Quarterly Earnings Forecast

Dan Roberts from The Financial Times ran an article earlier this week on "McKinsey warns on guidance" (subscription required) that began with:

McKinsey is leading a growing backlash against companies providing guidance on earnings, after concluding the quarterly ritual increases share price volatility and short-termist management.

The article later goes on to observe:

Tim Koller, a partner in McKinsey's New York office, said: "Because guidance creates short term trading opportunities, it increases rather than decreases volatility. Certain types of hedge funds like it, but then there are some hedge funds who cannot tell you what the company makes."

Nevertheless, many companies are reluctant to stop the practice, especially when slowing earnings growth means some will be accused of trying to hide bad news.

McKinsey says better ways of providing transparency for investors are by focusing on disclosure about business fundamentals and long-range goals.

McKinsey’s research reminds me of a long standing pet peeve.  I cannot tell you how many CEOs have complained to me about the short-term horizon of the stock market in valuing their stock.  From the perspective of these CEOs, investors are to blame: “Why can’t they take a longer term view, instead of hammering us on short-term performance results?”

At one level, I am very sympathetic with this.  Public markets, especially in the US, do tend to put undue emphasis on short-term performance. But who’s to blame for this?

Ask these same CEOs and their management teams two simple questions:

• What will your relevant markets look like five to ten years from now?

• What will your company need to do in order to thrive in these markets five to ten years from now?

Almost always, the answer will come back that there’s just too much uncertainty to have a clear point of view on this. But, here’s the rub: If the senior management team of acompany doesn’t have a clear point of view on where the company is headed, why should investors put a lot of faith in the long-term performance of the company? In the absence of a clear and compelling long-term perspective, investors naturally fall back on short-term results.

Now, if you probe more deeply, each executive on the management team has a set of assumptions about the long-term direction of the business.  The problem is, they rarely articulate these assumptions and they even more rarely engage in an explicit and systematic discussion with the rest of the management team to test and challenge each other's assumptions. As a result, there is often significant divergence within the management team regarding the long-term requirements for success.

I advise these CEOs to reflect on what investors would need in order to focus on long-term performance. They should then reassess their own practices to determine what they could do to shape the horizons of their investors.

Some investors like day traders and certain hedge funds are unlikely to ever take a long-term point of view. Part of the challenge for CEOs is to attract and retain investors with a longer-term investment horizon.

But to do that, they need to have a compelling long-term narrative about their business that goes beyond generalities and platitudes. For the narrative to be compelling, it must be more than a “story” – it needs to be based on a deeply held point of view shared by the entire management team. Also, the actions taken by the company need to be completely consistent with the narrative. The entire senior management team ought to reinforce continually that narrative in their public pronouncements and help investors to understand the performance benchmarks that will indicate whether the company is on course to exploit these longer-term opportunities.  They certainly should not be catering to short-term horizons with quarterly earnings forecasts.

Comments

[bernardo]

I believe the reason Wall Street pushes the short term is because CEO are focused on the short term. Most CEOs do not have a point of view that goes beyond the present. Most strategies are future/perfect tenses of the present. In addition, most CEOs are not selected for vision. They are selected for their EQ. EQ is the present not the future.

I would also add that the value of most companies has a good split between the present and future as measured by cash flows that are divide between 5 years and terminal value.

Finally, what evidence to we have that Wall Street is myopic in its evaluation of individual firms?

[Thomas Tunstall]

Just to elaborate a bit on the challenge of adopting a longer term view: Too many executives and boards fail to make consistent use of basic tools such as scenario planning that encompasses a wide variety of possible futures. Or game theory, which can help them better understand both customer and competitive responses to strategic initiatives. Yes, the future is uncertain, and we should guard against a false sense of precision about how events will play out. Nonetheless, as Pasteur said, "Chance favors the prepared mind." Senior leadership should do a better job ensuring that their minds are indeed prepared.