One more earnings season closes with TV channels getting
analysts and other talking heads to discuss earnings “hits and misses”.
Companies that have delivered results better than “expectations” are immediately
rewarded by higher share prices e.g SBI, while those that have disappointed are
sold by investors e.g Infosys. Setting expectations – and then beating them - seems
to have become essential strategy for a CFO/CEO seeking to maximise near-term
shareholder value. What role does “management guidance” play and should
companies seek to set investor expectations through frequent earnings guidance?
Forward looking
statements and earning guidance
Forward looking statements are meant to help the investor
community, especially analysts, take a considered view on the earnings outlook
of a company. Earnings guidance is more specific – it usually relates to making
a forecast of the EPS (earning per share) of the company.
The case for management making earnings forecasts is to
lower information asymmetry – where a more informed investor is able to make
better investment decisions as opposed to the lay investor. It is supposed to
help lower stock price volatility because investors are more informed of the
management’s view and can presumably invest with greater confidence – or so the
theory goes.
The counter- argument is equally powerful. Paradoxically,
frequent management guidance makes the investor community heavily dependent on
management input. Variations in performance from stated targets leads to
violent market reactions – making the stock price more, not less, volatile.
When combined with a company that tries to “game” the
investor, by first guiding for a lower performance, and then delivering better,
it leads to generation of “whisper number”. Much like a dog chasing its tail,
it then becomes difficult to predict if the performance measure that the market
is using as “benchmark” is the official (lower) forecast or the higher “whisper
number”. In either case, the credibility of management guidance is suspect.
Management Myopia
A research conducted in 2007 by Mei Cheng et al explains the
problem through this interesting diagram below. Their conclusions are even more
interesting – “dedicated guiders invest less in R&D, meet or beat analyst
consensus forecasts more frequently and have significantly lower long-term RoA
growth than occasional guiders.” They term this “myopic” managerial behaviour –
sacrificing long term growth for the purpose of meeting short-term ones.
Endogenous nature of earnings guidance
Does management have
predictive capability?
Another issue with guidance is the limited ability of
management to be accurate. In my experience, I have seen three scenarios where
management guidance is reliable:
The first scenario is where the industry outlook is so good
that even mediocre companies are able to deliver high growth. The IT industry
in the mid nineties is a case in point. Here, companies manage to beat guidance
regularly, and, usually have a “buffer” of earnings which is carried forward to
the next quarter. Predictable earnings growth quarter on quarter in a
high-growth backdrop makes for very “prescient” managements. The crystal ball
becomes a lot murkier when the industry becomes more competitive. In my view,
Infosys currently suffers from this malaise.
The next scenario is when the company operates in a sector
where product changes are slow, and consumer behaviour is the dominant
variable. Fast moving consumer goods is a suitable example. Consumer behaviour
for low involvement products changes slowly, and this reduces performance
variability. As with all generalizations, this too is prone to challenge – the
story of Hind Unilever vs Colgate, or Nirma vs HUL is too well known. But the
exceptions prove the rule – when the road is straight, the rear view mirror can
be used to drive the car – bar the accidents! And managements are great at
looking at the rear-view.
The last scenario is when we deal with banks and financial
institutions. Looking at the annual report of a bank always reminds me of a
painting of Pablo Picasso! It’s what you imagine it to be. No other industry
allows such creative accounting –the management’s ability to predict earnings 5
years out to the second decimal is a given!
In most cases, the ability of management or forecasters to
spot a change of trend before it happens is almost non-existent. Crompton
Greaves was projecting great exports to European countries well after the
collapse of demand in these areas. In Apr 2011, World Steel Association (WSA)
was predicting steel consumption in India to grow 13.3%. By Oct 2011, the
estimate was lowered to 4.3%. WSA members produce 85% of the world steel
output. The list is endless. In the current environment of extreme
macro-economic volatility, this predictive capability is even lower.
Interpret guidance-
use the data, ditch the prediction
The best use of a management commentary is to take note of
the details. In between results, only the management can tell investors how the
business is faring. Details on deals done, those underway, and the performance
till the day can be informative to the investor. However, when it comes to
making forecast, a dose of healthy scepticism coupled with an overarching macro
viewpoint will be a more reliable aid.
Investors tend to believe that managements have some special
insights on the business. While this may be true about technology, competition,
and market dynamics – it rarely extends to a greater predictive capability.
When it comes to the future, trust your own judgement. It has as much a chance
of being correct as that of the management.
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