Time to stop giving earnings guidance?

WHEN Chinese water treatment firm Bio-Treat released its latest results a fortnight ago, all hell broke loose in the stock market - because the company's earnings were significantly lower than expectations, the stock was hammered, losing as much as 30 per cent in one day in the wake of a slew of 'sell' recommendations from analysts.

The fact that analysts called a 'sell' on the stock was by itself not remarkable. However, what was worthy of note was the near-unanimous reason - it wasn't Bio-Treat's poor financial performance per se but the loss of management credibility brought about by the earnings shock.
In fact, one foreign house's report on Bio-Treat was entitled 'More a credibility issue than an earnings problem' and said the market will not only focus on the negative earnings surprise but also on the way the whole communication process was handled.

In other words, the market penalised the company for not being open enough about an upcoming drop in profits. Or, to put it differently, Bio-Treat paid the price for not properly managing the market's expectations.

Which begs this question: now that quarterly reporting is mandatory - or at least it will be soon - should companies still continue to provide the market with periodic earnings guidance? Or should local firms follow the lead of most companies in Europe and an increasing number of large Wall Street companies like Coca-Cola and Gillette and stop giving any sort of projections?
The first thing to note is that although performance guidances are not compulsory, it is considered good practice - if that performance looks like it will differ greatly from the picture the company previously conveyed to investors. So in Bio-Treat's case, it could be that the numbers were radically different from what analysts had forecast from briefings or conversations with the management, hence the harsh treatment handed out to its shares.

(To be fair, Bio-Treat has subsequently provided a detailed account of what went wrong - inclement weather was a key reason for project delays and cost overruns, so it was impossible to predict an earnings shock. As such, it did not issue a profit warning).

But what if it had never been forthcoming with forecasts in the first place, and its only communication with the investment community was via its periodic earnings reports and whatever forward-looking statements are contained therein? Would it still be obliged to say something between earnings announcements if it knew that the market's forecasts were too optimistic?

Maybe. Providing the public with regular updates serves the useful purpose of removing much guesswork out of the investment process, thus ensuring as level a playing field as possible. Moreover, it is generally acknowledged that the disclosure regime should foster more communication, not less.

However, notwithstanding the fact that the 'no guidance' school of thought basically argues that investors are actually better off with less information, it does have plenty of appeal.
Proponents believe that constant performance updates - like quarterly reporting - encourage short-termism and distract management energies from long-term goals. It has also been argued with some justification that if companies stop giving guidance, stockbroking research will really be independent instead of the present rehashing of management-originated projections.
A big problem however, is that studies have shown than firms that practise less or no guidance tend to have lower institutional ownership and may find their shares underperforming as a result. So it appears advisable for companies to actively manage the market's expectations unless they are so well-established or are of such great standing that they can afford to limit their communiques to investors to three-month intervals.

The best that can be said therefore is that each company should decide for itself what the best policy is - if it opts to give guidances, it should be mindful of the dangers as illustrated by the Bio-Treat episode. For some, choosing to say nothing outside of the quarterly reports may actually be the best option.