In a recent tweet, President Trump suggested the possibility of doing away with quarterly earnings reports in favor of six-month (or longer) reporting intervals.
In this Industry Focus: Financials clip, host Shannon Jones and Motley Fool contributor Matt Frankel discuss why this change could be implemented, the pros and cons, and whether it's a good idea.
A full transcript follows the video.
This video was recorded on Aug. 20, 2018.
Shannon Jones: Alright, last Friday, President Trump tweeted, and I'll read it for our listeners who are catching up. Specifically, he said, "In speaking with some of the world's top business leaders, I asked what it is that would make business and jobs even better in the U.S. Stop quarterly reporting and go to a six-month system, said one. That would allow greater flexibility and save money. I have asked the SEC to study."
Alright, Matt, let's unpack this particular tweet. Just for our listeners catching up, currently, public companies are required to report earnings on a quarterly basis. But according to President Trump and others, this schedule may be less than ideal, some even calling it quarterly capitalism. Matt, tell us what this all really means, and what's really driving the desire for this change, too.
Matt Frankel: Quarterly reports came about in the Security Exchange Act of 1934, a response to the Great Depression. Everyone was concerned that investors weren't being well informed about what's going on in public companies. As an investor protection, companies are required to report every three months, just to kind of inform their potential investors, let them know what they're doing, to make better decisions.
The problem with that is, it's evolved to where it really encourages short-term thinking on the part of management teams. In other words, managers are often incentivized to perform to this quarter's numbers, especially when they're issuing quarterly guidance projections, which is a whole other issue. Managers are often incentivized compensation-wise, where the stock price is going to be at the end of this year, at the end of this quarter. They want to make the analysts' projections, so the stock doesn't plunge as a result of missing estimates.
So, they make decisions based on what's best for the company over the next few months, rather than what's best for investors over the long-term. They might choose to cut down on their capital spending to make their earnings look better, whereas instead, they could spend more money if it's going to have a better long-term effect. The concern is that managers are making trade-offs that are good in the short-term but bad in the long-term, and that the long-term potential of American business would be so much better if they didn't have the requirement. That's the main idea behind this.
President Trump's not alone. In addition to the business leaders he was talking to, we've heard from Warren Buffett, who says that quarterly projections are generally a bad thing because they encourage short-term thinking. Jamie Dimon, CEO of JPMorgan Chase. There have been several others. There have been studies done about this. I read one right before we recorded, a study from The Accounting Review, that said, outside of the U.S., a lot of places don't have these quarterly requirements. Companies that have annual reporting requirements instead of quarterly have, on average, 10% greater sales as a percentage of their assets, 3.5% higher sales growth a year, and 1.5% greater return on assets. There have been studies done that say that getting rid of quarterly reporting does incentivize companies to make better long-term decisions that pay off in the form of better sales, better returns. He's got a point there.
In addition, when he says it's costly and time consuming, he also has a point there. Quarterly reports are complex accounting documents. A lot of investors and a lot of analysts only read the earnings press release, which is usually a short form. But if you look at what's called the 10-Q, which is actually the quarterly report, these can be pretty lengthy documents. I just checked, Apple's recent quarterly report was 56 pages long, of a bunch of calculations and descriptions of their business. These are time consuming, lengthy processes that cost companies money, encourage short-term thinking, and just generally may not be in the best interest of long-term shareholders. That's where this debate came from.
Now, whether a six-month calendar would be any better is anybody's guess. I don't know if it would make that big of a difference if reporting requirements were stretched out by three months. But there's definitely an argument to be made that quarterly reports are not in the best interest of long-term investors.
Jones: Absolutely. The key here, and what's really driving it, just to reiterate, is that basically, many executives and business leaders think that the U.S. markets definitely have a very myopic view when it comes to company performance. I think it's hard to argue against that. When you have the short-term earnings targets that you're trying to meet, ultimately, and you really can't blame many of these executive teams for having to cut back on capital expenditures and really investing in the business. I think there's definitely a valid point there. Also, with the cost of compliance, like you mentioned.
