Sunday, April 5, 2009

Even Buffett Isn't Perfect: Chapter 10

In this the final chapter, a discussion takes place about whether management should give earnings guidance. Buffett's position on this matter is made clear. He believes that when managers give quarterly guidance (i.e. tell analysts what the next quarter's earnings are expected to be), it inappropriately encourages managers to focus on short-run profits rather than the business in the long-run.

It should be noted that providing guidance is not mandatory, but certain firms do so voluntarily. While Janjigian agrees that short-run earnings management is a bad idea, and that the best way to manage is with a long-term horizon in mind, he doesn't believe guidance is what causes short-term thinking. Janjigian argues that analysts will form expectations regardless of whether management offers guidance, and therefore the incentive to manage in the short-term is present whether management offers guidance or not.

The author argues that investors want to avoid price volatility and that is why these investors are against guidance. (However, it should be noted that when we met with Buffett, he was very clear that he likes volatility, because that's what allows him to profit by buying low!) Janjigian argues that volatility is higher for companies that don't offer guidance, since management is in the best position to offer the best forecast of the next period's earnings.

Finally, the author cites studies that suggest stocks drop after managements announce they will no longer offer guidance. The authors of the studies believe dropping guidance sends a signal to investors of bad news ahead, which causes the stocks to drop.

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