Recent events have revived a long-dead idea that should have remained in the grave, specifically that there is great benefit in replacing quarterly reporting with semiannual. The usual suspects, top managers of public corporations, are responsible, and this time gained an ally in the White House. The seriousness of this ill-gotten revivification is enough to bring us back momentarily and we’re hoping to put a wooden stake through its heart.
It’s feasible that it will take more than reprinting one of our columns to turn aside this unwise move, but we think presenting anew a 2015 essay, “Building Mutually Beneficial Strategic Partnerships with Capital Markets” will help do the trick.
As a way of introduction, we present once again the immutable and inarguable four axioms on which we have built our frame of reference for reshaping accounting policy and regulation:
- Incomplete (also untrustworthy and infrequent) information creates uncertainty for investors and the capital markets.
- Uncertainty increases risk for those investors and markets.
- Risk makes them demand higher rates of return from the investments.
- That demand inevitably produces lower stock and bond prices as well as higher capital costs for security issuers.
Therefore, if managers and public policymakers want to make things better for investors, the markets, the whole economy, and, yes, themselves, this whole idea of semiannual reporting needs to be reburied and left there.
As background, the original column was prompted by a private effort of a consortium of CEOs who engaged a large law firm to plead their case that uninformed investors and markets are somehow good for the rest of us, to which we said and still say, “Fuhgeddabout it!”
In early September 2015, The Wall Street Journal published a piece by David Benoit entitled “Time to End Quarterly Reports, Law Firm Says” in which he reported that the “influential law firm Wachtell, Lipton, Rosen & Katz has an idea that may be music to the ears of its big corporate clients and a nightmare for some investors and analysts: end quarterly earnings reports.”
Cutting to the chase, this proposal to eliminate quarterly reports is totally wrong. Instead of starving investors by restricting the flow of information, managers need to transform them into well-informed strategic partners with intertwined mutual interests.
A sob story?
Benoit reports that Wachtell sent its proposal to the Securities and Exchange Commission in order “to combat what it and some others see as an excessive focus on short-term performance that they say has been encouraged by activist shareholders.”
In other words, the law firm’s attorneys claim that corporate managers just can’t execute long-term strategies because their pesky owners keep interfering. It follows, but only in management’s minds, that reporting but twice a year will create a moat of silence that will keep the unwashed barbarians out of their hair.
Don’t your hearts just go out to those afflicted and oppressed executives who are forced against their wills to be accountable for their policies and outcomes? As we write, we’re wiping away a flood of tears. Of course, they aren’t brought on by sympathy but by our uncontrollable laughter … .
The idea of reporting less frequently is not just nonsense. It’s not even complete nonsense. It’s utterly foolish and absolutely absurd nonsense.
Three bad premises
Wachtell’s proposal relies on three bad premises:
- Capital markets are a nuisance instead of mutually beneficial partners for converging a stock’s market value on its real intrinsic value.
- Capital markets make better decisions when they have little or no access to up-to-date firsthand information.
- Managers can control their stock price and cost of capital by minimizing how much they report instead of providing frequent, honest, clear, and complete adult-level communications about their real long-term plans.
We dismantle these assumptions below.
Markets as partners
Back during the first two-thirds of the 20th century, most managers saw themselves locked in battle with four markets:
- Labor markets: They believed the only way to get employees to work hard was through pressure and intimidation.
- Output markets: They assumed customers would eagerly buy whatever their companies produced.
- Input markets: They were convinced their supply chain members were so privileged to be doing business with their companies that they could be brow-beaten into conceding rock-bottom price reductions.
- Capital markets: They believed they had free rein to manage any way they pleased because investors lacked the power to restrain them.
Notably, events over the final third of the century significantly changed their relationships with three of these markets.
The first thing to crumble was their condescending attitude toward labor after the concepts of human resource management made it clear that employees are more likely to be loyal and productive when they’re nurtured, challenged, and rewarded, instead of threatened.
Next, their presumptive attitude toward customers collapsed when the success of Japan and Europe in applying Total Quality Management proved that a company must completely satisfy their needs or lose them to someone who does.
Finally, managers’ domineering attitude toward their supply chains vaporized when Japanese manufacturers reaped extraordinary benefits from just-in-time techniques. Close collaboration all up and down the chain ensures that inputs arrive on time and meet the quality standards needed to keep the line moving.
In summary, companies’ relationships with these three markets evolved 180 degrees away from exploitation and conflict to become mutually beneficial partnerships that help both parties.
Alas, though, today’s management corps doesn’t seem to have ever pondered whether they would be better off if they developed similar closely-aligned relationships with the capital markets.
As we understand it, these markets demand only two things from managers: possible future cash flows, and useful information for assessing those cash flows’ amounts, timing, and uncertainty. Obviously, managers who fail to satisfy either or both of those two demands will always encounter higher capital costs and discounted stock prices.