Another really interesting point is that, you do see increased volatility in the markets, especially around that first quarter of the year when people are gearing up for earnings season in Q1. There was actually another report out not too long ago that pointed out that the VIX, the volatility index that measures investor fear, actually tends to rise an average of about 5% right around that Q1 earnings timeframe. I think there's definitely a lot more volatility that comes into the mix when you are reporting on a more frequent basis.
To your point, Matt, I think, whether that is every three months or every six months is kind of debatable. I think you're going to see increased volatility the more you actually push that out, especially if you're not giving more frequent updates in between. But we'll get to the disadvantages of the system in a second.
As you pointed out, overseas, we do have other countries that have gone to this every six months schedule. You've got U.K., Australia, New Zealand, the European Union, even, with the six-month semi-annual schedule. There's also, too, an advantage to harmonize across the board and across the globe.
With that being said, valid points on the desire to move toward this six-month schedule. But let's really unpack what this means for investors. There are some obvious disadvantages to going to the six-month system. Matt, let's start with the first one that everybody should probably already know or have guessed by this point, it really comes down to transparency.
Frankel: Yeah. Like I mentioned, the quarterly reports came out of the Security Exchange Act of 1934. The whole point of quarterly reports is to protect investors. So, it becomes a question, at what point are investors not getting enough information? And is there a way to go to a six month or even annual reporting schedule while keeping investors sufficiently informed?
There are several possible avenues this could take. We could go to annual reporting, but companies are required to disclose certain material events throughout the year that they're not required to disclose ordinarily. There are a couple of different ways they could take this.
But the big drawback is, having access to all this information is what makes the markets fair and efficient, to some degree. It levels the playing field between Wall Street experts and the public by making this same information available to everybody. You don't need to be a detective, you don't need to analyze all the numbers yourself. The companies put out quarterly reports, you see all the numbers in black and white, and you can make your decisions just like everyone else on Wall Street can.
It's definitely going to be an interesting debate, to see how they would deal with that issue. But it definitely is an issue of transparency, getting away from quarterly reports.
Jones: Exactly. You hit the nail on the head, it really comes down to investor protections at the end of the day. At least with a quarterly system in place, investors have more opportunities to not only just detect fraud or accounting irregularities, but really, too, if you think about it from an investor perspective, every quarter, you get a better sense of whether or not this company is staying the course. Are they growing favorably or, are they responding to changing market dynamics in the way that they should? Having that increased frequency of reporting really gives more information so that an investor can make an informed decision.
Like I mentioned, too, I think when you begin to report less, obviously, there's a chance that companies could try to cook the books a little bit more in between those every-six-month reporting schedules. That's not to say that on a quarterly basis, companies don't do that already. But at least there's a little bit more of a safety net to be able to detect those things early. And then, too, I think you have to consider, right now with U.S. and our reporting standards and our regulatory framework, U.S. stocks actually are more attractive when it comes to investment opportunities, especially from international investors. That's because of the framework that we've built over the years. Because of fallout from time periods where we didn't have the regulatory scrutiny that we do now, I think for most, you can usually very easily look back and see time periods in our history as a country when regulatory standards began to back off or become laxer. It didn't necessarily incentivize the companies to actually give more reporting and be more transparent. I think that's one important consideration here.
I'm all about giving the average retail investors more transparency and more power at the end of the day. That really comes down to good corporate governance, too. To cap it all off, Matt, would you be in favor of moving from this quarterly earnings system to a semiannual or even maybe just an annual system?
Frankel: It definitely has its pros and cons. You mentioned earlier that earnings season right now, the VIX tends to spike, stocks tend to move up and down pretty big, if you went after quarterly earnings. Could you imagine if earnings were only released once a year, how big those moves would be? The volatility could be solved and not solved at the same time.
But just to sum it up, I'm all for it, if they can figure out a way to do it without sacrificing transparency. Maybe you don't have to disclose all of your earnings. Then we'd get away from whether or not you made the numbers every quarter. But, there are still some things that should need to be disclosed, maybe a quarterly brief or update. But generally speaking, we are long term investors all around here, we like giving the public as much information as possible. So, I'm for it with the caveat that, as long as it doesn't sacrifice transparency too much, I'm in favor.