Market Views: Fixed Income
Less can be more: How to improve financial reporting
The recent debate on the usefulness of quarterly reporting in the US misses the point.
Unstructured Learning Time
While recent tweets have sparked the debate on the usefulness of quarterly reporting requirement, we believe the crux of the debate focuses too much on the frequency, and not enough on the actual problems: it’s too much information, it’s not always the right information, and it costs a lot to produce and process.
The first beer is the best
I will never forget the explanation of the law of diminishing marginal utility from a college professor. “The first beer tastes and makes you feel the best.”
In economic terms, the high initial utility of a good or service declines toward zero marginal utility as its available supply increases. This economic law, in many ways, is connected to the ongoing debate between quarterly versus semi-annual financial reporting and guidance.
This debate has been going on for years and has generally focused on the cost versus benefit to equity investors. The first precedent of corporate reporting dates back to 1903, with US Steel having voluntarily published its annual report. However, financial information from public companies was not required until 1911 when Kansas passed the first Blue Sky law. Over time, most states had similar statutes, but after the Wall Street Crash and following the Great Depression, the federal government took reporting authority away from the States and issued the Securities Exchange Act of 1934, requiring standardised periodic financial information on public companies to help investors assess and price the cost of debt and equity capital.
Mind your "Ks" and "Qs"
In the US, public companies are required to submit Form 10-Q (“Q”) for each of the first three quarters of a company’s fiscal year and an annual report on Form 10-K (“K”) at the end of their fourth quarter. If a major event occurs during the quarter, companies must complete a Form 8K or “current report”.
Most investors react to the initial quarterly press release published on an 8K a few weeks after quarter end. A few weeks after the press release, the Q arrives in the form of an unaudited phone-book-sized document filled with legal jargon and accounting boilerplate.
The recurring costs associated with public reporting requirements such as legal, financial reporting, investor relations and audit-related fees are considerable, especially for smaller companies. This is at times thought to be one of the factors contributing to the decision to switch from a listed company to a privately held company. Over the last decade, the number of public companies has more than halved from 7,600 to approximately 3,500 today.
This has especially impacted the high yield market, where more than a third of new issuers are from private companies. While costs will vary widely depending upon the size and complexity of a company, average costs associated with being a public company is estimated to run to more than $1,500,000 annually. Adding to preparation costs is the cost associated with the quarterly consumption of the Qs.
There are approximately 14,000 investment manager research staffers in the US. If these researchers spend an hour studying financial reports of a couple dozen companies four times a year, it adds up to over 1,000,000 hours spent studying historical information.
While costs associated with the preparation and analysis of quarterly reports are significant, unnecessary quarter-end trading and the corresponding transaction costs in response to frequent financial information can also mount up.
Although identifying unnecessary bond transactions costs specifically tied to quarterly reporting would be difficult, it is important to note overall trading costs are substantial.
A 2015 study from the University of Southern California Marshall School of Business that analyzed the costs of trading bonds, known as the bid-ask spread, estimated total transaction costs for the 12 months prior to March 2015 of $26 billion. This is especially significant when considered relative to the overall level of Treasury yields and credit spreads.
Beyond the most liquid series of the largest issuers, buying and selling transacting costs for corporate credit can reach 5-10% or more of the credit spread, which significantly reduces total return to the investor. Although no investor is forced to trade when new financial information is released, it does create an incentive.
While these consumption and transaction costs are born by the issuer, analysts, and investors, the enterprise cost has become the most scrutinised. Business leaders are worried that companies are too concerned with short-term profits instead of focusing on investing in their workers, research, or operations.
Benefits of a long-term focus
While research and development spending is rising in the US, the argument is that it could be higher or increasing at a faster pace if there were fewer public assessments. Management could have the flexibility to increase strategic investments, which might reduce profits temporarily, but could pay off handsomely over the long term if such capital expenditures were properly administered.
There is evidence from a McKinsey study that a longer-term perspective indeed increases revenue versus a short-term focus. According to the study, from 2001 to 2014, the revenue of long-term-oriented firms cumulatively grew, on average, 47% more than the revenue of short-term-oriented firms, and with less volatility. Similarly, the earnings of the long-term-oriented firms grew 36% more than those of other firms over this period, and their economic profit was 81% higher.
The real debate, particularly when it comes to enterprise cost, is not about quarterly or semi-annual reporting, it is about guidance. Companies manage analyst expectations by selectively guiding the market up or down prior to earning reports. In addition to formal and informal forward-looking information, management teams spend a lot of time massaging earnings using both accounting choices, known as earnings management, and operating discretion such as the timing of research and development expenses, accruals and impairments.
