So much for transparency; quarterly reporting may be harming firms and investors, reports Christopher Alkan
For Wall Street’s equity analysts the three-monthly updates from America’s companies are keenly awaited. The quarterly earnings season is a period of high excitement on the markets. Within seconds of a release, shares can gyrate as analysts and investors take the pulse of the nation’s leading companies.
But there is a growing chorus of opinion that this storm of activity, now common to most rich-nation markets, is unhelpful and may even be destructive. A recent report for the British government by economist John Kay argues that forcing companies to release financial reports so frequently actually harms investors and businesses.
When it comes to data, Kay argues in his report published in July that “useless information is often worse than useless.” This paradox is backed up by a mounting stack of economic studies. Many now believe that overly frequent reporting encourages businesses and investors to make short-term decisions that sacrifice long-term returns. Some studies have even suggested that quarterly reporting is more damaging to investors than high-profile frauds such as the collapse of Enron.
This academic backlash seems to be having an impact on government policy. The European Commission is considering ditching the requirement that firms update investors once every three months. So far the US remains wedded to quarterly reporting, but some experts believe that even there support for frequent statements is eroding.
The tradition of obligatory quarterly reporting was born in the US. Ever since the early 1970s, American firms have been compelled to publish these regular updates. And the practice has gone global. In 2004 the European Commission published rules insisting that companies publish interim management statements. The practice is also increasingly prevalent in South-East Asia. Only certain emerging markets have been lagging behind.
“More frequent reporting can be seen as part of a venerable historical trend towards giving investors ever more information,” says Phillip Stocken, professor of accounting at US university Dartmouth College.
On the surface there are compelling reasons why the world should have followed the US’s lead. Some experts argue that allowing companies to vanish off the radar for long periods of time can be dangerous. In the gaps between company reports, valuable information is more likely to be restricted to privileged investors that are closest to the firm.
“That can leave ordinary investors out in the cold,” says Professor Stocken. “If this group feels the odds are stacked against them many will eventually just withdraw from the market. That is in nobody’s interests.”
The biggest fans of quarterly reports tend to be stock analysts, who spend much of their time poring over these releases. Fadel Gheit, a veteran oil analyst at investment bank Oppenheimer who has been following quarterly reports for close to three decades, believes they give greater clarity to investors. “Some people complain that quarterly reporting is overkill. But you have a choice of whether you want to dive deeper into the figures or not. Nobody is forcing investors to look at these numbers,” he says.
Gheit says he can quickly plug new numbers from a quarterly report into existing spreadsheets to give a clearer picture of how a firm’s fortunes are developing. “It’s not as though analysts worship these releases,” he says. “But each pixel gives us a better image.”
Such arguments are only superficially appealing, according to many investors. The most basic complaint is that quarterly reports provide little useful information. “I think investment banks and stock market analysts who make their living by promoting trading turnover like quarterly reporting, but the figures don’t often mean much and are easy to manipulate,” says Peter Montagnon, a senior investment adviser to the Financial Reporting Council.
Long-term investors increasingly suspect that quarterly figures are far from a pure representation of a firm’s fortunes. “The first danger of these updates is that they encourage companies to smooth out earnings,” says Robert Talbut, chief investment officer at Royal London Asset Management, which manages £44bn of funds. “The idea that companies should be so predictable as to hit quarterly forecasts is simply an illusion.”
To create the facade of such continuity, firms can use an array of gimmicks, such as tweaking allowances for losses or delaying maintenance, says Stocken.
Analysts such as Gheit counter that such expedients can’t hide the truth for long. “If a company has real troubles then accounting tricks will only delay the day of reckoning,” he says. Still, the flaw in most quarterly reports is that they aim to reduce fluctuations that might make investors nervous. To that extent they are seldom the whole truth.
Talbut believes that far from being a harmless distraction, the three-monthly updates are damaging. The first group of victims, he says, are the investors themselves. “The main effect is to encourage investors to churn their portfolios,” he says. “There is an awful lot of worthless activity surrounding quarterly reports.”
Such turnover generates commissions for the banks but can sap returns at pension funds and other investment institutions. The flurry of releases once every three months also subjects stock pickers to information overload, says Liz Murrall, director of corporate governance and reporting at the Investment Management Association.
The underlying problem, Kay concluded in his final report, was often a subtle one. Even when investors conclude rationally that a quarterly statement adds little of value they may still feel compelled to trade.
“People may feel obliged to act on [useless information],” Kay concluded, partly out of fear that others will do so. “In securities markets, irrelevant information becomes relevant if you believe that others may think it is relevant.”
Another complaint about frequent updates is that they also impose a financial cost on the firms themselves. “Quarterly releases mean that some companies are in almost continuous reporting mode,” says Dr Nigel Sleigh-Johnson, head of ICAEW’s Financial Reporting Faculty. “That can put a lot of pressure on the finance functions of businesses and even impair the reliability of reports.”
It can also be a distraction for management, according to Governance for Owners, an organisation that brings together executives and long-term investors such as California state employee pension fund CalPERS. This is something that managers are reluctant to admit publicly, the group says. Paola Perotti, a partner at Governance for Owners, says no public company chief would go on the record as being against quarterly reports but that in private they were more forthcoming.
