On Wall Street: The lunacy of earnings guidance

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Here is the deal: my goal is to raise the level of readers’ interest by 3-5 per cent by the time they finish this column. After a year of my monthly musings, they will experience an overall level of satisfaction 10-12 per cent higher than in 2005. And if I meet my own predictions, I will get a pay rise and a corner office.

Sound like lunacy?

That is the exact same bargain US chief executives have struck with Wall Street over quarterly earnings guidance. Egged on by the analysts and fund managers, America’s corporate leaders have been feeding periodic forecasts of their companies’ results to the stock market.

To make it worth their while, chief executives have also tied part of their multimillion-dollar pay packages to beating those self-imposed goals. Fund managers are not complaining because they, too, are assessed quarterly and need all the help they can get to outperform those pesky indexes. As for analysts, after the regulatory rigmarole they went through, they were just grateful for chief executives’ help in filling their spreadsheets.

In theory, this idyllic situation where different beasts in the financial jungle scratch one another’s back should attain the greater good of more transparent markets. In practice, it has turned into a mug’s game that is in danger of creating a false market in some US stocks.

Allowing companies to set their own performance benchmarks inevitably sets the bar too low. Only chief executives belonging to the “Turkeys for Christmas” fraternity will set guidance their companies cannot meet.

Unsurprisingly, Thomson Financial estimates that an average of 60 per cent of companies beat analysts’ estimates each quarter. The latest figures show an even better success rate. In the third quarter, nearly 75 per cent of S&P 500 companies have smashed expectations. And I mean smashed: the average gap between what companies made and what the Street forecast is double the long-term average.

Such unerringly positive results warp the market’s view of success and failure. That is particularly true for the minority of companies that refuse to spoon-feed guidance to the market. Just ask Alcoa. Last month, the aluminium maker reported an 86 per cent rise in third quarter net income and said it was experiencing the best year in its century-long history. Its reward: a 6 per cent slide in its share price for “missing” Wall Street expectations that had forgotten to factor in a well-flagged fall in aluminium prices.

A market that punishes a near-doubling in profits but keeps rewarding small gains over artificially set, short-term benchmarks is clearly not working. Unless, that is, you are a hedge fund. As an exasperated chief executive told me, “there is a whole cottage industry of hedge funds that is getting richer shorting the stock after the results”. There is, of course, nothing inherently wrong with investors exploiting important corporate announcements to trade in and out of stocks.

But why create a system that actually facilitates this type of behaviour? Lending such a helping hand to speculators neutralises one of the main reasons for quarterly guidance: encouraging fund managers to invest for the long-term by keeping them abreast of corporate developments. In fact, institutional shareholders would be well advised not to buy or sell stock around results’ time as their trades would be drowned out by the wave of short-term bets placed by hedge funds.

Given its perverse effects, the best solution would be to get rid of quarterly guidance. Letting the market fend for itself would lead to less accurate predictions. In the UK, where guidance is banned, only 14 per cent of analysts get their forecasts right, less than half the US figure, according to Parson Consulting. Yet such inaccuracies provide short-term traders with a fuzzier target, making it harder for them to influence the direction of share prices.

But if wholesale change is too much for Wall Street to bear, companies and investors ought to at least alter their mindset. Quarterly guidance should be seen as a check-point for the company’s long-term strategy not an end in itself, and certainly not the trigger for knee-jerk investment reactions. As for my performance, based on my estimates, I have beaten my reader satisfaction forecasts. So, please judge me on results, but only the ones I achieve.

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