There’s a debate over whether requiring quarterly financial reports is good for publicly-traded firms and their shareholders.
Proponents argue providing timely information to shareholders is crucial to make sure managers are not wasting their time making bad investments. But a team including Rahul Vashishtha, an associate professor of accounting at Duke’s Fuqua School of Business, along with Fuqua colleague Mohan Venkatachalam and Arthur Kraft of City University London, studied the effects of increasing the frequency of reports. They found evidence it creates short-sightedness that harms firms by forcing them to focus on immediate results at the expense of long-term investments. In another study, conducted with Venkatachalam and Vikas Agarwal of Georgia State University, Vashishtha found the fund managers that invest in those firms become similarly myopic when fund managers are required to provide frequent disclosure about their own investment activities.
Vashishtha discusses these studies and their implications in this Fuqua Q&A.
You found evidence of corporate myopia, but what form does that take and what are the negative effects?
We found long-term investments declined at firms that had to increase their reporting frequency. Annual capital investments at those firms declined by about 1.5 percent. This decline might seem low but given the average annual capital investments of these firms was about 9 percent of their assets, it is a significant number. Also, we found firms cut capital expenditures mostly in industries where those investments take longer to pay off.
You can imagine a scenario where cutting investments would be a good thing, if a firm was over-investing and needed to cut back. But we find these investment cuts are associated with decline in firm performance. Among firms that had to increase their reporting frequency, we found sales were about 10 percent lower as a percentage of assets; annual sales growth of about 3.5 percent less; and return on assets around 1.5 percent lower. This is all compared to firms that did not face the increased frequency.
It’s very compelling evidence that these are inefficient cuts driven more by the desire to avoid investments that won’t pay off for a long time and thus hurt quarterly earnings.
Since all public firms report at the same frequency, how were you able to attribute these effects to the quarterly report requirement?
We studied the effects of three moments when companies were required to report more frequently. The first was 1955, when the U.S. Securities & Exchange Commission switched from requiring annual to biannual reports. The second was 1962, when the American Stock Exchange required all newly-listed firms to report quarterly. The last was 1970, when the SEC began mandating quarterly reports.
We studied 545 firms, matching firms that changed their reporting frequency with companies that were already reporting more frequently. We matched firms for size and industry and studied their annual investments and performance for the five years before and after the increase in their reporting frequency. We also controlled for other variables that might have affected the firms’ investments and performance, such as profitability, leverage and their investment opportunities.
That provided an ideal natural laboratory to see how mandating more frequent performance measurement affects firm behavior.
Where does this myopic pressure come from?
Ultimately the myopic pressure comes from investors being very impatient. If investors are thinking sufficiently long term, they would be willing to put in the time and resources necessary to understand the reasons for quarterly earnings shortfall. Then they would not punish firms for poor short-term performance resulting from investments in creating long-term value.
We looked at why investors behave so myopically. We studied mutual fund managers, because they are the single largest class of institutional money managers in the U.S., and examined what makes them so impatient about firm performance. We find they are concerned about their own performance measurement, because they are reporting to their own fund investors. And if the funds do poorly in the short run, investors withdraw from them. So we’re seeing similar myopia at the fund manager level.
In 2004, the Securities and Exchange Commission began requiring fund managers to report quarterly to their investors the details of every stock they were holding. That shock to the system gave us the opportunity to see how fund managers reacted to the new reporting requirement.
We found evidence that once their performance was evaluated more frequently, they themselves became myopic, and that in turn affected the firms they were investing in. Suddenly they had to worry more about their short-term performance. So if a fund manager made a long-term bet on a firm, the performance of that bet over a very short horizon was now visible to fund investors, who might see it as a bad bet if it’s losing money in the short term. Anticipating that type of behavior, fund managers just become more reluctant make those long-term bets.
Your research suggests this myopic pressure is pervasive. What, if anything, can managers do to avoid it?
Managers and investors would both be better off if managers did not behave in this short-sighted way. But our work suggests the quarterly reporting requirement furthers a lack of trust that prevents this from happening.
At the end of the day, myopic pressure comes from investors not having enough information about the long-term prospects of a project. If investors knew what managers do, there would be no myopia. Everyone understands a dollar invested in research and development is great for a firm. So managers need to do more to help investors see that. For example, they could place more emphasis on long range strategy in their disclosures, explain why it’s fine if the quarterly earnings have gone down and describe in detail how the manager’s plans will eventually pay off for the firm. Of course, managers must also be willing to take the hit if investors don’t agree.
Firms can also focus their efforts on recruiting the kind of investors who are in it for the long haul. That can benefit firms in two ways. First, they don’t have to worry about investor exits. Secondly, that type of investor is more likely to work to understand your long-term strategy. Someone who is going to sell your stock next quarter is not going to make that effort.
This is only part of the story, but given how much corporate managers say the frequency of reporting destroys value, we believe it is a very big part of the story. The arguments on both sides of this debate are very clear, and it’s really hard to dismiss arguments unless you have empirical evidence about what’s really going on. This is some of the first scientific evidence on the cost side of the debate.