In 1901, George Westinghousesent a letter to his shareholdersexplaining that WestinghouseElectric hadn’t issued financialreports for the prior four yearsbecause it wasn’t in “the interestsof all.” The company didn’tbother with another annualreport until 1906.
Companies today can onlydream about investors willing togive them such latitude. Instead,many often feel hostage to WallStreet’s drumbeat for ever-higherquarterly earnings. The debateover long-term managerial focusand what companies shouldreport to their shareholders haswelled up again in recent years,after the meltdown of many companiesprompted widespreadreaction to what many see asexcessive pressure on executivesto deliver consistent results, evenat the expense of longer-termperformance.
The concerns have produced agrowing outcry for change. Initially,the calls came from pensionfunds and other institutionalinvestors that invest heavily inindex funds. More recently, businessgroups have joined thedebate, with recent statementsagainst short-termism comingfrom the U.S. Chamber of Commerceand the Business RoundtableInstitute for CorporateEthics, among others.
The Aspen Principles
The most ambitious campaignhas been mounted by the AspenInstitute, an independent leadershipthink tank. Last summer, afour-year effort culminated in theso-called Aspen Principles, a documenttitled “Long-term ValueCreation: Guiding Principles forCorporations and Investors.” Onereason the paper took so long todraw up is that the principles representa consensus view of groupsfrom both of these camps, includingthe Business Roundtable,Office Depot, PepsiCo, Pfizer,and Xerox on the company side,and investors such as the AFLCIO,the California PublicEmployees’ Retirement System(CalPERS), and the Council ofInstitutional Investors (CII).
The principles represent aremarkable achievement, givenhow these groups square offagainst each other on issues rangingfrom proxy access to executivecompensation. Despite themeeting of the minds, the AspenPrinciples remain a work inprogress. They call on companiesand investors to use long-termmetrics on a range of behavior,from corporate operations to executivepay. But while the groupcame out clearly against themuch-criticized practice of quarterlyearnings guidance, it didn’tgive a clear and detailed descriptionof what the alternative metricsshould look like. It’s now taking upthat task, as well as searching forways to draw in more companies,says Judith Samuelson, executive director ofthe Aspen Institute’s Business and SocietyProgram. The group started the follow-upeffort in December.
A key hurdle is defining exactly what theproblem is, which can be difficult to pindown even after all these years of complaints.There does seem to be someconvincing evidence that a short-term perspectivecan drive inferior corporateperformance. For example, a recent studyby REL consultants of Atlanta found thatthe 1,000 largest U.S. companies employeda variety of short-term tactics toboost their collective working capital by$100 billion in the last quarter of 2006—only to see all those gains erased whenworking capital plunged by a total of $122billion in the first quarter of 2007. RELfound similar patterns in 2004 and 2005.The study identified five common practicescompanies used to pump up theiryear-end numbers, including product discounting,delaying payment to suppliers,accelerating the collection of bills due,halting inventory purchases, and runningat full capacity to reduce overheads.
Since executive compensation typicallyis tied to corporate performance in variousways, critics argue that such manipulationstems from misaligned pay incentives thatprompt widespread earnings manipulation.“It is clear that year-end gamesmanship isakin to binge dieting, where an unreal andunsustainable illusion of beauty is createdfor the purpose of meeting the expectationsof others,” REL’s report concludes.
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The Aspen Principles
- Companies stop providing quarterly earnings guidance to analysts
- Corporate boards communicate with long-term oriented investors on senior executive compensation
- Senior executives hold stock rewards beyond their tenure
- Senior executives are banned from hedging the risk of long-term oriented stock options
- “Clawbacks” are used to recoup comp later proven undeserved
Earnings Misguidance
However, the evidence gets somewhatmurkier when it comes to quarterly earningsthemselves. The practice of issuingearnings forecasts began in the early 1980s,a few years after a 1978 decision by theSecurities and Exchange Commission toallow companies to issue forward-lookingprojections, provided they were accompaniedby appropriate cautionary language.Quarterly forecasting became commonplaceby the 1990s, leading to all the gamesmanshipduring the late-decade tech boomin which day traders would punish stocksthat missed the consensus forecast. In thewake of the tech-market crash, the SEChelped put a lid on some of the excesses byrequiring companies to give guidance andother material information to all investorssimultaneously (Regulation Fair Disclosureor RegFD).
Some companies then began to ditch thequarterly earnings practice. Gillette wasamong the first, in 2001, when it followedthe advice of board member WarrenBuffett, whose own Berkshire Hathawayhad never indulged in the quarterly game tobegin with. Coca-Cola, where Buffet alsosat on the board, followed suit the next year,as did Intel. McDonald’s did so in 2003.
What’s unclear in all the debate is justhow much the pressure to deliver quarterlyresults drives short-termism. Some criticsthink that companies which drop suchguidance just want an excuse to cover upmanagement failures. For example,Gillette’s move came after the razor companymissed its own earnings targets seventimes and took a hit to its stock price eachtime.
Some evidence for such a skeptical viewcame in a study last year by University ofFlorida professor Joel Houston and twoothers. The companies that drop quarterlyearnings guidance, they found, tend to beunderperformers. Their analysis, whichlooked at 222 companies that stopped guidancebetween 2002 and 2005, also foundthat investors got less forward-looking informationfrom these companies afterward.What’s more, the lack of guidance led toincreased volatility, presumably becauseinvestors had less information. Since volatilitycan attract short-term traders looking fora quick buck, it’s not at all clear that doingaway with the short-term guideposts frees upthese companies to focus on the long term.
In fact, the study found some counterintuitiveindications that the reverse mayhave happened. For one thing, those thatdropped quarterly guidance didn’t subsequentlyincrease their capital investmentsor research and development budgets—anunsettling finding in light of the argumentthat such long-term planning often is sacrificedwhen companies operate quarter toquarter. In addition, Houston and his colleaguesfound that nearly a third of companiesthat dropped guidance started rightup again later on. “Taken together, our evidenceindicates that guidance stoppers aretroubled firms, not role models for mitigatingmanagerial myopia by ceasing quarterlyguidance,” the authors conclude.
While the question of quarterly guidancemay not yet be settled, both corporate andinvestor groups agree that an emphasis onshort-term results has led many U.S. companiesastray in recent decades. What’s lessclear is whether they can come to an agreementabout what it means to focus corporatestrategy on the long term.