BULLS & BEARS: Markets way too focused on quarterly profit outlook

July 31, 2006

A new report by the CFA Centre for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics calls on various constituents in business and investing to break their focus on "shorttermism."

A key recommendation in the report, titled "Breaking the Short-term Cycle," urges corporate leaders, asset managers, institutional investors and analysts to end the practice of quarterly earnings guidance. This Wall Street ritual is counterproductive on a number of fronts.

By itself, the term "guidance" exposes the hypocrisy of this process, as it essentially describes how corporate executives steer securities analysts to the estimated earnings number they expect to report when they publicly release their earnings every three months.

At present, analysts spend an inordinate amount of time questioning executives about details regarding a company's short-term prospects. The data provided by management is then plugged into the analysts'"earnings models," which generate a figure representing their quarterly earnings forecast.

A decent-size company may have 20 or more analysts following the business and computing a quarterly earnings estimates. Then there are the investment-services firms that compile the estimates from all these analysts and post the average or "consensus" earnings estimate for each of the thousands of companies.

Because corporate executives generally telegraph enough information to signal their internal expectations for quarterly earnings, the majority of analysts hover around a similar earnings estimate. This is a predictable safety-in-numbers phenomenon, as most analysts do not wish to stick their neck out and look foolish on earnings release date. This alone, the "coincidental" happy agreement on earnings estimates, should make one question the value of this exercise.

On the other end, the executives at the various companies must devote a significant amount of time and resources in communicating these short-term projections to the investment community-a distraction from managing the business.

In fact in the report, these think tanks conducted a survey of more than 400 financial executives and found that 80 percent of the respondents indicated they would decrease discretionary spending on such areas as research and development, advertising, maintenance and hiring in order to meet short-term earnings targets, and more than 50 percent said they would delay new projects, even if it meant sacrifices in value creation.

The third players in this short-term cycle are the asset managers-namely the institutions, mutual funds and hedge funds-too many of whom make investment decisions based on quarterly earnings estimates.

The report urges these investors to encourage companies to provide more meaningful long-term value-creation goals. It also suggests that asset-manager compensation should become more aligned with long-term performance and long-term client interests.

The report noted that highly skilled analysts and asset managers should view a decrease in corporate earnings guidance as a chance to differentiate themselves and to add value by doing more direct research and creating superior valuation analysis.

The entire report can be accessed at www.corporate-ethics.org/pdf/Shorttermism_Report.pdf.

Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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