The disclosure dilemma: Why more disclosure has led to less information

The last three decades have been the golden age of disclosure, as both accounting rule writers and regulators have pushed companies to reveal more and more about their prospects to investors, both in the US and internationally. Some of this push can be attributed to more activist investors, demanding more information from companies, but much of it can be traced to accounting fraud/malfeasance, where companies held back key information from investors, who paid a price as a consequence. In response, legislators, the watchdog agencies (SEC and its equivalents) and the accounting rule-writers (GAAP, IFRS) have all responded by increasing the amount of information that has to be disclosed by firms. That should be good news for investors, but here are the contradictions that I see:

• If the objective of “disclosure” laws is to prevent the next Enron, Parmalat or Worldcom accounting scandal, it clearly has not worked, since we seem just as exposed as we have always been to these problems. If anything, companies seem to have become more creative in hiding “bad” stuff, in response to disclosure laws, making it more difficult to detect problems. 
•  If the objective is to help investors value companies better, it has not worked either. To me financial disclosures are raw data, when I do valuation, and I must confess that I find financial statements more difficult to work with today than I did thirty years ago, when disclosure laws were less onerous.

So, what gives here? Why have these increased disclosure requirements not worked the magic that they were supposed to? While we can point to lots of reasons, including imperfections in the disclosure requirements, I think that the biggest problem is that the disclosure rules have turned financial disclosures into data dumps. To see my point, take a look at the 10K for a publicly traded company, even a small one, and you will see a document that runs into tens or even hundreds of pages. For instance, Procter & Gamble’s most recent 10K runs 239 pages and it is slim next to Citigroup’s most recent 10K which runs more than 300 pages.  If you are interested in valuing Procter & Gamble or Citigroup, you have to work your way through these pages, separating the wheat from the chaff, or more specifically, information from data. Faced with information overload, it is easy to get distracted by the legal boilerplate (you might as well throw out the entire section that discusses risk) and the trivial details that clutter modern disclosures. In my estimate, less than 10% (and that is being generous) of a modern financial disclosure has any value to an investor and to find this information, here are some things to keep in mind: 

1. Read with focus: Know what information you are looking for, before you start looking for it.  In other words, reading a 10K, just looking for useful information, is equivalent to digging up your backyard, looking for interesting stuff. Your most likely outcome is that you will end up with a mountain of dirt and little to show for your work.
2. Don’t sweat the small stuff: If you are valuing a $ 60 billion dollar company, you can afford to skip over that section that describes in excruciating detail a $25 million real estate lease that the company has entered into or the $50 million lawsuit filed against the company. 
3. Don’t cater to your inner accountant: We know that accounting has its fixations and that financial disclosure often cater to these fixations. Thus, there are large chunks of these documents that are dedicated to how intangible assets have been “fair valued” or goodwill has been “impaired” (a mythical asset that exists only in the accounting world). Since I don’t trust accounting fair value judgments to begin with and goodwill has but a peripheral role (if that) in cash flow based valuation models, I can afford to skip these sections. 

As some of you already know, I do teach a valuation course at Stern and my invite to anyone who is interested in sitting in still holds. Since a key part of doing valuation is learning how to work with financial disclosures, I recently put together a webcast on disclosures, where I used P&G’s most recent 10K to value the company. If you are interested, you can find the webcast with the supporting material (the 10K, my slides and my valuation of P&G). In fact, they are part of set of webcasts I am doing on the nuts and bolts of valuation:
http://people.stern.nyu.edu/adamodar/New_Home_Page/valuationtools.html

I am afraid that things will only get worse for investors. The push towards more disclosure, well intentioned though it might be, is unstoppable and  will create more bulk in annual reports and company filings, and more distractions for investors.

While I am sure that I will be ignored, here are my suggestions to the regulatory and accounting disclosure czars if they truly want to help investors:

