We devote significant resources toward the creation of timely and accurate financial reporting at our portfolio companies. This includes an operating and capital budgeting process at a level of detail to which most small businesses are unaccustomed. Detail does not guarantee accuracy – especially in its first iteration – meaning month-to-month variability is the norm rather than the exception (for seasonal businesses, in particular). Over time, we hope our focus on enhanced business intelligence will lead to better forecasting and planning, but some degree of short-term volatility is unavoidable. We feel comfortable working in this state of ambiguity by focusing more on short-term process and long-term trend, but it does create some difficulty when asked to provide forward-looking estimates of our portfolio performance to external stakeholders who may be more accustomed to working with larger, even public, companies.
Thankfully, we are not the only ones who struggle with this balance. Jamie Dimon (J.P. Morgan) and Warren Buffett (Berkshire Hathaway) recently published an editorial in the Wall Street Journal in which they asked all public companies to move away from providing quarterly earnings-per-share guidance, which they argue leads to an “unhealthy focus on short-term profits at the expense of long-term strategy, growth and sustainability.”
Although the number of public companies issuing guidance has declined (31% of S&P 500 companies currently issue annual EPS guidance, down from 36% in 2010), many still adhere to the practice based on the belief that the more information a company provides, the better the market will be at evaluating its value. Unfortunately, it seems that may not be the case. For instance, a 2006 McKinsey report found that, in aggregate, companies saw no long-term difference in volatility, valuation, or liquidity, three common “pro-guidance” arguments. Furthermore, some argue that at some point the tail starts to wag the dog, as the company providing guidance becomes more and more focused on managing towards short-term results at the expense of longer-term initiatives. The McKinsey report explains further:
“Analysts, executives, and investors understand that the practice of offering quarterly earnings guidance can have intangible costs and unfortunate, unintended consequences. The difficulty of predicting earnings accurately, for example, can lead to the often painful result of missing quarterly forecasts. That, in turn, can be a powerful incentive for management to focus excessive attention on the short term; to sacrifice longer-term, value-creating investments in favor of short-term results; and, in some cases, to manage earnings inappropriately from quarter to quarter to create the illusion of stability.”
Importantly, Dimon and Buffett draw a significant distinction between reporting (actual performance) and guidance (forecasted performance). The reporting piece is crucial as it allows shareholders to know whether or not the company is on, or wildly off, track ideally before something irreparably bad happens. From the WSJ op-ed:
“Our views on quarterly earnings forecasts should not be misconstrued as opposition to quarterly and annual reporting. Transparency about financial and operating results is an essential aspect of U.S. public markets, and we support being open with shareholders about actual financial and operational metrics. U.S. public companies will continue to provide annual and quarterly reporting that offers a retrospective look at actual performance so that the public, including shareholders and other stakeholders, can reliably assess real progress… Clear communication of a company’s strategic goals—along with metrics that can be evaluated over time—will always be critical to shareholders. But this information, which may include non-financial operational performance, should be provided on a timeline deemed appropriate for the needs of each specific company and its investors, whether annual or otherwise.”
At Chenmark, while we maintain a long-term time horizon with respect to any investment, we acknowledge the requirement that our companies execute against a budget introduces a degree of pressure to “hit numbers”, a pressure which flows upward as we are asked to anticipate portfolio performance in the aggregate. Some of this dynamic we believe is healthy, as variance from plan can highlight areas for improvement or real business risk. However, we are wary of instances where a myopic focus on achieving specific earnings numbers can lead to imprudent decisions, or perhaps worse, a lack of risk taking. That tension will never disappear entirely, but Buffett and Dimon’s counsel on guidance and reporting resonate as we try to zero in on “real progress” without getting stuck on short-term results. Now, if only Buffett and Dimon had been our guidance counselors in high school…