Personal Finance

Smart Money: Eliminating earnings reports is the wrong fix for short-term corporate thinking

Quarterly reports are a bedrock for stock investment decisions. The latest news from a corporation on its performance can send shivers through markets.
Quarterly reports are a bedrock for stock investment decisions. The latest news from a corporation on its performance can send shivers through markets. Associated Press

Every now and then a remarkably bad idea springs to life. It gets debated, ridiculed and eventually discarded. In the marketplace of ideas, free and open debate help to determine which ideas are useful and which wind up in the rubbish heap. (John Stuart Mill was onto something). We tolerate reprehensible ideas because, ultimately, free speech leads society toward a greater truth.

This column is about a concept so misguided and ill- conceived that it cries out for a debunking.

The idea is that publicly traded corporations should stop reporting their quarterly financial results. Moneybeat reported that the idea originated in Britain, with Legal & General Investment Management, which manages $1.1 trillion in assets. Legal & General, according to the report, “contacted the boards of the largest 350 companies on the London Stock Exchange supporting a move away from quarterly reports.” That idea is now being championed in the U.S. by Martin Lipton and Sebastian Niles, both of the law firm Wachtell Lipton.

Before we dissect the problems with this proposal, let’s acknowledge upfront that there are many legitimate problems related to the quarterly earnings dance. It gives some companies an excessive incentive to disproportionately focus on short-term results. The pressure to game accounting can be overwhelming, and the way many companies use and abuse financial reporting is laughable. Longer-term capital expenditures, research and development, and investing can get neglected for fear it might hurt the quarterly numbers. Ignoring the long term leads to ill- advised acquisitions, needless firings and relentless obsession with cost cutting. Short termism certainly underlies the current practice of borrowing money to buy back shares.

The Wachtell lawyers are not the only people who have identified excessive focus on short-term quarterly data as an issue: others, including BlackRock Chief Executive Officer Larry Fink, McKinsey & Co., and presidential candidate Hillary Clinton, have all weighed in on this issue. But few have been willing to make so radical a suggestion as ending quarterly reporting, which now is mandated by Securities and Exchange Commission rules for publicly traded companies.

The focus on earnings has “corrupted” publicly traded companies and their management, according to New York Times reporter Alex Berenson’s 2003 book “The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America.” Corruption isn’t too strong word, but there is nuance that is easily overlooked.

This is because there are other forces contributing to short termism. Once we consider those, it might be possible to craft a solution to the corrosive effects of quarterly reporting that’s less extreme than killing off quarterly reports.

First, we must acknowledge that the present executive compensation structure is a profound source of short-term thinking. If we want to end short termism, then the stock-option portion of compensation should be structured for a much longer period of time. If management can’t exercise or sell shares for five or 10 years after they are awarded, it might do wonders for ending the relentless focus on each quarter’s results.

On a related compensation issue, let’s discuss why corporate management is paid for how well the stock market is doing, as opposed to how well their company does. Correlations and other evidence show that the broad market cycle (bull or bear) itself is a huge factor in individual company returns. So, too, is how well the firm’s specific sector is doing. Managers have little or no control over these things, but compensation plans are designed as if they do. This is beyond silly. Not only should the incentive portion of executive compensation (often in the form of stock options or grants) be longer term, but it should be based on metrics that gauge a company’s performance beyond mere stock movement.

Back to quarterly earnings. Why do we even require them in the first place? The answer is that thanks to the transparency provided by regularly reported earnings and profits, investors can make informed decisions about which stocks to own or avoid. Owners of public companies have hired managers to run the businesses for them, and they want to see with some consistency how healthy the companies that they own actually are. If there are issues with how the business is being managed by the hired corporate executives, the owners want to know sooner rather than later – and to have a chance to make course corrections. Quarterly numbers allow that to happen.

Despite the short-term focus management often has, the market itself has rewarded those companies that have a long-term focus. The most successful companies in the world have proven this. Apple, Google and Amazon are not unique in their understanding that success requires a perspective that extends beyond the next quarter.

Wachtell Lipton joins a long list of those who have decried corporate short-termism. The problem has been correctly identified. The proposed solution has been found wanting.

Barry Ritholtz, a Bloomberg View columnist, is the founder of Ritholtz Wealth Management. He is a consultant at and former chief executive officer for FusionIQ, a quantitative research firm.,