Changing Earnings Rules Could Boost These Sagging Stocks

September 28, 2018, 10:30 AM UTC
Illustration by Jonny Wan
Illustration by Jonny Wan

PRESIDENT TRUMP’S IMPROMPTU Twitter musings often move stock markets (along with investors’ heart rates). But in one recent tweet, the President proposed a reform of those markets—one that some money managers see as a potentially important improvement.

In August, Trump made a surprise announcement via tweet that he had asked the Securities and Exchange Commission to consider reducing the required number of financial reporting periods for public companies from four a year to two. Trump cast the proposal as a money-saver for companies, but some investors like it for a different reason: It could discourage the kind of short-term thinking that undercuts research and development and hurts shareholders in the long run.

Once a company goes public, it’s legally obligated to release detailed financial information every quarter. Analysts and shareholders study these reports intently, using them as a stethoscope to track the corporate heartbeat. Many companies also provide “guidance,” or estimates of how earnings will fare in the future, and when a company misses those marks, the stock often suffers.

That, in the eyes of critics, is where the trouble begins.

For some companies, meeting quarterly estimates to bolster share prices begins to outweigh long-term planning, encouraging maneuvers that range from cheap short-term tricks (like stock buybacks) to self-destructive cuts—including reductions in R&D spending.

Those choices, in turn, can lead to weaker results. K.R. Subramanyam, an accounting professor at the University of Southern California, recently evaluated nearly 2,000 companies, focusing on “dedicated guiders,” those within each industry that issued guidance most frequently. Those companies met quarterly goals more often than their peers but also invested less in R&D—and generated lower earnings growth over the long term.

Data like this helped move the Business Roundtable, the lobbying group chaired by JPMorgan Chase CEO Jamie Dimon, to join with Warren Buffett this summer in urging companies to provide guidance less frequently. The President’s proposal would go a step further by reducing the reports themselves.

Not everyone agrees that such changes would benefit investors. Some observers, including Subramanyam, believe that many companies would keep playing the guidance game even if reporting requirements were eased. They also argue that stock prices would exhibit more volatility around earnings announcements if those reports happened only twice a year.

Still, some shareholders would probably benefit. Stocks of “higher quality” companies—those with stable management, healthy balance sheets, and track records of solid performance—would likely get a boost, since investors would trust them even if management “went quiet” for a while. And the biggest beneficiaries might be the market’s lab geeks—companies that devote a high percentage of their budget to R&D. After all, at any given time, you can find stocks that are getting clobbered by impatient investors because company leaders’ long-term plans are hurting short-term earnings.

Here are three R&D big spenders that are currently caught in that bind, and whose stocks could rebound as their research investments pay off. (That’s true, whether or not reporting rules change.)

The industrial giant 3M (MMM), famed for Scotch tape and Post-its, invests 6% of revenues in R&D—about double the level of the average industrial firm. Morningstar estimates that each of those dollars eventually generates $9 of profit. Still, that forecast hasn’t been enough to boost 3M’s stock, which is down 13% over the past six months. The company has also suffered from a slowdown in smartphone purchases in China, which has hurt sales of electronics that sport its optical film (used as protective covers on the devices), and the auto-sector slump has nicked its car-care product line. Still, 3M’s problems have nothing to do with execution, says RBC analyst Deane Dray, who says the stock deserves to trade at a premium to its peers.

Less frequent reporting could also benefit companies in mid-turnaround. Ford Motor (F), which PwC identifies as one of the auto industry’s largest R&D spenders, is a prime example. Ford has made big commitments to autonomous-vehicle research, putting it on a collision course with Silicon Valley. And it hasn’t yet launched a long-awaited revitalized product mix, which will include a new Explorer SUV and a relaunched Bronco SUV series. But if those efforts pan out, and Ford reduces other expenses, “the stock is undervalued,” says Morningstar analyst David Whiston. The rebound will likely take a while, but investors will get paid to wait; the stock’s dividend yield now stands at 6.4%.

Travel-tech company Expedia Group (EXPE) gets 45% of its revenue outside the U.S. To boost that share, it’s spending heavily on marketing and development in regions where its presence is limited—particularly Europe, where it lags Booking Holdings, owner of travel sites like Priceline and Kayak, by a significant margin, notes Wedbush analyst James Hardiman. Investors have been skeptical of the market-building, driving shares down 10% over the past year, but they’ve warmed up as more details have emerged. A big success in Europe could lift their mood in the long run.

A version of this article appears in the October 1, 2018 issue of Fortune with the headline “A Formula For Better Returns.”

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