1. Focus on principles, not rules: The principles that govern valuation are simple and robust, but they seem to take a back seat to rules when it comes to disclosure requirements. To provide a simple example, capital expenditures should measure what a company invests in its long term assets, whether those assets are tangible (land, building, equipment) or intangible (human capital, brand name, intellectual property). Not only are the accounting rules governing capital expenditures unnecessarily complex but they are internally inconsistent, with different rules governing tangible and intangible investments. (Prime exhibit: the treatment of R&D expenditures). 
2. Less is more: My wife, who is the "organizer' in our house, has a very simple rule for everyone in the family. For every new item that any of us buys, one item has to be removed (given away or abandoned) from our closets. It is an excellent rule, since in its absence, we would undoubtedly hoard what we already have, on the off chance that we might need it in the future. I would propose a similar rule in disclosure. When companies are required to disclose something new, an old disclosure requirement of equal length has to be eliminated, thus preventing disclosure bloat.
3. Target investors, not lawyers: As I browse through financial disclosures, I am struck by how much of the content is written by lawyers, and for lawyers, with the specific intent of shielding companies from lawsuits and/or regulatory backlash. While I understand that companies are gun shy about being sued, and that this protection is necessary,  it may be time to allow companies to file two disclosures, one for lawyers and one for investors. Using P&G as my example, I could construct an investors' 10K, about 20 pages in length, stripped off all the legalese that the full 10K includes.
4. Let accountants do accounting (and not valuation): I know that "fair value" accounting is here to stay, but  I believe that the push is misguided. By requiring accountants to play the role of appraisers, it asks them to play conflicting roles: provide a faithful recording of what has happened in the past (traditional accounting) while also forecasting the future (a key component of making valuation judgments). In the process, I think that we will end up with financial statements that do neither accounting nor valuation well and that investors will pay the price.

Looking forward, investors will increasingly be tested on their capacity to separate the data that matters (information) from the data that does not (noise or distraction). There is an interesting twist (and I thank Bill, who commented on this post for this insight). The increasing complexity of financial disclosure does open up the possibility that investors who can navigate their way through these disclosures and separate information from data will have a competitive advantage over other investors, who give up in frustration.

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Earnings surprises, price reaction and value

The earnings season is upon us and each company’s earnings announcement is eagerly awaited, traded upon and talked about. For widely followed companies like Apple, the obsession with what the next earnings report will deliver overwhelms any sensible assessment of what it means for the company. But is this obsession merited? Do earnings announcements have significant effects on value? If so, why? More importantly, can you make money off earnings announcements? 

The “Announcement” Process
To understand how and why earnings reports matter, we should start by looking at the process. Publicly traded companies are required to report on their performance at “regular” intervals. In the US, the reports have to come every quarter, with full financial statements filed with the SEC. The degree of disclosure varies across markets, both on timing (quarterly, semi-annual and annual) and on information (partial reports of performance in some regimes).

The reporting ritual is highly scripted, at least in the US, in terms of timing (companies report earnings on about the same date every year, give or take weekends, and in the same format to allow for year to year comparisons). The initial report provides the bare bone details (revenue growth, earnings per share and a breakdown of a few extraordinary items) and is followed a few weeks later by the full filing of the quarterly report (10Q) with the SEC.

Since earnings reports contain information that can affect prices, the SEC does regulate trading and disclosure around the reports. Insiders are restricted from trading before earnings announcements and Regulation FD bars firms from providing information about upcoming earnings reports to subsets of investors (analysts). In theory, at least, the information in an earnings report should be “news” to markets.

Companies may be restricted from providing information selectively to analysts following them, but this does not prevent analysts from forming and propagating their expectations about what the earnings report will contain to their clients and, by extension, the public. In fact, a substantial portion of a typical equity research analyst’s time is spent on the “earnings forecasting” exercise, and there are services that assess analyst quality by looking at how close the forecast comes to actual numbers. In the US, services such as Zacks and I/B/E/S that track and report analyst forecasts of earnings and you can find them in the public domain (Yahoo! Finance or similar sites)

The Expectation Game
When a company does report its earnings, markets will react to the “news” in the report but the way we measure the news has to be relative to expectations. Thus, a company that reports that its earnings went up by 30% may be seen as delivering bad news, if investors were expecting an increase of 40%, and a firm that announces an earnings decline of 30% may be providing positive information, if the expectation was that earnings would decline by 40%. Thus, it is not the magnitude of the earnings change that matter but the “surprise” in the earnings, measured as the earnings change relative to expectations.

But how do you measure expectations? One obvious answer is to use the analyst estimates of the earnings and news reports like this one generally compare the earnings change to the “consensus” estimate of earnings change to frame the report. A second is to use the “past” earnings growth for the company as a measure of expected earnings growth. With either measure, then, a positive (negative) earnings surprise then becomes an earnings report where the actual earnings per share exceeds (falls below) the expected value (using consensus earnings estimates or historical earnings growth).

While you can use analysts or history as the basis for estimating expected earnings, the market expectations process is a more nuanced one and more difficult to model. In the last two decades, firms have become more attuned to playing the earnings game, and have become increasingly adept at beating earnings expectations by playing both sides of the game. First, they work on analyst expectations, using selective leaks to bring expectations down, prior to earnings reports. Second, they work to mold the actual earnings, using both accounting choices (earnings management) and operating discretion (timing of R&D expenses, for instance) to deliver results that beat expectations. The problem with this game is that markets catch on and adjust expectations accordingly.

