While we are on the subject of earnings management, let me highlight today’s Washington Post column by Steven Pearlstein — Leap of Illogic on Wall Street Leaves GE Flat-Footed — on the dangers:
Over time, this strategy has made GE the stock to own for long-term investors looking for “a safe and reliable growth company,” as [GE CEO Jeff] Immelt likes to put it. Unfortunately, under his predecessor, this wonderful reputation somehow got transformed into a solemn promise to deliver double-digit earnings growth every quarter, and to do so in a way that precisely matched the earnings guidance provided by the company. To meet those expectations, GE has become suspiciously adept at booking revenue and expenses and timing asset sales to meet earnings estimates with amazing precision and consistency.
The extent of this earnings management was revealed last month when an embarrassed Immelt explained that GE’s failure to hit its quarterly number was a result of the credit crisis, which in the past two weeks of the quarter had suddenly and unexpectedly reduced the market value of securities holdings and prevented it from completing anticipated real estate sales. But rather than acknowledging the folly of predicting quarterly results in the midst of a financial panic and worldwide economic downturn — particularly for a company reliant on financial services and “lumpy” industrial sales — Immelt prostrated himself before analysts and promised it would never happen again.
The problem Pearlstein notes, however, is that this strategy can come back to bite you:
Having decided that GE’s earnings surprise was the result of flawed corporate strategy, it was easy for Wall Street’s analysts to take the next leap of illogic and conclude that salvation could come only from buying and selling assets. That, by coincidence, just happens to be the only course that generates fees for Wall Street brokers and investment bankers. If Immelt had dared to tell them the truth — that he needs the cash generated from some of these maturing businesses to invest in new markets and new technologies for the long term — he would have sent GE shares into a tailspin.
Pearlstein is clearly frustrated with the way Wall Street treats such companies:
Immelt has the right strategy for General Electric, and he’s the right man to execute it. But he risks being frustrated in his efforts if he cannot transform his company’s relations with investors and opt out of the mindless earnings-expectation game. General Electric didn’t become a great company just by buying and selling assets — it did it by creating innovative products and continually finding better ways to produce them. It won’t remain a great company if it allows stock flippers and Wall Street analysts to distract it from its mission.
Right on: I have argued the same point in numerous posting on this blog. The problem is what to do about it. In part, it is a case of corporate relations. Watching a recent CNBC special on Warren Buffett, it was clear that he has done a masterful job of picking his stockholders by encouraging long term investors and discouraging short termers. Of course a Class A stock price of $100,000 helps in that regard – and it has not stop some from shorting the stock. It just means that Buffett doesn’t worry about the short term movement in the stock. But not everyone is a Buffett.
There is the United Technologies Corporation approach to highlight the company’s reputation and intangibles. UTC undertook a systematic effort to let Wall Street know about all the various aspects of their business and the strength of their intangibles.
Then there is the option of going private. Some have suggested that the best way to keep a company innovative to take the company away from Wall Street (for example, see The Gartner Fellows: Clayton Christensen’s Interview Part 1). This can be either through the existing private equity markets (at the risk of debt-overloading) or these new private trading markets.
Ultimately, there is the systemic issue of speculation. Speculation will always be a part of markets (a necessary part some would argue). But the issue is whether speculation or long term investment drives the market price. My preference is for long term investment. When speculators drive markets, markets fail — they turn into bubbles. But I would not ban speculation. My favorite solution is the sliding scale capital gains tax. Tax short term profits at a much higher rate than long term returns. That would help discourage the stock-flippers Pearlstein (and others) worry about.