Executives, fund managers and even politicians have criticised publicly traded companies’ undue focus on generating profits in the next quarter instead of making investments with good five-year prospects.
To encourage these companies to take a longer-term perspective, several regulators have shifted corporate reporting requirements from quarterly to semi-annually.
Most prominently, in 2013 the European Commission amended its Transparency Directive to abolish the requirement for quarterly reports by publicly traded companies in favour of semi-annual reports.
After an impact assessment, the commission concluded that “quarterly financial information is not necessary for investor protection”.
But a recent study severely undermines the commission’s conclusions.
According to the study, when investors did not receive quarterly reports from non-US companies, they relied on price-relevant information in the quarterly reports of large US companies in the same industry. But the price reactions of these non-US companies were off base in the first and third quarters because investors overreacted to the information in the US reports.
Emmanuel De George and Salman Arif, assistant professors of accounting at London Business School and Indiana University respectively, carried out the study by identifying three “bellwether” US companies, based on the largest market capitalisation, in each of 61 industries. Then they matched these companies to a large number of non-US companies from 31 countries in the same industries.
The academics then examined the reaction of these non-US peer companies to the quarterly earnings announcements of the US bellwether companies. They found a statistically significant relationship between the stock price movements of the US bellwethers and the stock price reactions of their non-US peers. For example, if the stock prices of US computer companies declined after their quarterly reports, the prices of non-US computer companies, on average, declined even more.
Finally, they analysed different reactions to the quarterly reports of US bellwethers by non-US peers that did report quarterly (such as in Japan and South Korea), versus non-US peers with only semi-annual reports (such as China and Indonesia).
They found that the non-US peer companies reporting semi-annually were “two times as sensitive” to US earnings news in the first and third quarters when they did not report. Critically, they also found that these overreactions to first and third-quarter earnings “are negatively correlated with returns” when these non-US peer companies later issued their own earnings reports.
In other words, when companies outside the US do not publish quarterly reports, investors attempt to fill the information vacuum by assessing the trends in US peer companies that do report quarterly. However, this process is fundamentally flawed: investors tend to overreact to trends reported by their US peers. When companies outside the US actually issue their semi-annual reports, their stock prices tend to exhibit “return reversals”.
I have discussed this study with equity analysts, who agree with its findings. When companies outside the US do not issue quarterly reports, analysts search for insights from comparable US companies that do issue quarterly reports. But the foreign and US companies are never really comparable; they have differences in size, location, currency and product mix.
In short, if European companies move from quarterly to semi-annually reporting under the amended Transparency Directive, investors will incur substantial costs in terms of inaccurate pricing for several months and related potential for insider trading.
Yet will these investor costs be outweighed by the benefits of semi-annual reporting by promoting a long-term perspective at these European businesses? I am doubtful. It seems more likely that these companies will shift their business focus to six months, rather than three to five years.
If regulators wanted to mitigate the problems of short-termism in listed companies more directly, they should adopt two measures. First, regulators should prohibit these companies from publicly projecting their earnings for the next quarter. These projections put undue emphasis on how well the company will do in the next three months.
Second, regulators should push boards to distribute executive bonuses and stock grants based on the company’s performance over the prior three to five years, rather than just the last year. Such an approach would incentivise executives to look beyond the current year to the longer term.
Pozen has been a nonresident senior fellow at Brookings since 2010. In 2015, he generously committed to endow the Director’s Chair for the Urban-Brookings Tax Policy Center. Until 2010, Pozen was executive chairman of MFS Investment Management and, before 2002, served in various positions at Fidelity Investments. He did not receive financial support from any firm or person for this article or from any firm or person with a financial or political interest in this article. He is currently not an officer, director, or board member of any organization with an interest in this article.