The danger of trying to guide a starving beast with bare morsels

Posted by Marc Hodak on July 24, 2007 under Unintended consequences | Comments are off for this article

Earning guidance is a controversial practice on Wall Street. Companies don’t like it because they’re concerned that investors place too much emphasis on one little number–current earnings–instead of focusing on the long string of future earnings that everyone knows should guide valuation. Managers are also a little concerned about the liability associated with “misleading” investors about earnings, i.e., falling short, even if for reasons beyond anyone’s control. Wall Street has the same concerns as management, plus the sense that certain managers may be pushing the accounting envelope a little far, or making short-term decisions to manage their earnings. Governance mavens don’t like the idea of one party trying to manage the other’s expectations. They would rather that companies simply became more transparent without the games.

So, if everyone is wary about earnings guidance, why is it so common? Over a third of the S&P 500 and perhaps a larger percentage of investors play this game. This game becomes more easily understood if one sees Wall Street as an animal that needs a certain amount of variety in its diet. Information from companies is a type of nutrient for the capital markets, and we are seeing the effects of nutrient deficiency in the feeding frenzy that surrounds earnings announcements. Companies try to mitigate this frenzy by offering earnings guidance, even though they don’t necessarily benefit from doing so.

Earnings guidance has been around in some form for a long time, but it really became a focal point for the investment community after the introduction of Reg FD. The intent of Reg FD was to create a “level playing field” for corporate disclosure. The main effect, however, has been to severely constrain the flow of information between companies and outsiders. Companies are justifiably afraid to disclose information in something other than the prescribed manner, and the market has suffered from the effects of reduced disclosure.

Since there are criminal as well as civil penalties associated with information leaks, their veracity, and their use in trading, managers and investors are forced into an increasingly rigid dance, kabuki-like, around the dissemination of information. Government has all at once made it very costly for managers with a bias toward openness to create greater transparency, and provided paranoid executives the perfect excuse to block almost any communications between company management and outsiders aside from those they are legally required to make. When it comes to financial communications, were are rapidly approaching a system where anything that is not mandatory is prohibited. That system looks like an anemic, ravenous beast following a person tossing morsels.

So, while I’m sympathetic to calls for ending earnings guidance, I know that guidance and the market’s over-reliance on guidance are just symptoms of a deeper problem whose real solution is to loosen up rules about disclosure and trading. The market wouldn’t look like it does now if managers weren’t penalized for disclosing information, or if investors weren’t penalized for seeking out information and trading on it. Instead, we have an equilibrium that no one could be comfortable with.