Why Would a CEO Stick with Quarterly Guidance?

I read an interesting take on this question today and I think it has a lot of merit. While many of us would prefer public companies abandon quarterly guidance, there are reasons why a CEO would keep giving it out. One reason might be to make them look good, and therefore enhance their job security.

If you are an active investment manager (whether for personal assets or professionally) you have likely observed in recent years that a pattern has developed during earnings season on Wall Street. Companies tend to beat estimates for the most recent quarter and guide estimates lower for the current and/or future periods. The end result is that most quarters finish with earnings coming in ahead of estimates on the whole.

While stock prices might dip in the short term because investors care more about future guidance than earnings already booked, this practice sets the bar very low. By keeping expectations meager, it maximizes the odds that the company will beat numbers next quarter, and that makes management look good. Under-promise and over-deliver (“UPOD” as Jim Cramer calls it). It works, and it’s what public companies should do in general (although maybe less often than every three months).

I think this is a great explanation for why many companies will keep playing the guidance game. It sets the bar low, makes them look like they’re doing a good job running their companies, and boosts their job security. If you don’t give guidance at all, the analysts could set the bar too high, forcing you to miss numbers and get an earful from investors.

How can investors play this growing trend? Buy stocks after a post-earnings sell off due to a guide down. After the company sets the bar low, investors adjust their valuations accordingly. Over the next couple months, Wall Street will realize the numbers are too low and the stocks will get a boost as strong performance is priced in again. Use that strength to pare off positions before the next earnings report if you think they might be lackluster or conservative.

That seems like the best way to trade the ever-growing trend of beating earnings and guiding lower for future quarters.

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7 Thoughts on “Why Would a CEO Stick with Quarterly Guidance?

  1. Anonymous on July 24, 2007 at 5:53 AM said:

    I don’t have the reference at my fingertips, but there are some highly regarded studies showing that firms that miss on earnings are far likelier to miss in streaks. That is, a Q1 miss is likely to be following by a streak of Q2, Q3 misses. Similarly, earnings surprises tend to be persistent. The data were through the late 1990s, from what I recall. The study may have been updated or possibly invalidated, but I doubt it. If anything, the introduction of Reg FD means that earnings surprise streaks should be *more* prevalent, since analysts don’t have inside information and are generally loathe to drastically alter their earnings projections.

    So I’m suggesting doing the *opposite* of your post. Buy (sell) companies with positive (negative) earnings surprises. It may be a matter of time horizon. Eventually they’ll mean-revert, but it could take a year or two. While I’d like to have clients with that kind of perspective, it is difficult to justify owning companies that have missed (and are likely to keep missing) when better opportunities abound.

  2. Chad Brand on July 24, 2007 at 6:03 AM said:

    I think you may actually be agreeing with my post, not vice versa. My point was that companies that want to beat numbers consistently will often lowball their guidance. This is done by beating numbers for the most recent quarter and giving conservative guidance for the next quarter, which makes it easier to beat numbers in the future.

    The companies that do this will beat numbers consistently (as you pointed out, these are the stocks you want to own). I was not suggesting that you buy companies that miss earnings estimates. I was suggesting that you buy after a positive surprise coupled with conservative guidance. Often the stocks will go down after lowballing guidance, but two months later they will most likely beat the estimates.

    On the other hand, firms that give out optimistic guidance will have a tough time beating consistently, which will result in the performance that you cited in the study.

    Sorry if the post was confusing.

  3. Anonymous on July 24, 2007 at 11:53 AM said:

    Thanks for the response, Chad. I *do* think we’re saying the same thing: buy stocks whose future earnings are mispriced (discounted too much) by the market.

    Where we differ, I think, is how “smart” or “dumb” market participants are relative to managers who provide guidance. I’m not an Efficient Markets guy, but I think many money managers try very hard to recognize “sandbagging” and trade on it, which means the consensus earnings should be reflected in the stock price, regardless of what management says.

    Therefore, your goal of buying after a positive EPS surprise with conservative guidance is more difficult than it sounds.

    Which brings us back to why Berkshire Hathaway and Google don’t give quarterly guidance, or why Hudson City Bancorp (HCBK)doesn’t do quarterly earnings conference calls.

  4. Chad Brand on July 24, 2007 at 12:09 PM said:

    Maybe it happens more with the stocks I follow, but I think it’s fairly common for a company to beat by a penny or two and sell-off after the report if the next quarter’s guidance is a penny or two below consensus. Not to say it happens all the time, but “buying the rumor, selling the news” is fairly common. Something to watch for this earnings season. Thanks for the comments.

  5. Rubens on July 24, 2007 at 12:13 PM said:

    I work for a large corporation in the energy industry and deal with budgeting and forecasting for our shareholder. The reason some companies are giving quarterly, not annual, guidance is simply that they can predict with MUCH better certainty their results for the current/next quarter than for the entire year. Think about it. Half the 3Q is already behind us, and forecasting the other half is not too dificult given the backlog, existing contracts, etc. I don’t think the CEO is playing games or trying to lowball the forecast. Guiding for several months to a year ahead is very complicated. For example, we deal with issues like gas and power prices, how much our power plants will be dispatched, how we will execute our hedging strategy, etc.

  6. Chad Brand on July 24, 2007 at 12:19 PM said:

    Agreed. In fact, it seems that commodity related stocks give guidance far less often than other firms, most likely for the reasons you cite… too many variables to predict with any accuracy. I don’t think my post explains every case, but it could in some instances.

  7. Chad Brand on July 25, 2007 at 8:38 AM said:

    Perfect example today… Corning GLW beats by 2 cents, issues in-line guidance for Q3, and the stock drops 6%. These are the kinds of opportunities I am referring to.

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