Can investors have too much information? Leading market experts warn that quarterly forecasts are not very useful to investors and they often lead to an unhealthy focus on short-term profits at the expense of a long-term growth strategy.
Several respected authorities, including Berkshire Hathaway CEO, Warren Buffett, and JP Morgan CEO, Jamie Dimon, have lamented the issuance of quarterly earnings forecasts by the management of publicly traded companies. While I agree with their sentiment, I fear that it is misunderstood by others who are suggesting that it should include the elimination of quarterly earnings reports (as found in Form 10-Q). This would be a mistake in my opinion as investors deserve all relevant information to make informed decisions about allocating their capital and managing the risks of their investments.
At issue are the concerns of Buffett and Dimon that “quarterly earnings guidance [forecasts] often leads to an unhealthy focus on short-term profits at the expense of long-term strategy, growth, and sustainability.” The two industry leaders point out that, when companies set earnings expectations, they then become hesitant to spend on expansion efforts which can crimp earnings growth. The obligation to deliver earnings as forecasted sometimes forces management to do things they would not ordinarily do, which could include massaging the numbers to close the gap. At the very least, it
Quarterly Earnings Reports Still Important
While there are some people also calling for the elimination of quarterly earnings reports, Buffett and Dimon are only targeting earnings forecasts. The distinction is important because the former is based on factual information about the company that informs investors, while the latter is more or less a prediction based on assumptions and best estimates. Buffet and Dimon have both expressed their support for the continued issuance of quarterly earnings reports.
Quarterly reporting is much more than simply announcing a company’s earnings per share. It provides critical information in the form of financial statements and management commentary. More importantly, it informs investors about new or changed risks that could impact the company’s performance. Investors have relied on quarterly reports since 1934 when the Securities and Exchange Commission first mandated them. They provide the transparency investors need to be able to make informed decisions and entrust their money to company management. Eliminating that would put investors in the dark while tilting the playing field towards professional investors who might have more access to inside information.
Even Without Short-Term Forecasts Companies Can Still Take a Short-Term View
The number of companies issuing quarterly forecasts has been declining over the last several years. Currently, less than one-third of S&P 500 companies still issue them, while major companies, such as Facebook Inc. (NASDAQ:FB), BP Plc(NYSE:BP), Unilever NV (NYSE:UN), and GlaxoSmithKline Plc (NYSE:GLK) have abandoned quarterly guidance in favor of multiyear outlooks.
It is important to note that, just because a company may not issue a quarterly forecast, it’s not necessarily an indication that it is committed to a long-term view. Company management is still under pressure to grow earnings per share. When a CEO’s compensation is tied to the company’s stock price, which equates to earnings in most shareholders’ minds, you can be certain it will some impact on the CEO’s behavior. And, although a company may not issue a quarterly forecast, Wall Street often does, which creates the same short-term performance pressures.
Investors Need to Focus on the Vital Issues
While investors should be leery of companies that try to predict the future through quarterly forecasts, they should also consider other factors that strongly indicate a company’s ability and willingness to invest in its future. For example, companies with strong free cash flow and the willingness to reinvest it for growth at the expense of current earnings, tend to grow earnings over the long-term.
A great example is Starbucks (NASDAQ:SBUX). When Starbucks entered China in the late nineties, Wall Street was not convinced it could succeed. As the company struggled in the early stages, analysts peppered CEO, Howard Schultz, with questions about when it will show profits. He simply answered back, “How big do you want us to be?” He essentially told them if they want Starbucks to succeed in China, then allow them not to show profits for a while and they’ll end up dominating the market. Today, Starbucks is firmly established in China, which is its key growth market. By the way, Starbucks does not issue quarterly forecasts – it issues annual guidance.
Ignore the Short-Term Noise
Investors should take advantage of the information available in quarterly earnings reports to make informed decisions. However, as famed investor Warren Buffet has warned, earnings forecasts are questionable at best since they deal with the uncertainties of the future. At worst, they can be a distraction for management if it causes them to “manage earnings” rather than plan and invest properly for the future.
The bottom line is, the more due diligence you can do to understand a company’s capacity to grow sustainable earnings over the long-term, the less inclined you will be to listen to the “noise” that comes from short-term forecasts.
