The Securities and Exchange Commission estimates hedge funds control more than $1.2 trillion in assets. That might represent only 5 percent of U.S. assets under management, but hedge funds account for more than 30 percent of all U.S. equity trading volume. Given the trend toward increased volatility, it’s not surprising to see renewed calls for companies to stop giving quarterly earnings guidance—on the theory that an undue focus on quarterly numbers generates volatility unrelated to the company’s underlying value.
What is surprising, however, is that large institutional investors such as public employee and union pension funds overwhelmingly endorse discontinuing quarterly earning guidance too.
Reports Of Short-Termism
The ultimate fear about earnings guidance is that it gives rise to a climate of “short-termism,” where investors ignore the long-term fundamental health of companies. Such worries have existed for years, but within the past year, three major reports have outlined a renewed focus on ”short-termism” in the capital markets.
In the spring of 2006, The Conference Board issued “Revisiting Stock Market Short-Termism,” the product of a Corporate-Investor Summit held in July 2005 in conjunction with the International Corporate Governance Network meeting in London. The report chronicles a “cycle” dating back to the 1980s when Japanese and German companies were perceived to be better competitors than their U.S. counterparts, because they planned and financed for the long term. The report found that a “chain” of actions by corporate managers, analysts, and investors militated in favor of a short-term quarterly focus, to the detriment of corporations’ ability to manage for the long-term. It also said that chain must be broken by concerted and coordinated efforts by all parties wrapped up in it.
In the summer of 2006, “Breaking the Short-Term Cycle,” was published by the CFA Institute and the Business Roundtable’s Institute for Corporate Ethics. Among other recommendations, companies were encouraged to end the practice of providing quarterly earnings guidance. If companies have “strategic needs” for providing earnings guidance, however, they should adopt range estimates and appropriate metrics “that reflect overall long-term goals and strategy.”
Just this past March, a third report was issued by a bipartisan commission established by the U.S. Chamber of Commerce: “The Commission on the Regulation of U.S. Capital Markets in the 21st Century.” To address concerns that U.S. capital markets do not foster sufficient confidence to maintain their global predominance, the chamber’s report also recommended companies stop giving earnings guidance and substitute a “fuller explanation of their long-term goals and their strategies for achieving those goals.” (See box at right for all three reports).
The U.S. Chamber report provides a brief but comprehensive survey of key studies and findings that support discontinuation of quarterly earnings guidance:
Corporate executives are likely to make suboptimal company decisions to meet analyst expectations;
Companies that are “dedicated” providers of earnings guidance invest significantly less in research and development than companies that are “occasional” providers of earnings guidance;
Long-term earnings growth rates of “dedicated” guiders are significantly lower than those of “occasional” guiders; and
Companies that rely on adjusting accruals or reducing discretionary expenditures to exceed consensus numbers achieve short-term positive impact on their share prices, but over the long-term, these companies tend to underperform relative to firms that do not manage their earnings to exceed forecasts.
Pozen
The topic came up again at the Council of Institutional Investors’ spring meeting held in March. U.S. Chamber Commissioner Bob Pozen, chairman of MFS Investment Management, noted to the audience that the SEC’s 2002 safe harbor rule encouraged companies to provide guidance; consequently, in 1994 less than 200 companies provided guidance, while by 2002, more than 1,200 in the United States made quarterly earnings projections. “This is insanity,” Pozen said, for all the reasons cited in the Commission’s report. He also pointed to one study, however, which showed that companies that stop giving earnings guidance tend to do so in advance of negative news.
Pozen urged companies join in “collective action” with those large well-respected companies such as Coca Cola and Pfizer that already do not provide quarterly guidance. In addition to Coca Cola and Pfizer, other companies at the CII meeting that don’t provide earnings guidance included Sunoco and Chevron. Chevron’s corporate secretary, Lydia Beebe, said her company instead provides projections for capital expenditures, a substitute strategic indicator.
Reaction From Institutional Investors
Companies feeling obliged to provide quarterly earnings guidance often do so because they are in industries such as retail, with notoriously short time horizons. They may also be smaller-cap companies or have fewer analysts covering them and don’t want to risk reduced analyst coverage.
An informal poll of institutions attending the CII meeting, however, showed remarkable unanimity among large institutional investors that earnings guidance should go. For example, the following investors (with more than $1 trillion in assets under management) support companies that do not provide quarterly earnings guidance:
Jack Ehnes, CEO of the California State Teachers Retirement System, said his public pension fund has long-term beneficiary payout requirements and supports companies that stop giving quarterly earnings guidance.
Mark Anson, former chief investment officer of the California Public Employee Retirement System and now chief executive of Hermes Investment Management in Great Britain, encourages corporations to focus on their “long-term prospects” and not get caught in the “noise of quarterly earnings management.”
Damon Silvers, associate general counsel of the AFL-CIO Pension Plan, said his union fund supports companies not giving earnings guidance because “there are different interests between funds and money managers and brokers.” The quarterly earnings focus is “part of a casino gambling market” where the quarterly earnings numbers provide a “defined event that can be used by various segments of the marketplace to make money.” Silvers said this activity is not in the fund’s best interest.
Richard Ferlauto, director of pension & benefit policy at the American Federation of State County and Municipal Employees, said he doesn’t believe in quarterly earnings guidance “because it distracts and diverts management from its focus on providing long-term shareholder returns” and encourages earnings manipulation. Asked what information AFSCME might like to have instead, Ferlauto said companies providing strategic extra-financial numbers that now may be regarded as “soft” should try to make them “harder” so they can be relied upon by investors.
Peter Gilbert, a U.S. Chamber Commissioner and chief investment officer of the Pennsylvania State Employees’ Retirement System, supports withholding earnings guidance to reduce earnings manipulation. Instead, he would like to see more “strategic information” and agrees that money mangers entrusted with assets from the Pennsylvania fund should be given a three- to five-year benchmarked time frame to hit their earnings targets and should not be sacked for “missing one or two quarters.”
Daniel Summerfield, co-head of responsible investment at USS (the major U.K. fund representing academics throughout Britain) pointed to a global investor-led initiative aimed at encouraging better long-term and integrated investment research. The “Enhanced Analytics Initiative” currently includes Continental European, U.K., U.S., Canadian, and Australian pension funds and asset managers with approximately $2.4 trillion in assets under management. Members pledge to allocate a proportion of their brokerage commissions to “interested and appropriate research agencies to encourage them to adapt their research process” and to compile better, longer-term, and more detailed analysis of extra-financial issues within mainstream research rather than the quarterly numbers. The initiative intends to prime sell-side brokers with a direct financial inducement for firms whose analysts engage in longer-term research and extra financial issues.
Others in agreement include: John Wilcox, vice president of corporate governance at TIAA-CREF; Michael McCauley, director of investment services and communications for the State Board of Administration of Florida, who has been researching corporate compensation practices; Anita Skipper, head of corporate governance of Morley Fund Management in Great Britain; and noted governance activist and Corporate Library Editor Nell Minow.
Ehnes
In addition to his comments on CalSTRS’ policies, Ehnes, who also serves as chairman of the CII, says he believes most CII institutional investors would likely approve of companies taking a long-term instead of a quarterly earnings focus. In support he cites two recent CII membership votes: (1) to endorse a major new Ceres initiative calling for shared action “on a large scale over a long period of time” to mitigate climate risk; and (2) to endorse a series of long-term investment principles put forward by the Aspen Institute.
While proxy season raises issues that divide companies and investors, this spring, the practice of companies discontinuing quarterly earnings guidance may well provide the basis for an unusual but welcome consensus.
No comments yet