The Announcement Effect
If you can measure earnings expectations, an earnings surprise should have an effect on stock prices, with positive (negative) surprises evoking positive (negative) responses. The earliest studies of earnings surprises used historical earnings to estimate expected earnings and found backing for this hypothesis. In more recent studies, consensus estimates of earnings have been used to measure expected earnings. The following graph captures the announcement effect of earnings surprises, categorized from most positive to most negative, with expectations measured as consensus estimate from analysts:

There are three interesting findings embedded in this graph. 

1. Pre-announcement drift: There is a mild drift in stock prices before earnings reports that is consistent with the eventual surprise: prices move up before positive surprises and down before negative surprises. I will let you make the judgment on whether this is evidence of insider trading, investor prescience or some combination of the two. 
2. Announcement effect: The announcement still contains news. On the announcement, the price effect reflects the magnitude and the direction of the surprise, with stock prices going up about 3%, on average, in reaction to the most positive surprises.
3. Post-announcement drift: The most surprising finding is that stock prices continue to drift after the announcement in response to the surprise. The graph below looks at the price drift in the 30 days after the announcement:

Differences across firms
There are studies that indicate that the returns associated with earnings surprises are more pronounced with some types of stocks than with others. For instance,

1. A study of value and growth stocks found, instance, that the returns in the three days around earnings announcements were much more positive for value stocks (defined as low PE and PBV stocks) than for growth stocks across all earnings announcements – positive as well as negative. This suggests that you are much more likely to get a positive surprise with a value stock than with a growth stock, indicating perhaps that markets tend to be overly optimistic in their expectations for growth companies. 
2. Earnings announcements made by smaller firms seem to have a larger impact on stock prices on the announcement date and prices are more likely to drift after the announcement. 
3. As with analyst reports, there seems to be evidence that the market reaction to earnings reports is a function not only of the earnings number reported but also the accompanying management commentary.
4. There is some evidence that the market reaction to earnings reports is greater at firms with high institutional ownership, with one rationale being offered that institutional investors tend to be more short term in their focus and thus more likely to respond to quarterly earnings reports.

There is one final aspect of the earnings game that may be affecting stock market reactions. As firms become adept at playing the game, managing expectations and tweaking earnings to beat expectations, investors have adapted. Firms that consistently beat consensus estimates now have to beat them by a "margin" (based upon their past history) to register a positive surprise. This is of course the phenomenon of "whispered earnings". With the Apple announcement due later today (July 24, 2012), the consensus earnings estimate is for earnings per share of $10.35 and the whispered earnings estimate is 67 cents higher at $11.02. The only problem is that Apple has beaten whispered earnings 42 out of the last 56 quarters. It is only a matter of time, I guess, before you have whispers on top of whispered earnings. My head hurts just thinking about the possibilities.

Playing the Earnings Game
So, how can investors play the earnings game? Using the earnings surprise graph as the basis for the discussion, here are some of the possible paths.
a. Predict the surprise: You can try to devise ways of forecasting positive or negative surprises before they occur. I know it is easier said than done, but to the extent that you can stay on the right side of the insider trading law and find advance indicators of upcoming surprises (trading volume changes, price patterns etc.) you can profit.
b. Trade on the news: To take advantage of the drift after the news, you could buy stocks after exceptionally positive earnings announcements and sell short on stocks after terrible earnings reports. Given that the drift is about 2-3%, don't expect this to do much more than augment returns at the margin. You could of course load up and use options to leverage the profits, but...

c. Play the earnings momentum game: While the first two strategies are short term, there is a longer term strategy that can be built around earnings reports. Studies indicate that companies that have consistently beat earnings reports over the last few quarters deliver higher returns in subsequent periods. Thus, in addition to screening for high quality growth and low risk, you can also screen for earnings momentum.
d. Intrinsic value assessment: As a believer in intrinsic valuation, I look for ways to tie the information in earnings reports to intrinsic value. To do that, though, you need to look past the top line news (earnings per share) and at the underlying details (revenue growth, operating margins and return on capital). If you do so, you may very well find  a report that looks positive on the surface (because the actual earnings exceed expectations) but contains enough negative news (lower revenue growth, declining margins and return on capitals) to cause intrinsic value to decrease. If the market misreads the report as "good" news and the stock price jumps up, you have the makings for a contrarian play.

So, here is the challenge. By the time you read this post, the Apple earnings report will have been made public. Evaluate it and make your judgment on how (if at all) you will incorporate it into your investment strategy for Apple. I have attached my intrinsic valuation of Apple (made before the earnings report came out) with suggestions on how to incorporate the information in the earnings report into value. Take your best shot!

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