Letters to the Editor
DISCOURAGE GUIDANCE, ENCOURAGE INDEPENDENT RESEARCH
When corporations release quarterly earnings, most of them also provide so-called future guidance. As a former director of research and senior equity analyst, I caution the investment community to accept any such guidance with a heavy dose of skepticism. In my opinion, future guidance is a manipulation by the company offering it and should be sparingly considered in any analyst’s financial model. Investor relations and public relations firms work hard at crafting euphemistic and benign press releases to mitigate the impact of impending earnings disappointments. Of course, if the earnings outlook is positive, euphemism is scrapped in favor of accentuating the positive. Guidance is a self-serving management tool designed to raise or lower analysts’ expectations, rather than an intended source of enlightenment and insight.
I believe guidance undermines independent and objective research analysis. It should be actively discouraged by the various security analyst organizations, including NYSSA and CFA Institute. It has a tendency toward wrongfully influencing analysts to overweight a management’s internal financial and economic forecast. How many times have we heard analysts blame management for their own disappointing earnings estimates? But they rarely analyze their own participation in accepting management’s inaccurate forecast and extend blame to themselves. The corollary is also true, when earnings come in higher than expected.
Analysts should explore many other resources away from the inputs of management, including mandatory financial statements filed with the SEC, to uncover potential problems and changes in expectations. The rules governing full disclosure are no impediment here, and no excuse. Under these rules, an event that has a material impact on the financial position of a company should be publicly disclosed. Out of fear of making a material revelation, many companies no longer speak to analysts individually or, with investor relations counsel by their side, make sure nothing is disclosed other than what was already publicly stated. Moreover, most publicly traded companies now offer periodic financial guidance—the carefully constructed universal conference call on which analysts are encouraged to rely.
There are important alternative sources that an analyst can draw upon, although pursuing them often demands individual initiative. After the elimination of nonrecurring gains and losses, a 10-year financial history can be quite revealing of possible changes in management’s strategic direction. At the very least, this data sets up the basis for penetrating and insightful questions supported by appropriate ratio analysis and side-by-side yearly and quarterly comparisons. Information derived from customers, subcontractors, and competitors, along with extractions from trade journals and inputs from companies in analogous industries, is equally telling. A downturn in the production of a specific type of metal sold to the aerospace industry, for example, might offer a clue to a future drop in airliner orders. Within the bounds of ethics and the exercise of good judgment, there is absolutely no FD restriction on obtaining vital insight into the public companies and industries from nonpublic private competitors.
A final point: the analyst builds confidence in his research only if he or she enjoys the support of the firm’s research director and, indeed, the firm itself (buy side and sell side).
The director should shield the analyst from negative pressures within the firm and also act as a buffer against unwarranted objections from the company being analyzed. With regard to the latter, the various analyst societies and CFA Institute should be prepared to offer pronounceable support in such matters. The director should make sure that the analyst’s research is thorough and well thought out. No doubt the analyst is likely to make some errors, but the research should reflect integrity from start to finish. Discouraging heavy reliance on guidance and encouraging a strong sense of independence is critical to that achievement.
Mort Langer
Langer Partners, Inc.
Floundering, Not Flourishing
I read the group interview (“The New You,” Spring 2009) with interest, but as an oft-displaced former sell-side analyst myself, I found one statement did not quite ring true. Research is “absolutely flourishing” in Europe, according to Candace Browning. Maybe so, but the evidence suggests that research analysts are not. Thomson Reuters Extel estimates that around 1,200 European sell-side analysts have lost their jobs in the last year; that is 15% to 20% of the June 2008 tally. See this article from Integrity Research Associates.
Name withheld
The Fault is Not in Our Stars
Over the past couple of decades, there has been a disproportionate focus on trying to obtain a larger slice of the total economic pie, rather than an emphasis on growing the total pie. Related to this as well was a desire for (almost) immediate gratification and an attempt to eliminate downside risk. These tendencies appeared throughout society, from corporate executives to individual consumers, and led to the accumulation of burdensome levels of debt; the passing off of risk as quickly as possible (i.e., packaging and selling of toxic debt); misaligned compensation structures; and, most disturbing, increasingly widespread fraud. This fraud ranged from lying on mortgage applications to lying on corporate financial statements (e.g., WorldCom, Enron), and from the spreading of false rumors in the financial markets to the outright fabrication of customer statements (e.g., Bernie Madoff).
The specific solutions for many of these problems are relatively straightforward and have already been discussed in detail. They include proper loan underwriting, with potentially the sharing or required retention of some of the risk; compensation which is longer-term in orientation and which also includes some sharing of the risk; the reinstatement of the uptick rule and the allocation of more resources to SEC investigatory efforts; and a more centralized and better-coordinated regulatory structure for financial markets.
But beyond these reforms, I believe that a broader change of attitude is needed. Corporate fraud is a significant drain for the economy and the country, as it leads to a misallocation of resources; an overall increase in the cost of capital; the need to pay significant resources to intermediaries to try to prevent or remedy the fraud; a societal decline of ethics; and a general decline in satisfaction or utility, as individuals feel less satisfied when they cannot trust companies, and corporate executives feel less satisfied when they are perceived as belonging to a group that is mistrusted. Due to the negative effects of fraud, we should all work together to move to a position in which trust in our corporations and our corporate leaders is reinstated.
Corporate executives must play a key role in this transformation, leading by example in how they treat all stakeholders, including employees, customers, shareholders, creditors, suppliers, distributors, and neighbors. They should also help prevent or expose fraudulent and misleading behavior, not only because it is the right thing to do, but also because it will benefit their companies and themselves. A reduction in the amount of fraudulent and misleading behavior would reduce the overall cost of capital, as investors would be able to reduce the required risk premium related to such possible behavior. These corporate leaders would also be viewed more favorably by the public.
Investment managers such as myself have assumed a more significant role in helping to shape the corporations in which we have invested, primarily through proxy voting, but also through our interaction with company management. There has been a growing acknowledgment by investment managers of their fiduciary obligation to assist their clients by using the appropriate tools available to help increase the value of their investments. However, there has also been an almost universal failure on the part of investment managers to assist in situations in which corporate fraud has occurred, most likely due to a desire to disassociate themselves from the fraud and therefore prevent negative reactions from their clients regarding the investment, and to avoid spending time and effort to expose and remedy the fraud. I believe this lack of involvement is a failure by investment managers to properly act upon the fiduciary duty they owe to their clients.
Given their detailed understanding of the companies involved and the financial markets, investment managers are in a unique position to help uncover and remedy corporate fraud. I feel it is time for investment managers to more broadly interpret and act upon their fiduciary duty to their clients, especially given their unique talents, knowledge, and experience. This action should improve the returns for their clients due to potentially better, more timely, and more likely remedial payments, as well as through the likely reduction in the frequency and magnitude of fraud.
Fraud and misbehavior should not be accepted as an inevitability. We may not be able to totally eliminate it, but we should certainly be able to reduce its rate of occurrence, especially if we all take seriously our collective responsibility to work together to expose and prevent it.
Joseph E. Stocke, CFA
Managing Director & Chief Investment Officer
StoneRidge Investment Partners
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