Although public companies are not required to provide information about how they are doing during the quarter, about 25[(-30) was not found] have official guidance policies. All of this is done, in many instances, to deliver results that superficially beat analyst expectations.
It wasn’t always this way. The guidance business took off during the latter half of the 1990s, after a Congressional Act was passed protecting companies from liability if their projections were not realized. At the time, executives generally believed that guidance would result in higher valuations from lower volatility and improved liquidity from more frequent information or transparency, particularly in in cyclical sectors.
However, studies have found that short-term guidance does not meaningfully affect investment, valuation or volatility. It doesn’t matter if information is meaningful or noise, when it provokes transactions it is good for traders but costly to asset owners. Also, much like costs related to Qs, public company executives have noted that the burden of providing and managing to guidance reduces long-term investment and is a motivating factor for public companies to de-register and become private.
It is likely that these (and other) academic findings led to the UKs Financial Conduct Authority having removed its quarterly reporting requirement in 2014. But with that, more than 90% of UK-listed companies continue to report on a quarterly basis as many are also listed in the US and have to report quarterly anyway.
Today, there are growing concerns that managing to a particular sales, margin or earnings-per-share could result in an inefficient allocation of investment, which in turn ultimately impairs the long-term prospects of the firm. While the payoff from strategic plans is difficult to predict annually or even quarter to quarter, in the last two decades, firms have become very good at playing the guidance game. Very large, complex, global companies have a remarkable ability to land earnings to within a penny per share of guided expectations. For example, a year ago for the third quarter of 2017, not one of the biggest US financial institutions earned less than the guided estimates. In fact, over the last two years, the largest banks in the US with billion and trillion dollar balance sheets managed to meet or exceed earnings per share (EPS) expectations 94% of the time!
From the perspective of a buy-side research analyst, three changes could potentially have meaningful benefits:
- Investors, industry groups and regulators should urge management to curtail guidance
- Replace 10-Q reporting with streamlined, periodic reporting of key performance indicators
- Reform regulatory reporting so that semi-annual and annual filings become more meaningful to investors
- Much like the law of diminishing marginal utility, we think frequent ad-hoc guidance should be replaced with periodic news releases on Form 8K. The information could be a mix of lightly audit financials with an explanation of material changes in revenues and earnings that occurred since the last annual or semiannual filing. These key performance indicator updates, provided every six weeks, would reflect how the market functions today while being less expensive and time-consuming. As this reporting replaces guidance, it would hopefully reduce the incentive for period-end financial statement manipulation.
Conclusion – greater transparency, less noise
Recently there have been calls for the SEC to study if changing from quarterly reporting to a six-month system would save money and allow for greater investment flexibility. While this is a good thing, we would caution that simply moving from quarterly to semi-annual reporting would be less than ideal, as studies from the UK suggest that it creates inefficiencies as investors seek, and trade, on alternative sources of information.
Instead, we believe investors would benefit from Ks and a detailed semi-annual report with an updated format based on investment principles, versus an archaic prescriptive approach. This can be accomplished by providing industries and issuers greater flexibility to customize information that is more valuable to providers of debt or equity capital.
Greater long-term transparency, less short-term noise. Now that’s something this credit analyst would raise a beer to.
 Jay R. Ritter, Warrington College of Business Administration, University of Floriday; University of Chicago Center for Research in Security Prices
 https://www.strategyand.pwc.com/media/fi le/Strategyand_Considering-an-IPO.pdf
 Harris, Lawrence, Transaction Costs, Trade Throughs, and Riskless Principal Trading in Corporate Bond Markets (October 22, 2015). Available at SSRN: https://ssrn.com/abstract=2661801 or http://dx.doi.org/10.2139/ssrn.2661801
 Barton, D., J. Manyika, T. Koller, R. Palter, J. Godsall and J. Zoffer. “Measuring the impact of short-termism.” Feb. 2017, McKinsey Global Institute.
 Analysis of guidance policies performed by KKS Advisors and Prof. George Serafeim of Harvard Business School using FactSet Guidance data.
 The Private Litigation Reform Act of 1995
 Call, A.C., S. Chen, A. Esplin and B. Miao. “Long-term earnings guidance: Implications for managerial and investor short-termism.” May 2016. http://www.hbs.edu/faculty/conferences/2016-imo/Documents/LTMF_May[(2022) was not found]202016.pdf
 Jamie Dimon and Warren Buffett WSJ oped “Short-Termism is Harming the Economy”
 For disclosure purposes, in 2016, Schroders, a UK-based company, elected to end its quarterly earnings. However, this article is intended only to further the discussion on this topic, and reflects the views and opinions of the author only, and does not necessarily reflect the views of Schroders.