Investors Need More Information, Not Less
President Trump often announces his policy interests through twitter. Last August 17th he tweeted this:
It was later learned that the idea for dropping quarterly reporting came from a conversation with former Pepsi CEO Indra Nooyi that focused on ways to improve job growth. Mr. Trump was quoted in the Wall Street Journal of semi-annual reporting: “I thought of it. It made sense. We are not thinking far enough out.”
Federal securities laws have required quarterly reporting since 1970. The Securities and Exchange Commission (SEC) requires similar information on a quarterly basis as is required to be filed annually, such as business summary, company history, executive compensation, equity, subsidiaries, and financial statements. The quarterly submission is generally less detailed than the annual one and financial statements are unaudited. Companies often go above and beyond the SEC requirements by hosting investor conference calls, presentations, and providing quarterly earnings guidance.
The arguments for dropping quarterly results seem sensible. The thinking is that companies spend too much time maximizing short-term earnings to please their public shareholders and, in the process, underinvest in research and development (R&D) for projects that pay off in the distant future. Both Jamie Dimon, CEO of JPMorgan Chase, and Warren Buffett have encouraged companies to drop quarterly earnings guidance as one of the worst practices that encourages short-term thinking. Companies would save time and cost spent on quarterly communication with investors and SEC filings, better utilizing both on running their businesses. Critics of quarterly results also point out that Europe is required to provide profit and loss on a semiannual basis and report revenue only every quarter.
A February 2017 study by consulting firm McKinsey tries to quantify the impact of short-term corporate focus on financial performance and jobs. The firm examined 615 large- and mid-cap U.S. publicly traded companies from 2001-2015 for patterns of investment, growth, earnings, quality, and earnings management. After controlling for industry characteristics and company size, McKinsey placed each company into short-term or long-term focused categories. The findings:
From 2001 to 2014, long-term firms cumulatively outgrew sales and earnings of other firms by 47% and 36%, respectively.
R&D for long-term firms grew 8.5% per year versus 3.7% for other firms. Further, long-term firms continued to increase their R&D during the financial crisis while other firms cut R&D.
Long-term firms saw their market caps grow $7 billion more than other firms and their financial returns were superior.
Long-term firms added 12,000 more jobs than other firms from 2001-2015. By extrapolation, the U.S. economy would have created five million additional jobs over this period if all U.S. publicly traded companies performed as these long-term firms. This potential job creation would have amounted to an additional $1 trillion in U.S. GDP, 0.8% per year on average.
This is an interesting study, but I’m not entirely convinced McKinsey can extrapolate the job creation benefits from long-term focused firms on to the rest of publicly traded companies. Couldn’t it be the case that long-term focused firms are growing at the expense of other firms in their industry? Further, smaller firms, omitted from the study, tend to be growing faster and, therefore, are already generating the lion’s share of U.S. employment growth. Nevertheless, the study reinforces my feelings as an analyst: companies with strong management teams that invest in innovation and meeting customer needs grow faster and have better returns than those worried about this quarter’s earnings.
As an investor, whenever I see proposals that restrict access to information, I’m skeptical. In the 1990’s I remember when companies would disclose information to institutional investors before individuals found out the same data from public releases. Reporters became obsessed with “whisper numbers,” that is, selective disclosure of financial metrics, the most popular of which was earnings per share, to professionals that would spark stock-moving trading ahead of quarterly communications.
The SEC clearly saw that this behavior was putting individual investors at a huge disadvantage to professionals and responded with Regulation FD (Fair Disclosure) that went into effect in late 2000. Reg FD requires companies to make a public disclosure of all material nonpublic information when such information has been revealed to securities market professionals and shareholders who may well trade on the information. While no regulation is perfect, I’ve noticed that stock prices don’t move as much ahead of press releases, like quarterly earnings, like they used to prior to Reg FD.
I think we would be back in the pre-Reg FD days if companies could wait six months between information disclosures. I don’t want to see the playing field tilted back to well-connected professionals like the old days.
I think another problem would be stock price drift, particularly with smaller, growth-oriented companies where current information is vital to determine their success with new markets, business models, etc. Investors complain already about market volatility and I envision it getting worse with less frequent reporting. With less timely data to assess, investors will demand a higher risk premium that will drive up the cost of capital for smaller companies. A higher cost of capital hurts job creation.
I find the quarterly unaudited financial statements (income statement, balance sheet, and cash flow) plus accompanying footnotes quite valuable to assess management’s aggressiveness or conservatism and to spot trends. Sometimes the numbers point to poor behavior and even fraud. Giving companies another three months of time lets those tilting toward dishonest activities hide even more.
Finally, I don’t believe the argument that extending the reporting period by just another three months will suddenly change management’s focus from short-term to long-term. I think the real key is the quality of information management shares with the public, not the timing. There are plenty of companies that saw their share prices go up in the face of quarterly losses, like Amazon and Netflix, as they patiently explained to investors their long-term view of what they could become. I’ve also seen cases where additional financial disclosure allowed investors to better assess a company’s value, like when Alphabet (better known as Google) decided to separately disclose its risky, money losing “Other Bets” ventures from its highly profitable search advertising business.
At this point the SEC’s Chairman, Jay Clayton, does not believe quarterly reporting, particularly for larger companies, will change anytime soon (in Europe large companies provide quarterly reporting because the market expects it). The agency is seeking input from companies and investors on the issue. Mr. Clayton does believe that for firms below $1 billion in sales, quarterly reporting and compliance can be an undue burden where investors may not want or need such frequent information. The issue is clearly a long way from being settled.
Daniel J. Boyle, CFA