Why Eliminating Earnings Guidance Is a Bad Idea

Includes: DIA, QQQ, SPY
by: Vahan Janjigian, CFA

As stocks bucked the trend by rallying in September, President Obama was out in force trying to sell healthcare reform. Unlike previous presidents who liked to keep a low profile, this one keeps popping up everywhere. He even appeared on just about every possible television program.

However, the talk among financial regulators focused on the short term versus the long term. They want less of the first and more of the second. Corporate directors apparently feel the same way. According to Agenda, a newsletter for corporate directors published by Financial Times, independent directors claim that pressure to focus on shortterm results is the biggest corporate governance issue they face.

Clearly, running a corporation with a long-term perspective in mind is better than trying to maximize earnings or the stock price during any particular quarter. For example, management could easily boost earnings this quarter by delaying capital expenditures or investments in research and development. Doing so, however, could prove costly over the long term. While we all want to see more long-term thinking, how best to achieve that goal is subject to debate.

One proposal that comes up repeatedly is to ban quarterly earnings guidance. Many observers blame guidance for fostering a myopic investment and management style. However, as I explain in chapter 10 of my book, Even Buffett Isn’t Perfect, eliminating guidance is a bad idea. Research studies show that ending guidance not only reduces the amount of information disseminated to shareholders, it also increases uncertainty and the disparity between actual earnings and the consensus estimate.

In addition, it results in a statistically significant loss in shareholder wealth; and it does nothing to reduce the focus on short-term results or increase the emphasis on the long term.

Other proposals to encourage long-term thinking make more sense. For example, in the U.S. we currently tax long-term capital gains at lower rates than short-term gains. If we want investors to pay more attention to long-term results,we should reduce the tax rate on long-term gains even further. If we want to be serious about this, let’s eliminate taxes altogether on any gains that are accrued over periods of 10 years or longer.

Let’s also look at voting rights. As things stand today, any investor with deep pockets can buy a bunch of shares and have as much say as the investor who has owned the stock for years. Why not consider a weighted-average voting scheme; one where the number of votes you get is tied not just to the amount of shares you own, but also to how long you have owned them? Proper executive compensation can also make a difference.

Let’s tie bonuses to long-term metrics and reward executives with stock they cannot sell for several years; and let’s take back bonuses based on financial results that are later determined to have been bogus. A stronger focus on long-term results makes sense. While there are many effective ways to achieve this goal, eliminating guidance will not do the trick.