Monday, June 18, 2007

Enlightened Leadership Should Encourage Guidance

Here we go again. The latest attack on quarterly earnings guidance comes from the Aspen Institute, a non-profit organization that according to its website is "dedicated to fostering enlightened leadership and open-minded dialogue." Promoting the elimination of guidance, however, is anything but enlightened. So in the hope of fostering some dialogue, here is my argument against eliminating guidance.

There is a widespread misconception that earnings guidance is bad because it causes investors and corporate executives to focus on short-term results rather than the long term. While no one doubts that running a corporation with the long term in mind is the better approach, it is wrong to believe that guidance is the problem. Investors certainly do focus on quarterly earnings numbers, but not because corporations give out guidance. They focus on quarterly results for only one reason--the SEC requires corporations to report results on a quarterly basis. It is because of this SEC requirement that investors form quarterly expectations. If the SEC told corporations to report results on a monthly basis, investors would form monthly expectations. This has nothing to do with guidance. Eliminating guidance will in no way stop investors from forming expectations.

Guidance is valuable information. After all, who knows better what a corporation is likely to earn, a bunch of Wall Street analysts or the corporation's own management? If guidance is not provided, analysts' earnings estimates will simply become more inaccurate. Earnings surprises would become bigger. By the way, there are at least two academic studies in circulation that prove this point. And in an era in which regulators are trying to promote more disclosure, how much sense does it really make to tell corporations to stop providing guidance?

The truth is that those who want to end guidance are upset about the volatility that occurs when corporations miss the earnings estimate by just a penny or two. They believe the ensuing sell-off is unjustified. They are probably right about this. However, instead of grabbing the opportunity to buy more shares at a lower price, as any self-respecting long-term investor should do, they want to eliminate volatility by eliminating guidance.

Furthermore, if they would really like to see a greater focus on the long term, perhaps they should petition the SEC to eliminate quarterly reporting altogether. There was a time when corporations had to report results just once a year. However, many corporations reported quarterly results long before a change in the law required them to do so. They did this for one simple reason: their investors demanded the information. This is exactly why corporations provide guidance. If investors want quarterly guidance, should we not be encouraging corporations to provide it?