Short-Term Guided Missiles

A few weeks ago, Berkshire Hathaway (NYSE: BRK-A  ) Chairman Warren Buffett made an appearance on CNBC to congratulate the daughter of David Dodd, a Buffett mentor and early investor in Buffett's partnership and, later, Berkshire Hathaway, for donating $128 million to a Pennsylvania Quaker school.  

Buffett's appearance was made hours before the Federal Reserve was due to announce its wildly anticipated decision on interest rates. When asked what he thought the Fed would choose to do, Buffett brushed off the importance of the decision and remarked, "I might mention that when Dave Dodd came into my partnership with relatively small funds, nobody knew what the Fed was doing that day, or a week earlier or the week after."

Buffett's comments seem to underline one of the reasons he has done so remarkably well over the past five decades: He has the ability to completely ignore short-term market factors. When David Dodd and his family made their investment in Berkshire Hathaway, they didn't have a clue what it would earn in the next few quarters (or more importantly, they didn't care). Regardless, he ended up doing extremely well.

That's why it baffles me why so many companies, analysts, and investors still attempt to wrap their heads around quarterly earnings estimates. Unless you hold a direct relationship to Nostradamus, don't kid yourself -- nobody can accurately predict exactly what a business will earn in the next few quarters. Even worse, trying to predict what quarterly earnings will be down to the penny will probably be about as accurate as Miss Cleo's late-night 1-900-number psychic advice (and your results might cost you more than Miss Cleo's $4.99 per minute).

Are we there yet? Are we there yet?
Alas, we live in an era of hand-held PDAs, BlackBerries, and instant messages. It isn't hard to see why so many people fixate on short-term, up-to-the-minute results. While many people claim to be "long-term" investors, short-term fluctuations can still dominate investment decisions. Instead of taking a long-term approach to good, well-managed businesses, the market dances around short-term performance and can severely punish companies that miss quarterly earnings forecasts by even the smallest amounts. There's nothing quite like a negative earnings surprise to send shares on a faster downward spiral than Britney's career.

Consider these frightening examples:

  • In September 2000, Apple (Nasdaq: AAPL  ) announced that it would report quarterly earnings less than what analysts were expecting from slower September sales. Consequently, Apple's stock fell by 52% and faced numerous analyst downgrades. Yikes.
  • In January 2006, Google (Nasdaq: GOOG  ) reported a surge in net profit, up 82% from the year before. As if this signaled Armageddon, Google shares fell more than 18% after failing to meet analysts' precise targets.

Success doesn't come 90 days at a time ...
Even more disturbing is the attitude many corporate managers take toward meeting expectations. With increasing amounts of executive compensation coming in the form of stock options that rely on short-term performance, not meeting quarterly earnings guidance can mean kissing their private jets and bottles of Cristal goodbye.

In 2001, Qwest Communications (NYSE: Q  ) CEO Joseph Nacchio explained how he felt about meeting earnings expectations. Not one to mince words, Nacchio explained, "It's more important than any individual product, it's more important than any individual philosophy, it's more important than any individual cultural change we're making. We stop everything else when we don't make the numbers." Not coincidentally, Quest soon began to miss its earnings forecasts and saw its stock nose-dive by 2002 once the company admitted some of the earnings reported to "make the numbers" had been false and misleading.

One for me, none for you ...
In a 2005 survey of 400 corporate executives, Professor Harvey Campbell found that over 80% of CEOs and CFOs who responded admitted they would delay spending on areas such as research and development, maintenance, and advertising in order to meet earnings estimates -- even if it meant sacrificing long-term shareholder value.

The results of management focusing on short-term goals can be disastrous to shareholders. For example, would the U.S. auto industry be in its current dire condition if it shunned short-term goals in the 1970s and focused on protecting itself from foreign competition? I'll admit, it's easy to look at in hindsight, but it goes to show that having management incentives tied to results just one quarter down the road can divert attention from the larger issues at hand.

Patience, please
Many companies have bucked the trend and choose to keep quiet regarding earnings guidance. Citigroup (NYSE: C  ) , Coca-Cola (NYSE: KO  ) , Google, Sears Holdings, and Mattel (NYSE: MAT  ) , among others, have refused to issue earnings guidance in an attempt to place an emphasis on longer-term performance.  

In the life of any business, the earnings results of any 90-day period will never be that important. If the viability of your investment rests on meeting short-term numbers, you're setting yourself up for failure from the get-go. What matters is purchasing a good company at a good price and holding it for as long as possible.  Don't get caught up in the noise, Fools. The road to investment success will come to those who are patient enough to ignore the markets short-term emotional greed.

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