A seemingly insatiable hunger for corporate information may be encouraging a tendency towards short-termism. Janine Mace examines whether Australian companies are dishing up too much data to investors on their outlook.
Don’t super size me
The current reporting season has opened on a subdued note, thanks to the turmoil in world equity markets, credit crunch-fuelled nervousness and uncertainty about global economic conditions.
CommSec chief equities economist, Craig James, notes: “Understandably, companies have been reluctant to provide exact profit guidance and have found it difficult to be forthright in their views of the next six months… There are more caveats on outlooks and a lot more provisos than there were 12 months ago when the economy was in good shape.”
So just how much information should companies be dishing out about their prospects? The answer, it seems, depends on where one sits on the table.
While analysts and short-term traders greedily gobble as much data as they can lay their hands on, companies and long-term investors tend to be more interested in regular sized portions of performance information.
A 2006 McKinsey survey found it was sell-side analysts, mutual or pension funds and internal company sources that were keen to be ‘super-sized’ when it came to earnings guidance.Their seemingly inexhaustible hunger for information has led to increasing concern about the tendency towards short-termism and a focus on volatile performance indicators rather than the drivers of long-term business success.
In the US, this debate has become heated, particularly given the emphasis there on quarterly earnings forecasts. Groups such as the Business Roundtable and the CFA Institute have called for an end to the earnings guidance game and for reform of guidance practices.
Market rules and materiality
Locally, the debate about earnings guidance has been more subdued due to Australia’s emphasis on half-yearly and annual reporting supplemented by the Australian Securities Exchange’s (ASX’s) continuous disclosure regime.
A survey by the Australian Investor Relations Association (AIRA) in 2005 found the majority of its members gave the market some form of guidance about future performance. However, the earnings guidance differed between companies and included profit and EPS growth ranges or targets, sales and profits, profit margins and revenue and margin targets.
Chief supervision officer of markets supervision at the ASX and chair of the ASX Corporate Governance Council, Eric Mayne, agrees with these findings, noting that the majority of companies provide guidance and that the ASX would expect them to do so.
The market rules are fairly straightforward when it comes to earnings guidance, he explains. According to the ASX’s Guidance Note No.8 on Listing Rule 3.1, “the way to manage earnings expectations is by using the continuous disclosure regime to establish a range within which earnings are likely to fall”.
The guide goes on to note: “As a general policy, a variation in excess of 10 per cent to 15 per cent may be considered material, and should be announced by the entity as soon as the entity becomes aware of the variation. If the entity has not made a forecast, a similar variation from the previous corresponding period will need to be disclosed. In certain circumstances, a smaller variation will be disclosable.”
However, Mayne says these figures are only guides and the key consideration is materiality rather than the actual percentage figure. “The issue is what is material,” he explains.
According to the AIRA survey, some companies do not offer explicit guidance, but will issue a comment when their internal forecasts are outside market consensus. One company taking this approach is Wesfarmers.
“We think the most appropriate way to advise the market is through the continuous disclosure regime,” explains Wesfarmers finance director, Gene Tilbrook. He says his company follows the Listing Rules, which require companies to disclose material variations from analysts’ consensus forecasts and expectations.
Tilbrook observes: “If the consensus by analysts is significantly different to ours, then we are obliged to provide information.”
Hunger for guidance
Analysts’ huge appetite for data is at the heart of the push for more guidance. The McKinsey survey found company executives believed the most significant benefits of issuing earnings guidance were to satisfy requests from analysts and investors, to maintain a channel of communication with investors and to intensify management’s focus on achieving financial targets.
While many companies believe issuing earnings guidance helps maintain open communications and increases corporate visibility, US research indicates this view may be misguided.
The McKinsey study found quarterly earnings guidance did not provide many of the expected benefits. It found “no evidence that it affects valuation multiples, improved shareholder returns, or reduces share price volatility”. Instead, the practice carried many costs in the way of management time, led to an excessively short-term focus and placed demands on employees.
A further report in November 2007 quantified this finding, noting: “Frequent earnings guidance doesn’t raise market valuations. Indeed, it appears to have no significant relationship with them, regardless of the year, the industry or the size of the company in question.”
Despite the local emphasis on continuous disclosure, AIRA’s Best Practice Investor Relations publication also notes a growing trend toward providing more earnings guidance in Australia.
The guide points to the growing use of technology, which has improved the speed and reduced the costs of getting information to the market, and the increasing focus on corporate governance and penalties for non-compliance, as driving this trend.
But for smaller companies, supplying forecasts can help encourage analysts to cover the company, which may reduce their costs of capital. “These developments have meant that there is much greater pressure on companies to make public disclosures and avoid selective disclosures,” the AIRA publication notes.
Tilbrook, however, believes that additional guidance can be counterproductive. “The question is whether you are opening up more issues by giving that sort of forecasting.” He says Wesfarmers is committed to keeping the market informed. “We consider internally how best to address the issue of informing investors.”