According to the paradigm we call Quality Financial Reporting, wise managers will cultivate close and productive communication-based partnerships with capital markets, instead of trying to deny them access to timely information.
Uninformed capital markets
In today’s information-driven world, most successful managers closely monitor their own companies’ results, increasingly with data dashboards that continuously keep them fully informed, not quarterly, not monthly, not weekly, not even daily, but minute by minute.
We simply cannot comprehend how they can look up from their own essential red hot data and somehow still believe the capital markets will embrace their companies even though they aren’t being provided with timely and useful information.
Neglecting the markets’ thirst for the latest data obviously leaves them uninformed, thus inducing these three rational (and devastating) reactions to their uncertainty:
- Market participants may decide against investing in a company, thus drying up demand for its shares and dropping their value through the floor.
- They may invest without full knowledge, compelling them to compensate for their risk by offering to buy shares only at discounted prices.
- They may gather their own intelligence from other sources, thus doubly depressing share values because they still face information risk and need even higher returns to recover their research costs.
Despite these negative outcomes, Benoit noted that quarterly financial statements have “for years drawn complaints from corporate managers who say they are overly costly and time-consuming to produce.”
Really?
We wonder whether these managers have ever actually compared the minuscule cost of hiring a few more accountants against the higher cost of capital and discounted stock prices that necessarily follow when they force the capital markets to keep guessing.
Further, the last time we looked, it’s shareholders who bear those higher preparation costs, not the managers.
For no valid reasons, Wachtell is laying down a pitifully thin smokescreen to somehow help its clients evade full accountability. It just won’t work …
Managing stock prices
Incredibly, it seems that most managers vainly believe they can manage their companies’ stock prices by crafting the information the capital markets use in their analyses. Here are three primary flaws in their scheme;
- Investors don’t have to believe, much less act on, everything or even anything the managers say or report.
- Investors can rely on any information they choose wherever it comes from and whenever it arrives.
- Investors are not compelled to buy or stay invested in any particular stock.
Even if managers could levitate their stock’s market price for a little while by reporting good news and hiding the bad, they wouldn’t be able to sustain it because the truth eventually comes out. Furthermore, for today’s markets, “eventually” means at most a few days, not years, months, or even weeks.
Now, what about activists? Although managers disparagingly call them “sharks” or “bottom fishers,” we consider most of them to be positive change agents because they confront situations in which bad policies and practices have depressed a stock’s price below its intrinsic value. When they arrive, share values usually increase because the markets anticipate increased cash flows and less risk.
Thus, it’s quite clear that Wachtell’s preposterous proposal to shield incompetent managers against activists is totally backwards. What’s actually needed is more protection for all shareholders against managements’ pointless schemes.
New partnerships
We guarantee that it never has, and never will, work to any managers’ advantage to begrudgingly comply with minimum reporting requirements established by politically influenced and otherwise compromised GAAP standards. Instead, imagine how different it would be if they comprehended that they would achieve great benefits by opening their treasure chests of data so everybody could quickly learn what’s happening.
We promise that voluntarily upgrading their reports’ frequency and contents will lead to mutually beneficial partnerships with the markets. Why? Because reducing investors’ risk will lower their demanded rate of return, thereby creating higher stock valuations and reduced capital costs that will completely outweigh the incremental costs of providing useful reports.
Bottom line, good managers won’t wait for bureaucrats to specify new mandatory practices but voluntarily build productive relationships with capital markets, thus replicating the decades-old revolutions in the labor, output and input markets.
Nothing but the truth
In our book, “Quality Financial Reporting,” we quote this insightful comment that Neel Foster shared when he was a member of the Financial Accounting Standards Board: “George Hatsopolous, the chairman of Thermo Electron … once observed that most of the CEOs he knew were always complaining that the market didn’t understand their companies and consequently their shares were underpriced. He allowed that if that was true, whose fault was it? Clearly, if the market didn’t understand their companies, it was because they were not adequately telling the story.”
We find it impossible to take Wachtell’s proposition seriously because that firm and its clients don’t begin to understand the assured benefits of positive relationships with their investors and the broader capital markets.
Our vision for the future forecasts more frequent reports that provide more truthful and useful content, instead of the same tired pseudo-information required by GAAP that doesn’t alleviate uncertainty. The best way for managers to make that happen is by voluntarily fostering mutually beneficial strategic partnerships, instead of pleading for even lower minimum financial reporting requirements.
There you have it: Today, just like we did in 2015, we’re talking plain economics and finance, not rocket science and certainly not just our opinion. In case they’re needed, we have additional arguments to make such as the one that reducing compliance expenses for a corporation doesn’t reduce costs but shifts them at much larger amounts to investors and the markets.
We’re hoping this revival will be enough let us get back to our golf and shuffleboard, but we stand ready to bring more wooden stakes to send this monster back to the graveyard.
