Financial journalists have been treated to a healthy dose of Warren Buffett in recent months. First it was an ambitious plan to reform health care cost structures, then it was the annual meeting, a mecca of value disciples. Most recently, we have been introduced to Commonsense Corporate Governance Principles (“CCGP”). While these principles aren’t solely the making of Uncle Warren, he and Jamie Dimon have been at the frontline of the organization’s press outreach, finding their way on CNBC and across all financial journalism.
CCGP lays out 6 guiding principles on a simple website. Interestingly, the press has focused on one of these six principles: the end of short-term guidance by publicly listed companies. As stated on the site, “Our financial markets have become too obsessed with quarterly earnings forecasts. Companies should not feel obligated to provide earnings guidance — and should do so only if they believe that providing such guidance is beneficial to shareholders.” Let’s unpack exactly why these titans highlight guidance as a problem with corporate governance:
Why Corporate America Guides
Guidance, in its most altruistic interpretation, is a means of generating trust with shareholders. Like any principal-agent relationship, trust is required because there is an inherent asymmetry of information. In the case of publicly traded equities, management has more real-time information about a company’s health than public investors, and the company chooses how to frame the dissemination of information into a standardized format. Investors want management to be fair and consistent in their dissemination of information so they can make informed analyses of value, while management want investors to align with their strategic vision to best unlock shareholder value.
Because investment and strategic decision-making are long-term decisions, guidance is more like a check-up on intermittent progress. This establishes the believability of management. Buffett and co. point out that this well-intentioned information has been perverted by the incentive structures within management, which is increasingly short in tenure. The pressure felt by management to demonstrate believability in the form of hitting quarterly numbers incentivizes them to make undesirable trade-offs to demonstrate believability and extend their tenure. This is often referred to as “managing to the quarter” rather than cultivating long-term value. According to data from FactSet, the percentage of EPS guidance that is lower than mean estimates of sell-side analysts has been 72% for the trailing 5 years. This gives you a taste of how “lower and beat” has become a numbing exercise for concerned long-term stockholders.
Long-Term Means Uncertainty…Embrace Uncertainty!
Long-term investments have heightened uncertainty at the time of entry but perfect clarity upon fruition. Think of it as an option’s value, where “moonshot” projects can turn out to be extremely valuable, or may end up being zeros. The value upon initiation reflects this range of outcomes. The longer the duration, the greater the time-value.
Uncertainty means that small-sample or short-duration results will naturally have more standard error. It means for every Jeff Bezos or John McCaw who accelerates compounding value through long-termism, there is a counterpart who fails at re-investment and destroys commensurate value. At the present, you won’t know which is which.
As a simple example of how long-term leads to certainty, look at the variance in investment returns for the S&P 500. The chart below shows the average 3, 5, 10, 20, 25, and 50-year period standard error, going back to the 1920s. There are periods spanning decades where the real-return of the index is flat. There are other such periods where your money would multiply. The higher variance at the front-end demonstrates the uncertainty at the point of entry which clouds decision making. This decision making leads to short-termism on the part of investors and destroys long-term value.
Uncertainty as a Mindset
Imagine if transacting out of publicly traded shares was a highly punitive action. The closest analog would be private equity, where secondaries exist but garner significant haircuts. Now imagine the impact this would have on corporate management if they weren’t worried about investor sentiment swaying their valuations or activists accumulating proxy threats. Without the selling pressure associated with short-term underperformance, management should be incentivized to think only about the long-term. This is the heart of what CCGP is hinting at. They are worried that too much long-term option value is eschewed for the pursuit of short-term stability, and that short-term stability necessitates poor decision making.
But will doing away with guidance solve the root problem? In our view, investors need to embrace uncertainty rather than penalize those who express it. Solving that problem is the core issue at play. As an example, if a CEO makes a massive strategic bet that she believes has a 60% chance of materializing, too often she is judged on the binary outcome (materialized or not) rather than on her accuracy in assessing the opportunity as value-creative. Compare that to a CEO who makes 100 60% bets and lands 59% of the time. She would be lauded for prowess. Are the two substantially different? Perhaps, given the magnitude of a “bet the farm” decision, investors may want more than 60% certainty from a CEO. But they can’t evaluate it with a beat vs miss mentality. Investors need to adopt Bayesian mindsets to evaluate performance rather than binary mindsets.