“At a recent seminar two chief executives mentioned that they spend half their quarterly board meetings discussing how to present their quarterly results and the effect the results will have on their company’s share price,” she says. “One of them complained shareholders were asking them to think long term and deliver in 90 days.”
Economic research backs up the idea that quarterly reporting is more than just a distraction. There is compelling evidence that firms sacrifice their long-term economic value to meet their quarterly earnings targets.
A survey of 400 CFOs in 2006 revealed that 55% of them would postpone an otherwise money-making longer term project in order to avoid missing analysts’ quarterly earnings expectations. The authors, Professor John Graham of Duke University, North Carolina, and Shiva Rajgopal of the University of Washington, argued that this short-term outlook was more damaging than headline-grabbing fraud cases.
Much of the media attention is focused on a small number of high-profile firms that have engaged in earnings fraud,” their paper said. “We assess that the amount of value destroyed by firms striving to hit earnings targets exceeds the value lost in these high-profile fraud cases.” The report estimated lost economic value of about $150bn per year – equivalent to two Enrons, the authors said.
“CFOs believe that hitting earnings benchmarks is very important because such actions build credibility with the market and help to increase their firms’ stock price in the short run,” the paper argued. “To avoid the severe market reaction for under-delivering, CFOs are willing to sacrifice long-term economic value, such as delaying a valuable project.”
A more recent paper in 2011, focusing on European companies, came to similar conclusions. Jürgen Ernstberger, a professor at Ruhr University Bochum in Germany, found proof that companies were willing to make short-sighted business decisions in order to live up to analysts’ expectations. Such myopic decisions included offering bigger discounts to consumers to boost sales in the short term, even at the cost of long-term performance. Such behaviour was more prevalent in nations that insisted on quarterly reporting, Ernstberger concluded.
Those who wish to scrap quarterly reporting dismiss fears that this would compromise investor safety or promote insider trading. Murrall says Investment Management Association members would not be short-changed by less frequent reporting. “Investors are already guaranteed that firms will disclose price-sensitive information to the market,” she says. “As a result, if the quarterly statements go, shareholders would not be kept out of the loop.”
The same point was made in October last year in a statement on reporting requirements by the European Commission. “Investor protection is already sufficiently guaranteed,” the statement said, citing the requirement for firms to publish market-moving information immediately.
Profit warnings in which companies keep investors informed of negative developments in their business outside the regular reporting schedule are extremely common. Data from Ernst & Young showed 73 such announcements in the first three months of 2012 alone.
This raises the question of how corporate reporting could be changed if quarterly statements ceased to be obligatory. Kay believes a new approach to financial and business information is needed. “The notion that one size fits all for reporting is a myth,” he says. “The relevant time scales for businesses vary depending on the type of firm you are dealing with.” For example, banks can appear to be doing well in any particular year. But this might simply reflect the fact that they are taking on excessive risk, which only becomes apparent over the course of several years.
In this context quarterly reports would appear to be just a distraction. Firms with these very long cycles – such as those in banking, construction or energy production – could help investors more by offering comparisons of their performance at the same stage in the previous business cycle. This would not need to be updated each quarter.
By contrast, there are firms for which a quarterly approach might be extremely helpful, such as in retail. Differences in reporting frequency and style would be determined by the needs of investors rather than government rules.
“There are certainly cases where investors will want to be kept very up to date with developments in a firm,” says Sleigh-Johnson.
While good intentions lie behind the rules that force firms to present their results regularly to owners, quarterly reporting appears – if unintentionally – to have many negative consequences. Investors become more tempted to churn their portfolios, even if the underlying performance of the business has not changed noticeably.
The tyranny of the quarterly report can also weigh on businesses. If firms merely used accounting tricks to smooth out their quarterly earnings, the outcome would not be so serious, they would simply be compromising the quality of the data they produce. However, a more serious consequence is that many companies are prepared to give up long-term profits to avoid losing face in the markets by missing quarterly targets.
Investors seldom ask for less transparency or information. The issue of quarterly reporting, however, is a rare exception. As Perotti from Governance for Owners points out: “Mechanisms need to be devised to ensure that both management and shareholders are suitably rewarded for thinking long term.”
Many feel that the most obvious starting point would be to draw a line under the mandatory quarterly report.
The Kay Review: reporting recommendations
Released on 23 July, the Kay Review of UK Equity Markets and Long-term Decision Making outlines specific recommendations concerning reporting to shareholders. The report has been “designed to provide a foundation for a long-term perspective in UK equity markets and describe the directions in which regulatory policy and market practice should move”.
Having previously described many quarterly reports as “self-congratulation with little substantive content” filled with data that’s “just noise”, one of Kay’s key principles is that at each stage of the equity investment chain, reporting of performance should be clear, relevant, timely, related closely to the needs of users and directed to creating long-term value in the companies in which savers’ funds are invested. With this in mind two of the review’s recommendations explicitly refer to financial reporting, stating
- mandatory IMS (quarterly reporting) obligations should be removed
- and high-quality, succinct narrative reporting should be strongly encouraged.
BIS is considering the recommendations of the report and is expected to make a detailed response later in the year.