How good a guide is guidance?
Short-term trading is not investing
The shortening of time horizons among professional investors in the United States has been occurring for decades and is a function of the corruption of what investing actually is. Professional investors now destabilise markets, not through buying and selling based on changes of opinion about the outlook for a business or its value, but simply by attempting to anticipate its short-term price movements and reacting more quickly than others.
John Maynard Keynes observed this devolution in 1936:
“Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from 100 photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole … It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
It seems little has changed, and if anything, the situation has become much worse. Sitting in our investment committee meetings, I am constantly surprised by the obsession of others with short-term earnings. In the US, a company that misses quarterly guidance or expectations is savaged, as if the change in the rate of growth over the prior 12 weeks signals a permanent end to its fortunes. Conversely, a company that beats its quarterly guidance is heralded as the new growth stock and its shares priced as if the rate experienced over the last 90 days will continue indefinitely.
Little thought, it appears, is paid to the possibility that the company was always going to report the number it ultimately did and that the guidance might have been set so it could be beaten.
Corruption of strategic visions
Hillary Clinton, in a speech a year ago at New York University, proclaimed, “It’s time to break free of the tyranny of quarterly capitalism.” She’s onto something. Pressure from recently minted analysts, who have never run a business, to have their earnings models and estimates validated by corporate CEOs and CFOs is an obvious case of the tail wagging the dog. It also corrupts a company’s strategic decision-making by prioritising the short-term needs of a bunch of disloyal gamblers over the long-term valuation creation requirements of investor-owners.
Investing has been corrupted by the focus on betting on rising share prices. A company that meets or beats guidance is likely to experience a huge bounce and academic studies showing stocks ‘outperform’ over the three, four or five subsequent days after a ‘positive surprise’ only fuels the fire of the addicts, reinforcing the gambling and speculative behaviour and reducing the stock market to a casino.
Lost along the way has been the understanding that the stock market is a venue through which investors can share in the wealth created by the compounding of profitably reinvested retained profits.
It seems, however, that July 2016 might mark a turning point. In a carefully worded open letter, the chiefs of America’s largest corporations and investment managers, including Warren Buffett, Jamie Dimon, Jeff Immelt, Larry Fink and others representing Blackrock, Vanguard, General Motors, T.Rowe Price and State Street Global Advisors, outlined a series of common-sense corporate governance principals such as:
“Our financial markets have become too obsessed with quarterly earnings forecasts. Companies should not feel obligated to provide earnings guidance – and should only do so if they believe that providing such guidance is beneficial to shareholders.”
Expanding on the above summary, the full document recommends: “Companies should frame their required quarterly reporting in the broader context of their articulated strategy and provide an outlook, as appropriate, for trends and metrics that reflect progress [or not] on long-term goals. Companies should determine whether providing earnings guidance for shareholders does more harm than good. If a company does provide earnings guidance, it should be realistic and avoid inflated projections. Making short-term decisions to beat guidance [or any performance benchmark] is likely to be value destructive in the long run.”
There is little doubt that when a company’s management announces a forecast, and some weeks out it becomes obvious it won’t meet the target, there is a very great temptation to find the difference, perhaps borrowing it from the future or even worse, borrowing it from thin air. Removing temptation is clearly superior.
There can be little doubt that the future of Australia, its employees, and investors, depends on the effective management of business and companies for long-term prosperity.
The recent evidence that corporate payout ratios for Australia’s top 200 companies have increased from 55% in 2010 to nearly 80% today (leaving just 20% of earnings retained and reinvested for growth), says a great deal about our nation’s growth prospects as well as the serious need to think beyond next quarter and the analyst community’s desire for short-term earnings certainty.
Article contributed by Montgomery Investment Management: (VIEW LINK)
Roger Montgomery founded Montgomery Investment Management, www.montinvest.com in 2010. Roger brings more than two decades of investment, financial market experience and knowledge. Roger also authored the best-selling investment book, Value.able.