How Regulation Promotes Short-Termism
Every so often some prominent individual in the investment community reaches the erroneous conclusion that earnings guidance is the root of all evil. The latest to promote this idea is Larry Fink, CEO of BlackRock (NYSE: BLK ). BlackRock, which has $4.6 trillion in assets under management, claims to be the world’s largest investment firm. Fink has held the top post ever since he co-founded the company in 1988. He is rumored to be at the top of Hillary Clinton’s list of candidates for Treasury Secretary, should she win the presidential election. Fink might even be petitioning for the job. CNN Money recently pointed out that he is beginning to sound a lot like Clinton herself, even to the point of using the same terminology. Both of them are on the warpath against what they call “short-termism” in corporate America. Fink penned a letter on February 1 to the CEOs of major corporations and used that term in the very first sentence, calling it a powerful force that is afflicting corporate behavior. Frankly, I can’t argue with much of what he says. I agree with him that there is too much attention paid to how a company performs over the short term and not enough paid to how it does over the long term. I consider myself a long-term investor, and I much prefer to see the companies I invest in managed with a long-term perspective in mind. For example, management can easily boost earnings in any particular quarter simply by slashing capital expenditures or by cutting spending on research and development. Yet doing so comes at the cost of long-term growth. I take exception, however, to Fink’s call to CEOs urging them to put an end to quarterly earnings guidance. This is not a new position for me. Because I feel so strongly about this issue, I devoted an entire chapter to it in my 2008 book, “Even Buffett Isn’t Perfect.” I favor guidance for a number of reasons. First, it comes straight from the horse’s mouth. Guidance is provided by the very people who are running the company. These people know better than anyone how the company is likely to do. I want to hear from them in as specific terms as possible. I don’t take what they say at face value. But I do want to hear what they have to say – then it’s up to me to judge what to make of that information. Second, studies show that analysts’ earnings forecasts are not particularly reliable to begin with… and it turns out they are even less accurate when guidance is not provided. Third, although some investors believe that executives are more likely to take actions that will increase company value over the long term if they don’t have to deal with the pressure of living up to quarterly guidance, studies on the topic uncover no evidence that companies increase capital expenditures or investments in research and development after they eliminate guidance. Fourth, studies also show that there is a negative stock price reaction when companies announce that they will no longer provide guidance. Interestingly, although management usually says they are eliminating guidance because they believe it is in the best interest of investors, it turns out they usually eliminate guidance when the company is having financial difficulties. What’s even more interesting is that these very companies often change their minds and begin providing guidance again when business conditions improve. There is one critical issue I wish everybody would understand. While it’s true that there is too much focus on short-term results, this isn’t the result of guidance. The reason investors pay so much attention to quarterly earnings in the first place is that the SEC requires corporations to report their financial results every quarter. That’s right. Short-termism is a direct result of regulation. So if you really believe that short-termism is a problem, instead of urging CEOs to stop providing guidance, it would be more effective if you urged the SEC to end the quarterly reporting requirement. To be clear, Larry Fink is not in favor of that. Neither am I. Perhaps this is the greatest irony of all. Our country recently went through a financial crisis that was in part caused by a lack of transparency. In response, regulators implemented all kinds of new rules specifically designed to increase transparency. Eliminating guidance, however, does exactly the opposite. It reduces transparency. To say that we’d be better off with less guidance is the equivalent of saying that we’d be better off with less information. That’s simply nonsense. As I said earlier, research studies show that there is a statistically significant loss in share value when companies eliminate guidance. These studies also show that companies that eliminate guidance continue to underperform for as long as a year. So if you own shares in a company that has regularly provided guidance and then stops doing so, you might want to think about getting out of that investment. On the other hand, if you are invested in a company that has never provided guidance, you need not worry. Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ) and Alphabet (NASDAQ: GOOG ) (NASDAQ: GOOGL ) are two companies that have performed well over the long term. Neither one has ever provided guidance.