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.
A research conducted in 2007 by Mei Cheng et al explains the problem through this interesting diagram on the next page. 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 as “myopic” managerial behaviour – sacrificing long term growth for the purpose of meeting short-term ones.
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 generalisations, 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 per cent. By Oct 2011, the estimate was lowered to 4.3 per cent. WSA members produce 85 per cent 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.