The Open Letter Main Street CEOs Should Write to Wall Street
Dear Wall Street CEO:
You’ve been taking it on the chin lately. On the other hand, the only CEO Obama has fired recently came from my side of town–Main Street—so maybe you’re not so bad off.
I have a proposition for you. For both of us, actually.
I, a Main Street CEO, am going to show you, Wall Street, how to create some real value out of “thin air.” I know, you think that’s your schtick, but hear me out.
From here on out, I propose to tell the truth about our earnings.
It’s that simple. We tell the truth about our earnings–warts and all. You come to believe it. You then no longer shave your estimates of our quarterly earnings, because we will no longer smooth them by moving things offsheet, or by tweaking policies from our financial subsidiaries.
Call it the “truth factor.” It really isn’t, though. It’s simply reversing the “suspicion factor” you’ve always had in place. Remember “quality of earnings?” Well, we’re going to provide the highest quality of all; not conservative accounting, but transparent accounting.
That’s the kind of financial value creation I know you understand. But let me go further—this policy is also going to create real value—as in higher productivity, lower costs, greater customer retention, high quality, better customer service—all that good stuff that actually drives business. Here’s how.
This morning, I’m going to announce company-wide that we are no longer including short-term incentives in our performance assessment plans. Here’s why.
Every sentient businessman knows that the dumbest way to run a business is to change plans every 3 months. The smartest way to run a business is to develop a long-term plan, based on long-standing business principles and policies and on core values. Then execute on it.
It is long-term plans, executed well, that produce the best short-term results—quarter after quarter after quarter.
But somehow, in my firm and nearly all others on “Main Street,” we lost track. It started out by our saying, “if you can’t measure it, you can’t manage it,” and “what gets measured gets managed.” So we started measuring everything quarterly (OK, I admit–way shorter than quarterly).
Maybe we got that from you guys.
Now, it pains me to admit this, but somehow—I know, it sounds crazy—we just flat lost track of the simple idea that long-term management produces the best short-term results. And we started thinking that because we were measuring short-term, we had to manage short-term. After a while, nobody would take a 3-week risk. Or honor a 4-week deal. Or sign up for a 6-month customer plan.
Like I said, dumb. But it’s the truth. It’s what we did.
But no more. From now on, we’re managing for the long-term. That doesn’t mean we’re giving up on metrics—precise metrics are critical for all kinds of things, like trend analysis and trouble-shooting. It’s just that using them like a steel cable linking to performance pay and quarterly earnings is not going to be one of those uses.
Our CFO is going to stop focusing on quarterly numbers within and without the firm. Internally, we are going to very clearly explain the long-term basis for performance assessment and goal-setting we will be using. After that, anyone found to be rewarding behavior solely for the sake of short-term numbers will be hauled before the management committee and asked to justify it in strategic terms, or to explain, "What part of long term management for performance do you not get?"
And mark my word, our earnings will go up. Because long-term management fosters relationships, trust, continuity, efficiencies, effectiveness, scale economies, customer loyalty, and employee engagement. And that makes money the old fashioned way–by creating real value.
Externally, you and yours are going to have deal with greater earnings beta from us. The quarterlies are going to be more volatile. But we’re done interpreting numbers for you.
From now on, you have to be good enough at what you do to discern the underlying pattern and explain it (hint: it will be generally NorthEast). We’ll tell you up front our policies, and show you over time how we live up to our pledge of transparency.
So my question to you, Mr. Wall Street, is do you have the guts to play the new game? My cards are on the table, as of this morning. Where are yours?
Lots of different things going on here.
For public companies, performance is measured minute by minute as the market adjusts the stock price. It is hard not to keep an eye on this. Quarterly earnings are required by the SEC for public companies and most financial reporting. Even if you are no longer managing to deal with these, they will be the elephants in the room.
I am a big fan of companies not offerig earnings targets or sales projections. That is just guessing at the future. As we have seen, it can lead to some questionable if not illegal behavior. Companies and their employees feel pressure to make those numbers.
The other issue is properly aligning incentives and compensation to match the long term strategy. I poked at this a little bit in Did Compliance Programs Fail During the Financial Industry Meltdown?
Thanks for the thoughts. And I recommend readers to Doug’s linked article above about compliance programs.
But I want to push back on a few of your comments.
First, yes the market does price, every second. But it doesn’t price performance–rather, it prices expectations of future performance. In the past, too many analysts and companies have taken that to mean that they should have "predictable" earnings, so that investors can extrapolate the future from the past.
Cisco and GE are two companies who made a religion of managing their earnings numbers to meet this presumed standard of predictability. And it ended up biting both of them in the butt, as it became increasingly clear that the approach of "managing to numbers" made the numbers more opaque–not less.
Good analysts have always known to look behind the numbers. The Street is not as dumb as CEOs, managers and compensation consultants like to think; they do, in fact, frequently assign higher valuations to companies whose earnings potential is more powerful, even if their past earnings records have been relatively ragged.
