Institutions Want End To Earnings Guidance
By Carolyn Kay Brancato — May 1, 2007
The Securities and Exchange Commission
estimates hedge funds control more than $1.2 trillion in assets. That might
represent only 5 percent of U.S. assets under management, but hedge funds
account for more than 30 percent of all U.S. equity trading volume. Given
the trend toward increased volatility, it’s not surprising to see renewed
calls for companies to stop giving quarterly earnings guidance—on the theory
that an undue focus on quarterly numbers generates volatility unrelated to
the company’s underlying value.
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 Dr.
Carolyn Kay Brancato is founder and director emeritus of the
Governance Center and the Directors’ Institute at The
Conference Board. She also recently served as director of the
Board’s Commission on Public Trust and Private Enterprise. The
author of two major books on corporate governance, Brancato
has been invited to speak on global trends in governance by
leading organizations in North America, Europe, and Asia.
Brancato began her career as a securities analyst for a Wall
Street brokerage house, then went on to become director of the
Industry Analysis and Finance Division of the Congressional
Research Service at the Library of Congress — the internal
research organization for the U.S. Congress. In this position
for nearly 10 years, she analyzed mergers and acquisitions,
leveraged buyouts, and major economic trends affecting U.S.
industries for Congress. She has also served as the executive
director of the Columbia Institutional Investor Project and
the staff director for the U.S. Competitiveness Policy
Council's Subcouncil on Corporate Governance and Financial
Markets.
Brancato developed the major source of data on U.S.
institutional investment used throughout the United States and
by the Securities and Exchange Commission and the Department
of Labor. She earned her bachelor’s and doctorate degrees in
economics from Barnard College at Columbia University and New
York University, respectively. She is a fellow of the Royal
Society for the Encouragement of Arts, Manufactures &
Commerce. She can be reached via email at
rivergrp@comcast.net.
Related Studies
 U.S.
Chamber Of Commerce Report On U.S. Competitiveness
(March 2007)
CFA
Institute & Business Roundtable Report On Short-Termism
(July 2006)
Conference
Board Report On Short-Termism
(TCB Charges $295; April 2006)
Related Coverage
 Earnings
Guidance Down, But Far From Out
(April 2006)
Focusing
On The Long Term: Companies Drop Guidance
(May 2005)
Related Columns
Rationale
For Earnings Guidance
(Lou Thompson; Dec. 2007)
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What is surprising, however, is that large institutional investors such as
public employee and union pension funds overwhelmingly endorse discontinuing
quarterly earning guidance too.
Reports Of Short-Termism
The ultimate fear about earnings guidance is that it gives rise to a climate
of “short-termism,” where investors ignore the long-term fundamental health
of companies. Such worries have existed for years, but within the past year,
three major reports have outlined a renewed focus on ”short-termism” in the
capital markets.
In the spring of 2006, The Conference Board issued “Revisiting Stock Market
Short-Termism,” the product of a Corporate-Investor Summit held in July 2005
in conjunction with the International Corporate Governance Network meeting
in London. The report chronicles a “cycle” dating back to the 1980s when
Japanese and German companies were perceived to be better competitors than
their U.S. counterparts, because they planned and financed for the long
term. The report found that a “chain” of actions by corporate managers,
analysts, and investors militated in favor of a short-term quarterly focus,
to the detriment of corporations’ ability to manage for the long-term. It
also said that chain must be broken by concerted and coordinated efforts by
all parties wrapped up in it.
In the summer of 2006, “Breaking the Short-Term Cycle,” was published by the
CFA Institute and the Business Roundtable’s Institute for Corporate Ethics.
Among other recommendations, companies were encouraged to end the practice
of providing quarterly earnings guidance. If companies have “strategic
needs” for providing earnings guidance, however, they should adopt range
estimates and appropriate metrics “that reflect overall long-term goals and
strategy.”
Just this past March, a third report was issued by a bipartisan commission
established by the U.S. Chamber of Commerce: “The Commission on the
Regulation of U.S. Capital Markets in the 21st Century.” To address concerns
that U.S. capital markets do not foster sufficient confidence to maintain
their global predominance, the chamber’s report also recommended companies
stop giving earnings guidance and substitute a “fuller explanation of their
long-term goals and their strategies for achieving those goals.” (See box at
right for all three reports).
The U.S. Chamber report provides a brief but comprehensive survey of key
studies and findings that support discontinuation of quarterly earnings
guidance:
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Corporate executives are likely to make suboptimal company decisions to
meet analyst expectations;
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Companies that are “dedicated” providers of earnings guidance invest
significantly less in research and development than companies that are
“occasional” providers of earnings guidance;
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Long-term earnings growth rates of “dedicated” guiders are significantly
lower than those of “occasional” guiders; and
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Companies that rely on adjusting accruals or reducing discretionary
expenditures to exceed consensus numbers achieve short-term positive
impact on their share prices, but over the long-term, these companies tend
to underperform relative to firms that do not manage their earnings to
exceed forecasts.
