Dear Valued Clients and Friends,
In what has been one of the most memorable interviews in financial media all year, CNBC’s Becky Quick scored a rare joint interview last week with Jamie Dimon, CEO of banking giant, JP Morgan, and investor extraordinaire, Warren Buffett. The two appeared together because they are working together via Dimon’s role in the Business Roundtable to fight against the corporate epidemic of “short-termism.” Specifically, they are calling for an end to the practice of “quarterly earnings guidance.” The entire conversation reinforces a key tenet of the core investment philosophy of The Bahnsen Group that is being entirely missed in this discussion.
Their broad point is not particularly controversial – corporate management ought not to lose sight of long-term corporate strategy and fiscal health. Should the focus on short-term metrics compromise long-term decision making, the latter must trump the former. Few outside a trading desk would disagree. The more specific point is controversial: as a tactic towards that longer-term stated goal, does ending “quarterly guidance” facilitate long-term wisdom, or rather, does it limit investor transparency? Is less information better than more information? Could there be an unintended consequence in promoting corporate management being less forthcoming with the investing public?
Dimon was clear in the interview – quarterly results are often a by-product of “the weather, commodity prices, volumes, competitor pricing” – things outside the CEO’s control in the short term. Systems, R&D, strategy – the things that matter to the long-term success of a business – are inherently long-term concepts and practices. Buffett points out that the very practice of offering short-term numbers “sends the wrong message … it makes them do a lot of things that are counter to the long-term interests of the business.”
Their reasoning has strong prima facie support – that in a culture focused on 90-day intervals and result reporting, C-suite behaviors, and thought processes are likely to be affected by this reality. This has been evident over the years (in extreme cases) by significant accounting fraud (at worst), or at least accounting “creativity.” But apart from such obvious negative consequences, the quarterly clock of corporate results may result in strategic expenses being deferred that ought not to be deferred, and general activities being shifted around to fit into a given calendar paradigm rather than what is organically logical for the business. It stands to reason, too, that it is all a huge waste of time. In a period where high-level CEO’s and CFO’s enjoy compensation never experienced in history, the time and energy used for such quarterly preparation and maneuvering and communicating represent a potential diversion from more productive behaviors.
I have long felt that quarterly guidance is irrelevant in the long term (companies always and forever get discovered for what they are), and primarily exists to drive activity for traders. That increased volume does increase volatility, especially around the quarterly periods, and it would stand to reason that it encourages poor decisions by investors who are prone to emotional reaction. Buffett and Dimon did not center their comments in Becky’s thoughtful interview around investor behavior, but rather on corporate behavior. And yet the logic of Buffett and Dimon’s underlying point applies to both sides – the producer of the information (corporate management), and the consumer of the information (investors). In a perfect world, we could simply reiterate the fundamental point that a business is a complex entity which over time must execute on a strategy, grow revenues, protect market share, innovate, compete, manage costs, and deliver results that produce profits to its stakeholders. That indisputable fact would trump all silliness around “this quarter our currency conversions cost us $.01 cent per share” or “an unexpected hurricane in Puerto Rico disrupted product deliveries by 1.7%” – etc., etc. The more important principles in long-term wealth creation would dictate investor decisions, and therefore, the incentives of the corporate management who are accountable to said investors.
But it is not a perfect world. And investors remain susceptible to the wrong decisions, at the wrong time. An obsession with quarterly results and quarterly guidance provides ample opportunity for investors to give into their worst instincts. However, long before highly regarded investor and business minds like Jamie Dimon and Warren Buffett began sounding the alarm on short-termism, investors have had a much better indicator of corporate health than quarterly earnings announcements, anyways. That indicator is, of course, the dividend management pays to shareholders.
I will provide necessary caveats in a moment, but let me say that if seeing through quarterly “gamesmanship” is the goal, few methods have ever been invented that allow such more effectively than the actual cash a company pays its shareholders. With or without quarterly guidance, modern accounting is too opaque, complex, and flexible, to ever signal with maximum clarity the real health of a company, free of distraction and noise. But management knows how their own company is performing, and how they expect it to perform. They know the big picture and can make sensible projections that are validated by what they actually do with cash. Revenues can be “created” through derivative swap transactions, but shareholder value is created when cash ends up in a shareholder’s pocket (or reinvested into more shares). Companies are far more likely to pull the wool over your eyes with “accounting guidance” than they are a real cash dividend. We always say, “many people make more money than their tax return says; but NO ONE makes LESS than it says!” Real taxes paid are the minimal indicator of real income. Likewise, an actual dividend paid and a company’s willingness to raise that dividend tells us more about the actual long-term health of a business than quarterly results!
The immediate rebuttal is easy to anticipate: Companies can manipulate with a reckless dividend, too. Think of the big financial companies in 2007 that were continuing to pay unconscionable dividends to investors even as their balance sheets were corroding. A high dividend paid when profits are eroding, strategy failing, and a balance sheet is in disarray, is not a good indicator of company health or confidence, but rather an exercise in futility. Indeed, at times the very best thing a company can do to steward its resources is cut or suspend a dividend. We offer no dispute to this! However, the sustainability and feasibility of a dividend, as well as a dividend’s path to growth, can be understood by understanding the company culture, management’s philosophy, the company’s own track record, and that always available but often overlooked part of the income statement – the free cash flow. Yes, a company can deceive shareholders who are not paying attention for a very brief while with an artificial dividend, but it is very hard to fool investors doing their job (and my job, I mean, our job). And it is impossible to do so for long, for the very reason that cash does not lie. Quarterly guidance can lie; cash paid either does not lie, or it doesn’t lie for very long. And to the extent it does lie, it sure is a stupid lie (do you think Citibank and Merrill Lynch would have liked the foolish dividends they paid in 2007 back when they came upon the realities of 2008?). We do not offer up dividend transparency as an infallible tool, only a vastly preferable one to all the others!
Becky’s interview has started a conversation we need to have on the benefits of short-term transparency against the long-term interests of company stakeholders. We take Mr. Buffett and Mr. Dimon’s side. But, we believe the greatest tool investors have (again, imperfectly) to transcend this, is, and always has been, the message a company sends you with the dividends they pay, and equally important, the dividends they grow.
David L. Bahnsen, CFP®, CIMA®
Chief Investment Officer, Managing Partner
The Bahnsen Group, HighTower