“In all of our communications, we try to make sure that no single shareholder gets an edge: We do not follow the usual practice of giving earnings guidance or other information of value to analysts or large shareholders. Our goal is to have all of our owners updated at the same time.”
Warren Buffett, Berkshire Hathaway Owner’s Manual
When Warren Buffett first wrote the Berkshire Hathaway Owner’s Manual in 1983, investors had far fewer options to access corporate information in a timely manner. During the 1980s and well into the early 1990s, it was still common to research investments in a library setting. Readers over forty might even recall reviewing old magazine and newspaper articles using microfiche machines, a practice that would seem ridiculously archaic to the millennial generation. By the mid 1990s, the “information superhighway” was born and investors increasingly had access to all sorts of information online. The past two decades has seen tremendous progress in terms of the volume and velocity of data, but this progress has not necessarily been accompanied by greater understanding; in fact, it seems like market participants are as bewildered as they ever have been and increasingly value “guidance” from experts and insiders.
Apple “Misses” Guidance
The most reported financial story of the first week of 2019 involved coverage of Apple’s “missed” revenue forecast for its fiscal first quarter period which ended on December 29, 2018. Apple CEO Tim Cook kicked off the year on January 2 with a letter to investors describing various difficulties the company experienced during the holiday quarter. The number analysts immediately focused on was the revised revenue guidance which was lowered to $84 billion from a range of $89 to $93 billion given during the last earnings call on November 1. The company also lowered the gross margin estimate to 38 percent from a range of 38 to 38.5 percent.
The reaction of the market on January 3 was swift and severe with the stock price falling nearly 10 percent, although some of that decline has been reversed over the past few days. Interestingly, Berkshire Hathaway’s Class A shares declined 5.6 percent on January 3 which far exceeded the decline in the value of Berkshire’s Apple holdings and appeared to reflect Mr. Market’s skepticism regarding Warren Buffett’s ventures into technology investing.
Apple is probably the most scrutinized company in the United States, or at least in the top five, and I have little of value to add when it comes to judging the intrinsic value of the company or expressing an opinion on its future business prospects. While Tim Cook tried to frame the reduced guidance in the most benign way possible, including blaming much of the situation on macroeconomic factors in China, market participants clearly see more serious trouble ahead, particularly related to Apple’s premium pricing strategy and reports of weak demand for the iPhone XR. The fact that Apple will stop presenting unit sales data for its product lines has only added to investor angst.
The Guidance Addiction
Companies that provide quarterly guidance to the investment community are doing so because the market appears to demand it. Earnings calls typically take place a month into the subsequent quarter so analysts expect executives to not only talk about the prior period but to give a sense of how things are going during the current quarter. Typically, management will furnish either a range or a point estimate for various measures and analysts will plug these numbers into their models and then herd around a “consensus” expectation for the coming quarter.
While this might seem harmless, let’s take a step back and think about exactly what the investment community is asking for. A month into a quarter, analysts are asking management to look at the first third of the quarter and to make projections for the next sixty days. Because investors pay so much attention to guidance, managers spend significant time thinking about these estimates and deciding how aggressive or conservative they should be. Since time is finite, this means that managers are not using this time to run the actual business.
When a large company like Apple makes a prediction on November 1 and then drastically revises the prediction on January 2, a period of only 62 days, this leads investors to believe that management does not have a handle on the business or that events are spiraling out of control. After all, two months is a very short period of time.
When managers provide guidance, this effectively causes analysts to crowd around the mid-point of the range in their own models and the variation of estimates is narrower than would be the case if analysts had to do their own work. This reduces the overall quality of analyst estimates and encourages analysts to do less work and to be more reluctant to make estimates that fall far outside the consensus. When guidance later must be adjusted dramatically, the effect on the stock price is likely to be much greater than would be the case if management provided no guidance whatsoever. The irony is that managers typically give guidance in an effort to reduce volatility in the stock.
Buffett Calls for Ending Guidance
A few months ago, Warren Buffett and Jamie Dimon co-wrote an article in the Wall Street Journal calling for an end to quarterly earnings estimates. The main point of the article is that the act of providing guidance shifts management from thinking about the long term to thinking about the next quarter.
The intrinsic value of a company like Apple will depend on the quality of the decisions Tim Cook makes over the next several years. Shareholders should want Mr. Cook and other executives at Apple to focus on matters such as the optimal price points at which to offer phones for various geographic markets along with R&D that will allow the company to retain its technical and aesthetic edge over time. The last thing shareholders should want is for Mr. Cook to focus his time and energy on providing analysts with estimates of Apple’s revenue and margin over the next ninety days.
If Apple or any closely followed company stops providing all guidance, the market’s reaction is likely to be negative in the short run because it could be perceived as an attempt to hide bad news. However, over time, analysts will come up with their own estimates and a market driven consensus will emerge, probably centered around a wider range of estimates. In time, the market will get used to the lack of spoon-feeding and the actual results delivered over time will drive the value of the stock. This is as it should be and the example of Berkshire Hathaway shows that guidance is unnecessary.
Guidance vs. Disclosure
An important distinction needs to be made between guidance, or forecasts, from management and the actual disclosures that are made regarding past periods in 10-Q and 10-K reports. Apple recently announced that the company will no longer report unit sales data for its product lines starting in the current fiscal year. Changes in disclosure, as opposed to changes in guidance policy, could very well send an important message to investors. In the case of Apple, investors have reason to view the lack of unit sales disclosure with some skepticism given that it is coinciding with weak sales. A reduction in disclosure at a time of weakness does not send the most bullish signal to investors.
Berkshire Hathaway shareholders have been paying a great deal of attention to Apple in recent quarters. At the end of the third quarter of 2018, Apple represented Berkshire’s largest equity holding and Warren Buffett’s bullishness on Apple’s prospects has been a tailwind for the stock until recently. Apple’s weakness during the fourth quarter could have enticed Mr. Buffett to further increase Berkshire’s Apple holdings. On the other hand, Berkshire’s new repurchase policy opened up the ability for Mr. Buffett to make potentially large buybacks.
We will have to wait until mid-February to learn whether Berkshire’s Apple stake increased during the fourth quarter, and news of any Berkshire repurchases will have to wait until the end of February when the 2018 annual report is released. After all, Berkshire doesn’t provide guidance.
Disclosure: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway, and by virtue of such ownership, also own shares of Apple on a “look through” basis.