Sunday, March 24, 2013

Does the Market Fail to Reward Long-run Managers?

        In the Wall Street Journal’s Intelligent Investor column, Jason Zweig reported on March 23 that the short-term focus of the stock market, measured by increasingly active trading and dramatic market reaction to apparently short-term information, was having an impact on executive decision making.  More specifically the article noted that,
This past week, Oracle's ORCL -0.99% stock lost 10% in a day after the company fell short of quarterly earnings expectations by one penny per share, and shares in FedEx  FDX +2.05% dropped by 9% in two days after a sharp decline in quarterly profits.  Investors with such itchy trigger fingers make corporate managers gun-shy—and that, in turn, might hurt profits in the long run. A survey of more than 400 senior corporate executives in 2003 found that 59% wouldn't invest in a project that would generate significantly higher long-term profits if it reduced earnings in the short run.
   Such an interpretation is unfair to the market.  Neither the price drops in response to earnings nor the active trading implies that the market is not attempting to assess the long-run value of a company.  In fact, the case of Facebook and many other technology companies is dramatic evidence of how far out the market looks.  Otherwise, how could Facebook have a market capitalization of more than $62 billion on the basis of its current, relatively anemic earnings?  It takes a little analysis to explain how a long-term oriented market could respond so strongly to apparently short-term information, but the key idea is the difference between projections, plans, and objective evidence.

    Presumably every major American company has a long-term strategic plan.  What’s more, management presumably has concluded that its current plan is the best one for creating value.  Otherwise why would that be the plan?  It should come as no surprise, therefore, that if managers are asked whether they have a plan for maximizing shareholder value, they will always answer, “yes.”  But since everyone will always say yes, the market cannot rely on what is said to evaluate a company’s long-term prospects and plan – it needs objective evidence.  The most important objective evidence to which investors have access is actual financial performance.  Unfortunately, that information arrives only in short-term quarterly installments.  There is no way for investors to observe the “long term” except via short-term increments.  What is critical to recognize is that the reaction to those short-term announcements reflects the market’s effort to use the objective evidence to reassess the company’s long-term outlook.  Oracle and FedEx dropped not only because they missed current earnings expectations, but because of what those misses implied about the earning power of the companies going forward.  A more dramatic example is Apple.  Apple dropped from $705 to $420 on the basis of apparently minor short-term news, not because the market is short-term oriented, but because that news led to reassessment of Apple’s long-run competitive position.  You might argue that the market overreacted to news regarding Apple, that the long-term implications of the news were not that significant, but that is a different argument the thesis of which is that the market does not properly assess the long-term implications of short-term news, not that it fails to consider those long-run implications.

    The foregoing can be demonstrated more formally by taking advantage of data on the revisions of analysts’ forecasts in response to earnings announcements.  In a comprehensive paper Bill Beaver, Wayne Landsman, Steve Stubben, and I show that when stock prices move sharply in response to earnings announcements, it is not the current earnings surprise that is the primary cause of the stock price movement; it is the revision of expectations for future earnings up to five years into the future.  This research makes it clear that the market is using short-term objective information to update its assessment of the company’s long-run outlook.

   In light of the foregoing, rejecting projects that offer long-term profits because of short-term negative impact on earnings is completed misguided.  Companies that adopt such a viewpoint have a long-term problem – namely managers who fail to understand how the capital market operates and penalize their shareholders and society as a result.

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