More not better
Unlike the position in the US, ARIA’s research found that only a handful of Australian companies provide quarterly updates on sales and/or profits, or release quarterly performance statistics. Most long-term investors and senior company executives are comfortable with this approach.
The Australian Council of Superannuation Investors (ACSI), which represents institutional superannuation fund investors with more than $240 billion under management, is unconcerned by calls for more frequent profit guidance. As ACSI executive officer Phillip Spathis notes: “This is a case where more is not necessarily better.
“At ACSI we have a long-term investment horizon and support companies being profitable over the long-term and that means expecting ebbs and flows in profitability.”
The Group of 100, which represents senior finance executives from major public and private businesses, holds a similar view. In September 2007, it issued a Policy Statement noting it did not believe that providing more information more frequently, for example quarterly reporting, necessarily served the best interests of shareholders and market participants. “Rather the focus of communication by the company should be to align long-term performance metrics with business strategy.”
The Australian Shareholders Association is also not pushing for more frequent earnings guidance. According to CEO Stuart Wilson, retail investors prefer companies to provide specific earnings information as part of their annual reporting. “In general, retail shareholders welcome guidance on earnings,” he says, but overall, he is dismissive of quarterly guidance. “I don’t see tremendous value in quarterly earnings forecasts.”
Spathis agrees that there is little value in such short-term information. “We would like to think things do not change that much in that short a time,” he says.
This matches the Wesfarmers approach to quarterly forecasting. “Quarterly forecasting takes you into the realm of providing lots of short-term information,” says Tilbrook, who points to the impact simple business fluctuations such as moving a shipment from one month to another can have on the results for a particular quarter. “We would rather have people understand the drivers of our business,” he observes.
Eyeing off the big picture
In Australia, calls for more guidance are blunted somewhat by the onerous requirements of the continuous disclosure regime.
Mayne believes meeting its requirements makes more frequent forecasts unnecessary. “The market thinks the ASX’s continuous disclosure regime is quite rigorous and in some cases more than that required by exchanges overseas,” he explains. “In fact, some see it as a disincentive to investing here… Anecdotally, we know it is viewed as quite robust.”
Wilson agrees, noting: “We prefer the continuous disclosure regime to quarterly forecasts … Focusing on them would definitely have investors taking their eye off the bigger picture. Under the continuous disclosure regime, where all material issues must be disclosed, shareholders stay informed.”
He believes corporations that decline to provide earnings guidance such as Wesfarmers are still obligated to keep the market informed, so the issue is not critical.
Spathis is also supportive of the regime. “If the market needs additional information then we have the continuous disclosure regime to deal with it.” He also believes that there are plenty of ways to find out how a company is performing. “For investors, there are ample opportunities to ask questions if they need more information.”
Companies such as Wesfarmers that choose not to issue forecasts still keep the market informed, Spathis argues. “Wesfarmers has an impeccable approach to corporate governance and disclosure, so it is not a problem,” he says, pointing to the company’s recent major acquisition of the Coles Group and its continuous information flow throughout the process.
In defending the rigor of continuous disclosure, Mayne points to the approximately 130,000 company announcements sent annually to the ASX. “In general, company disclosure is quite good,” he says. “We think what companies are required to do under the regime should give investors comfort that they are being kept informed.”
Focussing on the short-term
Much of the debate about more frequent earnings guidance and quarterly forecasting is rooted in growing concern about short-termism. Many corporations, particularly in the US, are perceived to be too focussed on achieving short-term earnings growth, rather than building long-term business success.
“We need to overcome the short-termism in this area,” Spathis argues. “Going forward, if we are serious about encouraging companies to think about sustainable long-term growth, then we cannot be interested in short-term indicators. We want responsible stewardship of companies.”
In fact, Spathis believes that focussing on short-term indicators can hide more than it reveals, creating incentives for the wrong types of corporate behaviour. “It is about ensuring a reduction in the potential for smoke and mirrors when it comes to accounting treatments.”
In the US, where the concern is growing about the trend towards short-termism, an influential coalition of CEOs, business groups and unions have called on companies to stop providing quarterly earnings guidance. Backed by major corporations such as PepsiCo, Pfizer, Xerox and Office Depot, the so-called Aspen Principles have been endorsed by the Business Roundtable, the Council of Institutional Investors and the New York State Common Retirement Fund.
In Australia, the Group of 100’s Policy Statement also expresses concern that an “excessive focus on short-term performance has a corrosive effect on long-term wealth creation because it is creating a climate of risk aversion”.
Be that as it may, Wilson believes abandoning earnings forecasts will have little impact on the trend towards short-termism. “Whether the company decides to give forecasts or not, the financial analyst community will continue to do their own. So if the process is discontinued, it is not going to combat the over-focus on short-term earnings,” he argues.
A more valuable change, notes Wilson, may be for company guidance on future earnings “to be taken as a forecast and for what they are”. This means respecting the ‘forecast’ label, rather than punishing a company for failing to achieve a prediction.
Spathis also worries that the current average tenure for Australian CEOs of only four years is encouraging short-term thinking, as human behaviour tends to follow the incentives set for it.
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