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Pozen
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The topic came up again at the Council of Institutional Investors’ spring
meeting held in March. U.S. Chamber Commissioner Bob Pozen, chairman of MFS
Investment Management, noted to the audience that the SEC’s 2002 safe harbor
rule encouraged companies to provide guidance; consequently, in 1994 less
than 200 companies provided guidance, while by 2002, more than 1,200 in the
United States made quarterly earnings projections. “This is insanity,” Pozen
said, for all the reasons cited in the Commission’s report. He also pointed
to one study, however, which showed that companies that stop giving earnings
guidance tend to do so in advance of negative news.
Pozen urged companies join in “collective action” with those large
well-respected companies such as Coca Cola and Pfizer that already do not
provide quarterly guidance. In addition to Coca Cola and Pfizer, other
companies at the CII meeting that don’t provide earnings guidance included
Sunoco and Chevron. Chevron’s corporate secretary, Lydia Beebe, said her
company instead provides projections for capital expenditures, a substitute
strategic indicator.
Reaction From Institutional Investors
Companies feeling obliged to provide quarterly earnings guidance often do so
because they are in industries such as retail, with notoriously short time
horizons. They may also be smaller-cap companies or have fewer analysts
covering them and don’t want to risk reduced analyst coverage.
An informal poll of institutions attending the CII meeting, however, showed
remarkable unanimity among large institutional investors that earnings
guidance should go. For example, the following investors (with more than $1
trillion in assets under management) support companies that do not provide
quarterly earnings guidance:
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Jack Ehnes, CEO of the California State Teachers Retirement System, said
his public pension fund has long-term beneficiary payout requirements and
supports companies that stop giving quarterly earnings guidance.
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Mark Anson, former chief investment officer of the California Public
Employee Retirement System and now chief executive of Hermes Investment
Management in Great Britain, encourages corporations to focus on their
“long-term prospects” and not get caught in the “noise of quarterly
earnings management.”
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Damon Silvers, associate general counsel of the AFL-CIO Pension Plan, said
his union fund supports companies not giving earnings guidance because
“there are different interests between funds and money managers and
brokers.” The quarterly earnings focus is “part of a casino gambling
market” where the quarterly earnings numbers provide a “defined event that
can be used by various segments of the marketplace to make money.” Silvers
said this activity is not in the fund’s best interest.
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Richard Ferlauto, director of pension & benefit policy at the American
Federation of State County and Municipal Employees, said he doesn’t
believe in quarterly earnings guidance “because it distracts and diverts
management from its focus on providing long-term shareholder returns” and
encourages earnings manipulation. Asked what information AFSCME might like
to have instead, Ferlauto said companies providing strategic
extra-financial numbers that now may be regarded as “soft” should try to
make them “harder” so they can be relied upon by investors.
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Peter Gilbert, a U.S. Chamber Commissioner and chief investment officer of
the Pennsylvania State Employees’ Retirement System, supports withholding
earnings guidance to reduce earnings manipulation. Instead, he would like
to see more “strategic information” and agrees that money mangers
entrusted with assets from the Pennsylvania fund should be given a three-
to five-year benchmarked time frame to hit their earnings targets and
should not be sacked for “missing one or two quarters.”
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Daniel Summerfield, co-head of responsible investment at USS (the major
U.K. fund representing academics throughout Britain) pointed to a global
investor-led initiative aimed at encouraging better long-term and
integrated investment research. The “Enhanced Analytics Initiative”
currently includes Continental European, U.K., U.S., Canadian, and
Australian pension funds and asset managers with approximately $2.4
trillion in assets under management. Members pledge to allocate a
proportion of their brokerage commissions to “interested and appropriate
research agencies to encourage them to adapt their research process” and
to compile better, longer-term, and more detailed analysis of
extra-financial issues within mainstream research rather than the
quarterly numbers. The initiative intends to prime sell-side brokers with
a direct financial inducement for firms whose analysts engage in
longer-term research and extra financial issues.
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Others in agreement include: John Wilcox, vice president of corporate
governance at TIAA-CREF; Michael McCauley, director of investment services
and communications for the State Board of Administration of Florida, who
has been researching corporate compensation practices; Anita Skipper, head
of corporate governance of Morley Fund Management in Great Britain; and
noted governance activist and Corporate Library Editor Nell Minow.
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Ehnes
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In addition to his comments on CalSTRS’ policies, Ehnes, who also serves as
chairman of the CII, says he believes most CII institutional investors would
likely approve of companies taking a long-term instead of a quarterly
earnings focus. In support he cites two recent CII membership votes: (1) to
endorse a major new Ceres initiative calling for shared action “on a large
scale over a long period of time” to mitigate climate risk; and (2) to
endorse a series of long-term investment principles put forward by the Aspen
Institute.
While
proxy season raises issues that divide companies and investors, this spring,
the practice of companies discontinuing quarterly earnings guidance may well
provide the basis for an unusual but welcome consensus.
Compliance Week provides general information only and
does not constitute legal or financial guidance or advice.
