Shareholder Communications: Why 'Short Termism' May Be Short Lived

Imagine for a moment turning on CNBC and watching Maria Bartiromo explain that while Company X has just announced it missed the “consensus earnings estimate” by a penny, resulting in a 10 percent drop in share price, she gleefully reports what the company is doing to create long-term value.

Few issues related to business management are as insidious as the market’s obsession with short-term results. Earlier this year, the U.S. Chamber of Commerce convened an independent, bipartisan commission on the regulation of U.S. capital markets in the 21st century. The commission’s key focus was on quarterly earnings projections as a causal factor for managements’ short-term behavior in running their companies. Specifically, the commission recommended that companies “stop issuing earnings guidance or alternatively, move away from quarterly earnings guidance with one earnings-per-share (EPS) number to annual guidance with a range of EPS estimates.”

In 2006, the CFA Centre for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics published a report called, “Breaking the Short-Term Cycle,” which took a broader view of the causes for short-term behavior. While pointing the finger at quarterly earnings guidance, the panel of participants, which included thought leaders from corporate issuers, analysts, and investors, confirmed what academic research suggests: “The obsession with short-term results by investors, asset management firms, and corporate managers collectively leads to the unintended consequences of destroying long-term value, decreasing market efficiency, reducing investment returns, and impeding efforts to strengthen corporate governance.”

What is often left out of the short-termism discussion is the effect of short-term compensation incentives for asset managers and corporate management. Consequently, the report recommends that compensation should be structured to achieve long-term strategic and value-creation goals.

Additionally, the report calls for leadership in shifting the focus to long-term value creation. Clearly, corporate boards of directors have an opportunity to play a significant role in providing this leadership to reverse the market’s myopia. They can achieve this by structuring executive compensation to focus on long-term goals and by providing strategic guidance to management that results in long-term value creation.

Just Say No

Is there a relationship between quarterly financial guidance and short-term behavior? A National Bureau of Economic Research survey of 401 financial executives found that 80 percent said they would decrease spending on research and development, advertising, maintenance, and hiring in order to meet short-term earnings targets and 55 percent said they would delay new projects, even if it meant sacrificing longer-term value creation.

Even more shocking was a Duke University survey of CFOs that found that, “nearly 90 percent of respondents admit that business decisions are often based on tenure considerations. That is, managers don’t develop strategies for the long term because they don’t expect to be around to see them reach fruition.”

A June 2007 survey of earnings guidance practices by the National Investor Relations Institute found that 71 percent of respondents provide financial performance measurements such as EPS, revenue, cash flow, and other quantifiable measures. Additionally, 51 percent provide earnings guidance, down from 66 percent in 2006. Consistent with the trend found in the 2006 survey, twice as many companies that are providing earnings guidance are doing so on an annualized basis rather than quarterly. The survey found that most companies that provide financial guidance do so to ensure that the sell-side consensus estimate is closely aligned with that of the company and achieves reasonable expectations from sell-side analysts.

The positive side of providing some form of guidance—financial or non-financial—is that it is a means of maintaining communication with the investment community. The negative side of financial guidance—primarily focused on earnings—is that it continues to feed the needs of the sell side to make quarterly estimates. The buy side is less focused on quarterly numbers. And, with the prospects for the future of the sell side continuing to dim, investors could see a lessening effect on short-term behavior by analysts and corporations.

Herein lies a key factor that is often missing as boards and senior management discuss whether they should continue to provide earnings guidance. The influence of the sell side is clearly waning and some even project that the it will become extinct in the foreseeable future. Why? The commissions that once supported sell-side research are rapidly declining. Firms such as Prudential have closed their sell-side research operations and Goldman Sachs only provides sell-side research to a few select clients.