The Digest #17

Published on April 15, 2020

In Today’s Issue:

  • The Earnings Guidance Trap
  • The Great Influenza of 1918
  • Howard Marks on the Future
  • Buffett Wears a Mask

To read last week’s newsletter please click here.

The Earnings Guidance Trap

Over the next several weeks, public companies will provide financial results for the first quarter of 2020. Traditionally, most larger companies also provide shareholders and analysts with “guidance” for the current quarter as well as the full year. There is no uniformity when it comes to such guidance but, typically, one can expect to see management provide a range for expected revenue and profit margins. This allows analysts to have a starting point for building their own valuation models and makes it easier to come up with price forecasts.

The COVID-19 pandemic hit the economy very hard in the first quarter and many companies had to suspend the prior guidance that they previously provided to analysts. This is understandable given the massive disruption that impacted most businesses during the quarter. Companies with particularly stable operations, such as Johnson and Johnson are still providing forward guidance to analysts but most companies will not be able to.

In June 2018, Warren Buffett and Jamie Dimon co-wrote an opinion article in the Wall Street Journal urging companies to reduce or eliminate the practice of estimating quarterly earnings. The focus on short-term earnings has a number of very dysfunctional side effects and makes it harder for managers to focus on long term value creation.

Quarterly earnings-per-share guidance is a major driver of this trend [short term focus] and contributes to a shift away from long-term investments. Companies frequently hold back on technology spending, hiring, and research and development to meet quarterly earnings forecasts that may be affected by factors outside the company’s control, such as commodity-price fluctuations, stock-market volatility and even the weather.

Buffett and Dimon cite other pernicious effects of quarterly earnings estimates including the reluctance of private companies with a longer term mindset to go public at all which has reduced the number of public companies available for investment. At the same time, they emphasized that they are not advocating less disclosure in reporting, only an end to management forecasts.

Berkshire Hathaway’s largest publicly traded equity holding is Apple which continues to provide quarterly guidance to analysts. When Apple announced that it would “miss” quarterly guidance in January 2019, the stock took a hit as analysts updated their earnings models and price targets. This proved to be a transitory decline in the stock price but there can be little doubt that it caused a major distraction within Apple at the time. In The Quarterly Guidance Trap Bites Apple, I attempted to make the case that Apple should consider suspending guidance.

The COVID-19 shutdowns will make it impossible for most companies to forecast sales or profits for the second quarter or for the full year. Analysts will have to make their own judgments regarding how the pandemic will impact individual companies and update their models accordingly. This is as it should be. Managers should be focused on long term value creation, not on “making the numbers” over a thirteen week period — whether in the midst of a pandemic or in calmer times.

The Great Influenza of 1918

The Great Influenza by John M. Barry was first published in 2004, long before the world was besieged by the COVID-19 pandemic of 2020. Barry sets the stage in a comprehensive manner by devoting nearly a hundred pages to the rapid advance of medicine during the final decades of the ninetieth century which culminated in the establishment of great institutions such as Johns Hopkins and the Rockefeller Institute.

These institutions would be at the forefront of medical research for decades and played an instrumental role in the response to the 1918 pandemic. There is much that we can learn from Barry’s account of the distant past with many parallels to what we are currently going through in our own pandemic of 2020.

Read a review of The Great Influenza published on The Rational Walk

Knowledge of the Future

Howard Marks published a memo yesterday pondering what we can and cannot know about the future. In the midst of the worst pandemic in 102 years, the worst economic decline in 90 years, the greatest oil price decline in OPEC’s history, and massive Fed action, Marks warns that “if you’re experiencing something that has never been seen before, you simply can’t say you know how it’ll turn out.” 

Marks has a lot to say about the bailouts that are currently taking place and the moral hazard that will result when people are rewarded for taking risks that turn out well in good times but are shielded from the downside when things go wrong. He emphasizes that markets work best when there is a healthy fear of loss and that the government should not seek to eradicate this fear.

Read Knowledge of the Future by Howard Marks

Buffett Wears a Mask

It was great to see a photo of Warren Buffett yesterday on Li Lu’s public Facebook timeline. Wearing what appears to be a surgical mask, Buffett seems to be healthy and in good spirits.

Buffett was forced to cancel the events surrounding the annual Berkshire Hathaway annual meeting this year due to the COVID-19 pandemic. However, the meeting itself will proceed on Saturday, May 2 and will be streamed live by Yahoo.

Buffett has said that he will not be making any comments regarding Berkshire until the annual meeting. Berkshire is expected to release first quarter results shortly before the annual meeting and Buffett is likely to take questions from journalists and analysts. 

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Copyright and Disclosures

Nothing in this newsletter constitutes investment advice and all content is subject to the copyright and disclaimer policy of The Rational Walk LLC. 

The Digest #17