Each quarterly earnings season, companies find new and creative ways of presenting their results in the most favourable light, as discussed in this article from the Economist.
Recently, there has been some high profile fallout from companies issuing creative earnings statements (Valeant and SunEdison, for example). In a general sense, we might ask whether the requirement for quarterly earnings disclosure causes companies and shareholders to focus on the wrong metrics. Graham, Harvey and Rajgopal found that CFOs regard earnings, not cash flows, as the key measure affecting investor decisions. Indeed, there is evidence that company share prices respond strongly, in the short term, to reported earnings and how these compare with (a) equivalent earnings from the same quarter in the previous year and (b) analysts’ consensus estimate of earnings. The practice of prioritising the declaration of profits can, according to the authors, lead to firms taking decisions that reduce long-term shareholder value, such as deferring investment in profitable capital projects that may depress earnings in the short term.
This focus on short-term profits may present an opportunity for the long-term investor. We have previously referred to a paper by Geoff Warren of CIFR, where he stresses the importance of long-term sustainable cash flows as the key indicator driver of long-term value creation. Investors should therefore seek to engage with portfolio companies’ management to refocus attention on cash flows, rather than earnings. Such an approach could also serve to distinguish those companies with a genuine long-term mind-set from those who are more interested in sustaining their share price in the short term.
This also raises a question around influence and engagement: are the companies directing attention to metrics they believe are more controllable, or are they seeking to manage their declared earnings because this is what shareholders are most interested in? And is there an opportunity for investors to influence the way their portfolio companies are managed by sending a clearer message to management on what they deem to be most important? Put another way, are investors fully exercising their power of ownership? Or is it a case of the market being dominated by short-term investors (presenting opportunities for longer-term investors to capture value)?