In a recent Wall Street Journal joint commentary, the CEO of JP Morgan Chase, Jamie Dimon, and legendary value investor, Warren Buffet, declared that quarterly earnings guidance “often leads to an unhealthy focus on short-term profits at the expense of long-term strategy, growth and sustainability.” They argue that companies frequently cut back investment in hiring, technology upgrades, and research and development to meet quarterly earnings guidance.
The challenge and stress of meeting short-term earnings guidance has likely contributed to the decline in the number of public companies over the past two decades. The universe of publicly traded companies has been steadily shrinking in the U.S. New businesses have been going public at less than half the rate of the 1980's and 1990's. About 3,600 firms were listed on U.S. stock exchanges at the end of last year, down more than half from 1997.
Good returns come from the decisions that sometime run counter to market sentiment and depend on whether the investor has the fortitude to maintain the necessary discipline.
Another marker for a short-term emphasis by management is the increasing use of pro-forma reporting and earnings. Some critics argue that pro-forma earnings are simply an effort by management to cast a company’s earnings in a more positive light or to gloss over poor financial results in an effort to improve stock performance. “Pro-forma earnings in current usage” means that many items are excluded from the calculation of net income at the discretion of management. Expense categories often excluded from pro-forma earnings include restructuring charges, one-time charges, non-cash charges and gains / losses from one-time sale of assets. There is no regulatory guidance or consistency in the reporting or calculation of pro-forma earnings, making comparisons difficult.
As a corollary to some companies’ short-term focus, individual and institutional investors can likewise be fixated on short-term results. Missing or beating quarterly earnings guidance can lead to an overreaction, both on the upside and the downside. How much emphasis should one actually place on a company beating a number that its management sets? Investors who react to one quarter’s results may buy or sell just when the reverse action is needed, based on the long-term intrinsic value of the company. Ironically, it is these overreactions on the downside that create new investment opportunities.