Take the spate of recent mergers and acquisitions across public markets. Certain companies are given the benefit of the doubt for projected synergies, while others are deemed to be “empire building” and poor stewards of investor capital. We see it in the stock movements of acquirers, which reflect some collective consensus. Why do certain corporate management get the benefit of the doubt? For a few reasons:
- Expectations may be misaligned between management and investors. Take the example of a company that is hitting its stride as a simple cash-generative entity, which decides to pivot to another vertical through acquisition. Suddenly, investors that underwrote their investment in the core-operations of the business must digest a strategic transformation. This may be a function of expectations around time-horizons or the viability of the corporate strategy. Many current proposed mergers come to mind.
- Trust is not appropriately earned. One would think a strategic decision by management is spurred by its expertise in understanding its trajectory versus that of its competitors. And yet, often these strategic deals are derided by investors as overreach and ego-driven. This is indicative of a lack of trust between principal and agent, as a trusting agent would lend the benefit of the doubt in such a situation.
- Not enough data is available to appropriately judge. Serial acquirers can generate a track-record of synergies and successful integration of acquisitions. This helps an investor base digest the next deal as a string of acquisitions within a broader umbrella strategy. One-off large-scale acquisitions scare investors because it feels uncharacteristic and outside of the scope of the existing strategy.
- Incentives are questioned. Imagine an investor base is pushing for a conglomerate to break apart, per a classic sum-of-the-parts discount. Resistance by a CEO may be seen as vanity or an unwillingness to relinquish control of a more powerful entity. This creates a vicious circle of doubt in management and further obstinance by it to threats.
Invariably, situations sometimes deteriorate and proxies are launched. Proxies can be ugly, and management can be ousted. This is not to say that shareholders are always right; sometime their short-term demands are actually worse off for the interest of long-term value. The ying and yang of this dynamic ultimately guides the health of capital markets.
Feedback loops: Short-termism in investing
Corporate guidance and short-termism is analogous to the trade-off between short-term and long-term performance for investment managers. Investment managers must weigh the short-term volatility of an investment, irrespective of its longer-term attractiveness. This is because they, as principals, must retain trust of their agents (LPs) when there is an asymmetry of information. Nothing wobbles that trust like a string of bad quarters. One way to combat this is by aligning their investment approach to their time-horizon. Like our hypothetical private-equity like approach for public markets, investors that demonstrate long-term thinking often codify this thinking through longer holding periods. It aligns their actions with their vision. Warren Buffet famously framed this as “punch card investing.” This requires LPs that have comparable duration, and that alignment must be clear from the start.
But to earn the trust of LP capital more often than not requires initial success, and that success often comes at the cost of chasing short-term alphas. One source of this alpha is trading earnings surprises, a consistent source of valuation recalibration. An incredible amount of resources are poured into generating earnings-related edge. It is the spearpoint of a cottage-industry of alternative-data providers leveraging new-fangled data science on under-the-radar datasets. There is something ironic about investors lamenting about corporate short-termism, while their own short-termism trades on the very vehicle that drives it.
Breaking Free from Short-Termism
Every investment manager preaches a desire for long-term thinking and long-term partners to enjoy its fruits. Like corporate America, having this is an exorbitant privilege. It means your LPs accept the heightened possibility of short-term pain for long-term outperformance, and this allows these GPs to harvest the option-value of uncertainty. Not every investor is afforded it nor do they deserve it.
First, both corporate and investment managers must deliver on some modicum of credibility. It may be small wins, or it may be a clear articulation (and execution) of process. Without it, there isn’t an initial olive branch to grow trust. From there, trust should be earned (and doled out) incrementally. No matter what you think of him, Elon Musk’s original mission statement established an aura of credibility that his shareholders have rewarded with optimism and fierce loyalty (which he has capitalized on!). The same could be said about Mark Leonard, John Malone, Nick Sleep, Warren Buffett, or Seth Klarman.
Perhaps more importantly, evaluators of managers (corporate and investor alike) need to embrace uncertainty and judge on the process by which managers make decisions, rather than the results. They should adopt Bayesian frameworks of analysis and reward those that take calculated risks with positive optionality. Over time, these managers will reward investors. Simply curtailing guidance may feel like the magic bullet to our woes, but it seems to be the tail wagging the dog. Principal-agent problems cut deep and need a transformative approach.
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