Saturday, March 14, 2009

Signal and Noise from Corporate America

Last night Daniel Bases wrote a lead for his Reuters story that was hard for someone with my analytic bent to resist:

It pays to communicate but Corporate America is doing less and less of it with investors as the U.S. economy falls deeper into recession, undermining market confidence in the process, a new study showed.

As I write this I see that I have accumulated 114 posts with "communication" as a label and 269 posts with "economy." The above sentence seemed to suggest that these two topics might be on a collision course; so I felt compelled to continue reading in the interest of trying to figure out what, if any, damage might ensue. Here is what I found:

The number of companies in the Standard & Poor's 500 index with a consistent track record over the past 10 years of issuing quarterly earnings per share guidance is down 36 percent in the last 10 months, according to Thomson Reuters Proprietary Research.

Well-known companies such as General Electric, Microsoft, Costco Wholesale, and Nucor have stopped giving consistent earnings guidance.

"They are just pulling back because they don't want to continue to have to put out numbers that they cannot meet on the street," said Martin Sass, chairman and chief executive officer of MD Sass, an investment management firm with $6 billion in assets under management.

"It has devastating implications for their credibility, their stock prices, and the like," he said.

For those, like myself, who try to invest wisely without deep-ending on tracking those investments, I feel it is worth observing that "earnings guidance" is a technical term. In a 2005 Commentary piece on, Richard J. Wayman called it "a relatively new term;" so I suppose it is now more familiar to those to try to follow the financial news as thoroughly as possible. Here is Wayman's definition:

Earnings guidance is defined as the comments management makes about what they expect their company to do in the future, also known as “forward looking statements.” These comments often focus on sales or earnings expectations in light of industry and macroeconomic trends. These comments are made to investors so that they can evaluate the company’s earnings potential.

It goes without saying that it is not easy to make credible "forward looking statements" under volatile conditions; but what does that mean for the more general issue of communication between a company and its investors? By not making any statement about the future, it seems as if a company may end up sending one of two messages:

  1. Things are going to be so bad that we do not want to frighten you into selling off your investments in our company.
  2. Things are so unpredictable right now that we really do not know what is going to happen over the next quarter, so we are not going to say anything about what might happen and ask you to trust our skills in running the company.

Neither of these messages is particularly beneficial to the company. In current conditions the first interpretation is likely to induce the very fear it is trying to prevent. The second interpretation is more honest; but will such an act of "coming clean" raise the level of trust that investors have in the company? Richard Bernstein, chief U.S. investment strategist for Bank of America/Merrill Lynch offered the following comment to Bases:

We pay very little attention to guidance at all. It's basically public relations to manipulate investor thinking, and has little to do with true fundamentals.

From his point of view, even that "act of 'coming clean'" is "basically public relations to manipulate investor thinking;" and, given how much deception and opacity we have been facing, it is hard to disagree with him. Nevertheless, we find ourselves in a situation where not communicating at all ends up sending messages that are just as noisy (in the technical sense of information theory) as any guidance messages.

The problem is that a statement of earnings per share over the coming quarter is nothing more than a single number. About two years ago I wrote a blog under the title, "If You Reduce it All to a Single Number, that Number is Almost Certainly Wrong!" Nevertheless, ours is a culture that desperately hungers for such numbers; and, as I observed almost a year ago, that is the culture that Nicholas Carr was trying to confront in his Atlantic Monthly article, "Is Google Making Us Stupid?" Whether we read it in an earnings guidance statement or in the first page of Google search results, we blindly accept answers while ignoring any message that provides the reasoning behind those answers. I would thus argue that the issue is not, as Bases seems to suggest, that we should be concerned that Corporate America is not throwing numbers at us; rather, the issue is whether or not it is in Corporate America's interests for investors to understand the nature of the situation behind those numbers. As an investor, I would think that it is in their interests; but I am sure there are plenty of companies whose managers would disagree. Nevertheless, since it is my money that is at stake, I feel that I should at least have the right to decide to invest it in companies who appreciate the value of understanding and avoid those who messages are little more than what Wayman calls SWAGs (Systematic, Wild Ass Guesses)!

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