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.
The Buy Side is Coming
Meanwhile, over the past few years, buy-side firms have substantially increased their research capabilities and continue to build their sector research—once the purview of the sell side.
Add to this the emerging trend where the bulk of stock selection is being conducted by Ph.D. quantitative types, or “quants,” who use algorithms and other mathematical techniques to create baskets of stocks, such as Exchange Traded Funds (ETFs) that are electronically traded on the major exchanges. So, the emphasis on stock selection based on traditional financial analysis, is being replaced by quantitative means. Earnings projections play a minor role, at best, in this process.
These changes in market structure and how stocks are selected give corporations an opportunity to break the back of short-termism and instead focus on long-term strategies and value creation.
A new Rivel Research Group study, which sampled 243 buy-side investment professionals from some of the leading mutual, pension, and insurance funds, found that management credibility and an effective business strategy remain the leading factors for making investment decisions, outweighing such factors as earnings per share, reliable cash flow, and a strong balance sheet.
While it is clear that corporations alone cannot break the short-term cycle, in light of the above factors they now have an opportunity to play a major role. The board of directors should provide the necessary leadership to make substantive changes in management’s behavior. How can this be done?
- The board’s power to establish executive compensation philosophy and performance goals is clearly a way to demonstrate effective leadership. In developing a compensation philosophy and the resulting goals, directors would be well advised to reflect on the current emphasis on financial metrics used to measure performance. Financial metrics are key drivers of earnings guidance. Companies that have eschewed financial guidance are now focusing on non-financial guidance that is more long-term oriented. These measures are statements about market conditions, trend information, industry-specific information, and main factors that drive earnings.
- Boards should recognize that more than half of the market value of the average S&P 500 company can be attributed to non-financial factors, key among them “quality of management.” While there are no standard methods of measuring this factor, it’s like defining pornography—you know it when you see it. The board’s role in selecting the CEO, fostering the development of top-quality management, and planning for success cannot be overemphasized.
- Other non-financial factors such as research and development expenditures, sales and marketing, innovation in creating new products and services, development of human capital, corporate brand, and reputation, also play major roles in investment decision making.
- The board should work closely with senior management to create a vision for the company that focuses on long-term value creation. Emphasizing long-term goals will send a clear message to investors and asset managers that the company is serious about long-term value and will not react to short-term issues by drawing down on future commitments to meet immediate needs.
- The CEO, CFO, and the investor relations officers must effectively communicate the corporate vision and strategies leading to long-term value-creation. The board should insist on periodic perception studies of investment professionals to determine if the strategies the company is taking are resonating with Wall Street. Perception studies should also measure senior management’s credibility, integrity and leadership.
- Finally, the board and senior management should have an in-depth discussion on the company’s guidance policy. If the company provides quarterly earnings guidance, the board should know why. While there may be some value in providing annualized financial guidance using a range of estimates, the board should question the extent to which this practice continues to feed Wall Street’s appetite for near-term financial results. An alternative is to focus on the non-financial factors that lead to long-term value creation. Boards should not forget that there are more than 80 million investors in the United States and less than a million are viewing the financial news networks as the commentators get excited over which stocks hit or missed the “consensus numbers.”
So Be It
In this era of rapid and significant changes in market structure and the means for selecting which stocks will lead to sound investments, boards have an opportunity, as never before, to demonstrate strong and effective leadership by breaking the short-term cycle and getting senior management to focus on long-term value creation.
Louis M. Thompson, Jr., is a managing director at Kalorama Partners, a global business consulting firm founded in 2003 by former Securities and Exchange Commission Chairman Harvey L. Pitt.