Warren Buffett thinks this whole discussion of whether or not a company beats expectations is problematic.
In his new annual letter to Berkshire Hathaway shareholders, the billionaire investor didn’t hold back his feelings (emphasis added):
“Finally, an important warning: Even the operating earnings figure that we favor can easily be manipulated by managers who wish to do so. Such tampering is often thought of as sophisticated by CEOs, directors and their advisors. Reporters and analysts embrace its existence as well. Beating ‘expectations’ is heralded as a managerial triumph.
That activity is disgusting. It requires no talent to manipulate numbers: Only a deep desire to deceive is required. ‘Bold imaginative accounting,’ as a CEO once described his deception to me, has become one of the shames of capitalism.”
There are two types of reported earnings, and both have shortcomings 👎
Each quarter, every publicly traded company is required to report detailed quarterly financial results in accordance with generally accepted accounting principles (GAAP) as defined by the Financial Accounting Standards Board.
GAAP allows for some flexibility in how companies do their books including how revenue is recognized and how expenses are accrued. The more liberties a company takes in its accounting, the more it may be accused of committing accounting shenanigans or even outright accounting fraud.
But ultimately, GAAP is considered very rigid as it forces companies to incorporate items that are arguably non-recurring or have values that can be very volatile over short periods of time.
As a result, many companies will report a second set of numbers adjusted for these items at the discretion of management. This process gets you what are often referred to as operating earnings, adjusted earnings, pro-forma earnings, or non-GAAP earnings. Management will tell you these earnings better reflect the underlying, ongoing health of the company.
Buffett has issues with how earnings are reported under both GAAP standards and non-GAAP practices.
He has long been a vocal critic of GAAP, as it requires Berkshire Hathaway to report the unrealized gains and losses of its formidable stock portfolio every quarter.
“The GAAP earnings are 100% misleading when viewed quarterly or even annually,” Buffett wrote. “Capital gains, to be sure, have been hugely important to Berkshire over past decades, and we expect them to be meaningfully positive in future decades. But their quarter-by-quarter gyrations, regularly and mindlessly headlined by media, totally misinform investors.“
But as you can tell from his earlier quote, Buffett is also skeptical of how executives achieve their non-GAAP operating earnings. And it has everything to do with the fact that Wall Street analysts help set the market’s short-term expectations by providing quarterly earnings forecasts.
I went into this in the November 1, 2021 issue of TKer: ‘Better-than-expected’ has lost its meaning 🤷🏻♂️. From the piece:
Expectations can incentivize bad behavior
As you can imagine, no manager wants to be responsible for having to report worse-than-expected earnings, which could trigger a sell-off in the company’s stock. After all, many managers, as well as employees, are paid with some form of stock-based compensation.
So, there are a variety of things managers can do if business is on track to fall short of expectations:
Earnings management: While companies have to report financial results guided by Generally Accepted Accounting Principles, those principles allow for some flexibility. With some creative accounting, a company can make its short-term earnings look stronger than they actually are.
Expectations management: During the quarter, management can send out signals to analysts that cause those analysts to be extra conservative in their estimates. Consider recent history: Ahead of 2021’s Q2 earnings season, corporate America was crying bloody murder about how inflation was threatening profitability. Sure enough, 87% of S&P 500 companies went on to beat expectations in Q2. Not only that: Profit margins actually expanded to record levels during the period!
Working employees’ asses off: If you’ve ever worked for a big corporation, then you’ve probably seen your boss’s stress level tick up near the end of a quarter or end of a year. You start hearing things like “quarter-end sprint” or “expenses have been frozen.” Long-term projects get shelved as employees are moved to quick-turnaround items. Random bonuses in the forms of cash or food start getting thrown around for work no one wants to do.
Also, this isn’t just about getting numbers up by the end of a quarter.
Sometimes you’ll hear managers tell you to tap the brakes or save that brilliant project for next quarter or next year. Odds are your company’s financials are pacing ahead of expectations. Why raise the bar on yourself with a massive quarter today when you can “hit the ground running” tomorrow?
This whole game of corporations providing short-term financial guidance and analysts estimating short-term earnings certainly keeps things interesting for short-term traders.
And sure, guidance and quarterly updates can reveal to investors the degree to which corporations are on track to achieve longer term goals.
But as we’ve discussed, a lot of this short-termism can incentivize some unproductive behavior and it also risks destroying value in the long term. (Let’s not forget about the fact that whether a company beats or misses analysts’ estimate are just as much an indictment on the analyst as it is on the company. As Morgan Housel often says, “earnings don’t miss estimates; estimates miss earnings.“)
The bottom line 😉
Whether or not a company beats analysts’ expectations for earnings usually tells you just how good executives and analysts are at precisely guessing the short-term behavior of customers, vendors, workers, and every other individual involved in the business. If the numbers are way off the mark, then there’s probably something going on. If they’re off by a little, maybe there’s not much to make a fuss about.
Beyond this headline generating phenomenon, companies provide lots of interesting detailed information about their business and the industry in which they operate. And their executives often share illuminating views on the economy from their unique perches. All of this can be quite useful for investors and anyone who cares about what’s going on in the business world. And so quarterly reporting isn’t all bad.
Investing isn’t easy and analyzing companies is very hard. And unfortunately, there’s no consensus on how to resolve the conflicts borne out of quarterly earnings reporting. For the time being, the best we can do is to stay educated and be mindful of the short-term pitfalls as we remain focused on achieving our long-term goals.