Put it this way: Which would the Street rather see–a steady stream of managed numbers with an expected future value stream of Y, or a more erratic stream of earnings with an expected future value stream of 1.2 x Y?
Someone can speak to this better than I can, but frequently, the market’s answer is the second scenario, not the first. It opts for value, not just steadiness.
Yet somehow companies themselves nearly always ignore this, in pursuit of the supposed "fact" that markets price their stock based on predictable earnings. And so they manage their businesses based on a fiction–that tweaking quarterly earnings somehow increases their stock price.
No, it doesn’t. It does just the opposite; it destroys stock price. Let me say it again: the more a company tweaks its earnings to make them predictable, the more it lowers its stock price. Why? Because the stock price doesn’t react to a company’s past ability to fake its way through a quarterly income statement–it reacts to the whether it believes that real earnings are in store for the future, or whether they too will be gimmicked-up.
Or, in simple terms: too many CEOs are managing their businesses based on a myth–the idea that Wall Street’s prices are determined by steady quarterly earnings-per-share.
The pressure that you speak of to make the quarterly numbers, Doug, is self-administered. They are doing it to themselves. They are disconnected from reality.
It’s a simple as "the best short term performance does not come from managing short-term, but long-term." If you buy that, then you cannot avoid the conclusion that short-term management destroys earnings.
I once saw a small company, in the midst of the dot-com boom, who took this to its cynical extreme. I was horrified to find that their earnings projections were made by a junior analyst–who achieved them by taking the simple average of the projections of all the analysts who followed the company.
It is all mirrors. The only sensible way to create value and communicate it is to tell the truth. That does not rhyme with keeping your eye on the minute to minute price–that behavior doesn’t just destroy value, it destroys stock price, and sooner than most companies like to think. It is, literally, self-destructive.
Yes, Wall Street is sometimes co-conspirator with the simplistic view of steady earnings, and I really don’t know to what extent a given price for a given company on a given day is a function of the "must meet quarterly expectations" pressure, and how much is based on a more nuanced view of prospects. But I know enough to know there are a lot of smart big investors out there who know the difference, and know how to arbitrage against stupid CEOs who are destroying real value in order to report steady numbers.
The fact that the SEC requires quarterly earnings and everyone watches them is irrelevant. The point is, are you going to destroy real value to feed the myth of steady earnings, or are you going to be transparent and let the earnings fall where they may, while being transparent and consistent about accounting policies?
The first one destroys value, the second one helps create it, and there enough people driving stock prices who know the difference.
I think we agree. I am just pointing out that structural issues in the system that need to be addressed.
GE is a terrific case in point. They had steady earnings for years and were handsomely rewarded for it. Do I think they were manipulating assets and pushing income around to meet those steady earnings. Yes.
But they also got hammered when they announced that they were no longer offering earnings guidance.
As I mentioned in my post, you need to make sure that compensation is properly aligned with this long-term strategy. If you are paying everyone with stock, those stock price changes affect your wallet and therefore your decision-making.
Clearly I am biased because I work in private equity, but there is a lot to be said for the long-term view of private equity ownership over the gyrations of a public company.
Charles, I think you hit the nail on the head. Wall Street CEOs need to start being more concerned about the company than the stock market. It is time that the company be focused on building and growing the company and it’s ability to do business instead of the stock prices. Stock prices move many times without regard to actual performance. If the leadership would focus more on the company that they are supposed to be leading and less on their stock options, I think that the companies would be more successful over the long term. Instead of basing the leadership’s pay on stock price how about basing it on profitability. Just a thought.
Jeremy @ RefocusingTechnology.com
Doug, thanks for that. Here’s some more I expect we agree with.
GE got hammered for suspending guidance–that is, not for telling the truth, but for telling even less truth! They took a bad situation (i.e. managed earnings, high opacity) and made it worse–now who knows whether they’re managing it, because removing guidance actually increases opacity!
The simple, right thing to do–what I suggested in the post–is to pick an accounting policy, announce it, and stick with it. No surprises there. Then let the apples fall where they will. Frankly I think guidance is still useful, because it’s a way to make policy transparent, and to continually reinforce the transparency of your compliance to those policies.
Finally, the problem with compensation is not linking it to stock–it’s linking it to stock at a point in time. Long-term alignment of interests between company and individual are to be desired, just as it’s desirable that stock prices in the long run track cash flow and economic value.
I suspect there’s no perfect solution to that, but lengthening the time horizon–i.e. making some compensation conditional on results after the time period in question–probably has some role to play. You’d know better than I; how can one align economics using stock in a longer term?
God bless us if this idea would really take hold; I would think I died and went to Heaven.
My reality check says we have been doing it the other way for so many decades that such change is going to be like turning the Queen Mary with a row boat. I am truly an eternal optimist, but, as a Chicago native, I was also nurtured in the mantra of "Chicago (read Wall Street) ain’t ready for reform yet".
But, but …. keep the challenge out there. Maybe, just maybe it will be heard and accepted.