysts that follow them are still being assessed on this ridculous yardstick.

I'll take fundamentals over managed numbers any day. Get those numbers in the marketplace and the factory floor, not out of the accounting office. Work on building a competitive advantage not a meaningless scorecard.


At 12:21 AM, Blogger Jay Walker said...

Bang on Rick! As usual.



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