The following may be controversial. It also may be dull to the point that you might not care. Here’s why you should care: quarterly reporting is a useful and productive use of corporate resources, and it would be a shame to lose it because some people with a patina of intelligence think it is harmful. Who knows? Losing it might even make you poorer.
The cause for tonight’s article is a piece from the Wall Street Journal, Time to End Quarterly Reports, Law Firm Says. Here’s the first two sentences:
Influential law firm Wachtell, Lipton, Rosen & Katz has an idea that may be music to the ears of its big corporate clients and a nightmare for some investors and analysts: end quarterly earnings reports.
Wachtell on Tuesday called on the Securities and Exchange Commission to consider allowing U.S. companies to do away with the obligatory updates, one of the most important rituals on Wall Street and in corporate America, suggesting that they distract executives from long-term goals.
The basic case is that quarterly earnings lead companies to behave in a short-term manner, and underinvest for longer-term growth, thus hurting the US economy. I disagree. There are at least four things that are false in the arguments made in the article, and in books like Saving Capitalism from Short-Termism:
- Quarterly earnings don’t produce value in and of themselves
- Quarterly earnings cause most corporations to ignore the long-term.
- Ending quarterly earnings will end activism, buybacks, and dividends.
- Buybacks and dividends are bad uses of capital, and more capital investment, especially for long-dated projects, is necessarily a good thing.
Why Quarterly Earnings are Valuable
I’ve written a number of articles about quarterly earnings and estimates of those earnings: Earnings Estimates as a Control Mechanism, Flawed as they are, and Earnings Estimates as a Control Mechanism, Flawed as they are, Redux. The basic idea is this: quarterly earnings results give investors an idea as to whether the companies remain on their long-term growth path or not. As I wrote:
Most of the value of a Corporation on a going concern basis stems from the future earnings of the company. Investors want to have an estimate of forward earnings so that they can gauge whether the company is growing at an appropriate rate.
Now, it wouldn’t matter if the system were set up by third-party sell side analysts, by buyside analysts, by companies themselves, or by a combination thereof. The thing is investors are forward-looking, and they want a forward-looking estimate to allow them to estimate whether the companies are doing well with their current earnings or not.
Don’t think of the quarterly earnings in isolation. A good or bad quarterly earnings number conveys information not about the current period only, but about all future periods. A bad earnings number lowers the estimates of all future earnings, telling market players that the long-term efforts of the company are not going to be so great. Vice-versa for a good number.
Now, in some cases, that might not be true, and the management team will say, “But we still expect our future earnings to reach the levels that we expected before this quarter.” That still leaves the problem of getting to the high future earnings, which if missed will lead the market to reprice the stock down.
They might also use a non-GAAP measure of earnings to explain that earnings are not as bad as they might seem. In the short-run the market may accept that, but if you do that often enough, eventually the markets factor in the many “one-time” adjustments, and lower the earnings multiple on the stock to reflect the reduced quality of earnings.
In addition, having shorter-term targets causes corporations to not get lazy in managing expenses and capital. When the measurement periods get too long, discipline can be lost.
Quarterly Earnings Don’t Cause Most Firms to Neglect the Long-Term
Firms aren’t interested in only the current period’s earnings, but about the entire future path of earnings. Even if the current period’s earnings meet the estimates, the job is not done. If there aren’t plans to grow earnings for the next 3-5 years, eventually earnings won’t meet the expectations of investors, and the price of the stock will fall. The short-term is just the beginning of the long-term. It is not either/or but both/and. A company has to try to explain to investors how it is growing the value of the firm — if present targets aren’t being met, why should there be any confidence that the future will be good?
Think of corporate earnings like a long-term project which has a variety of things that have to be done en route to a significant goal. The quarterly earnings measure whether the progress toward completing the goal is adequate or not. Now, the measure is not perfect, but who can think of a better one?
Ending Quarterly Earnings Would Not End Activism, Buybacks, and Dividends
I can think of an area in business where earnings estimates don’t play a role — private equity. Are the owners long-term oriented? Yes. Are they short-term oriented? Yes. Is capital managed tightly? Very tightly. All excess capital is dividended back — it as if activists run the firms permanently.
If there were no quarterly earnings in the public equity markets, firms would still be under pressure to return excess capital to shareholders. Activists would still analyze companies to see if they are badly managed, and in need of change. If anything, when companies would release their earnings less frequently, the adjustments to the market price of the stock would be more severe. Companies that disappoint would find the activists arriving regardless of the periodicity of the release of earnings.
On the Use of Excess Capital
Investing, particularly for the long-term, is not risk-free. In an environment where there is rapid technological change, like there is today, it is difficult to tell what investments will not be made obsolete. In such an environment, it can make a lot of sense to focus on shorter-term investments that are more certain as to the success of the project. It is also a reason why dividends and buybacks are done, as capital returned to shareholders is associated with higher stock prices, because the capital is used more efficiently. Companies that shrink their balance sheets tend to outperform those that grow them.
As an example, large acquisitions tend not to benefit shareholders, while small acquisitions that lead to greater organic growth do tend to benefit investors. The same is true of large versus small investments for organic growth away from M&A. Most management teams can adequately estimate and plan for the growth that stems from incremental action. Large revolutionary investments are another thing. There is usually no way to estimate how those will work out, and whether the prospects are reasonable or not.
In one sense, it’s best to leave those kinds of investment projects to highly focused firms that do only that. That’s how biotech firms work, and it is why so many of them fail. The few winners are astounding.
Or, think about how progressive Japanese firms were viewed to be in the 1980s, as they pursued long-term projects that had very low returns on equity. All of that failed, to a first approximation, while the derided American model of shareholder capitalism prospered, as capital was used efficiently on projects with high risk-adjusted returns, and not wasted on speculative projects with uncertain returns. The same will prove true of China over the next 20 years as they choke on all of their bad investments that yield low returns, if indeed the returns are positive.
Remember, bad investments are just expenses in fancy garb — it just takes the accounting longer to recognize the losses. Think of Enron if you need an example, which brings up one more point: good investing focuses on accounting quality. Accrual items on the asset side of the balance sheets of corporations get higher valuations the shorter the accrual is, and the more likely it is to produce cash. Most long term projects tend to be speculative, and as such, drag down the valuation of the stock, because in most cases, it lowers the long-term earnings of the company.
If quarterly earnings are abolished, intelligent corporations won’t change much. Investment won’t go up much, and the time horizon of most management teams will not rise much. If you need any proof of that, look at how private equity and large mutual insurers manage their firms — they still analyze quarterly results, and are conservative in how they deploy capital.
The only great change of eliminating quarterly earnings will be a loss of quality information for equity investors. Bond investors and banks will still require more frequent financial updates, and equity investors may try to find ways to get that data, perhaps through the rating agencies.
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