Whether you’re a fan of Tesla CEO Elon Musk or you think he’s just a nutjob, you owe him some gratitude as an investor.
That’s because he’s spotlighting an issue that regularly costs long-term investors a lot money: the tyranny of quarterly earnings reports.
The problem here is that quarterly reports enable investors and traders who like to impose their short-term thinking on CEOs to earn a quick buck — by pressuring CEOs to maximize near-term profits. This can hurt investors who are in it for the long haul.
Heaven forbid a CEO sacrifices near-term earnings to fund some cockamamie “visionary” plan that just might change an entire sector. The truth is, though, long-term thinking can be an investor’s best friend, as Warren Buffett loves to point out. The obsession with quarterly earnings reports gets in the way.
“They are really not good measures for a lot of public companies,” says Patrick McGurn, special counsel for Institutional Shareholder Services, which offers analysis that helps institutional investors make proxy voting decisions. “You want to look at what a company is going to do over the course of the cycle.”
Or longer, in the case of a pioneering entrepreneur like Musk. Musk now wants to take electric-car maker Tesla TSLA, -8.93% private, in part, to get away from the focus on quarterly results — and the obsession with inevitable short-term stumbles — by short-term thinkers.
But going private is a radical solution. It cuts off a company from market funding. And it will take Tesla shares out of the hands of Musk’s many true believers who now own the stock.
How autocratic leaders can help investors
Many companies take a more moderate approach to shutting down the short-term noise. They use dual share classes that concentrate voting power in the hands of a few people — often the founders. Or else founders own huge stakes, giving them enough voting clout to tune out the short-term thinkers.
Yes, these measures seem autocratic and undemocratic. So they are controversial. But they can actually pay off big time for investors.
Back in 2011-2012, for example, I suggested Amazon AMZN, -0.23% Facebook FB, -0.52% and Alphabet GOOGL, -0.67% in my stock newsletter, Brush Up on Stocks, when they were out of favor, in part because each had ownership structures that shielded them from the threat of takeovers and interference by activists. But this gave founders the power to brush off investor concerns about a lack of near-term profits, and invest in strategic plans.
Those stocks have all been great outperformers since then — up fivefold or more. Amazon has advanced almost 10-fold.
Those worked out, but autocratic ownership isn’t always good. For every Mark Zuckerberg or Jeff Bezos, there’s a management entrenched by a mechanism such as special share classes or devices that make it hard to change boards. Protected from the threat of takeover, bad managers can milk companies for extravagant pay or give juicy contracts to friends at the expense of shareholders, cautions McGurn, at Institutional Shareholder Services.
As an investor, how do you navigate this mess? What’s the best way to identify companies that have shielded themselves from short-term thinking, but don’t track the downside of entrenched management into your portfolio?
Here are the three solutions
1. Know your autocratic managers
When companies have dual share classes that give management concentrated voting power, don’t run away. Instead, hear them out so you can decide whether they have a long-term plan that makes sense. Listen to their earnings calls and study their filings.
You won’t always get it right. But good CEOs with concentrated voting power realize they have to explain what they are up to. And they spend a lot of time doing so. “They know they can’t just go to market and say ‘trust us,’ ” says Bryan Hinmon, portfolio manager of the Motley Fool Global Opportunities Fund FOOLX, +0.28%
Back in 2012 when Facebook, Amazon and Google were getting bashed for sacrificing near-term profits to fund long-term plans, CEOs and top managers were making a good case in earnings calls that their strategies made sense.
Around this time, Facebook’s Zuckerberg was trying to get mobile right because he knew it was the future for social media. He took a lot of heat, but he turned out to be right. Google was fine tuning Android and fiddling with self-driving cars. Android now helps Google better target ads. Autonomous vehicles seemed weird at the time, but they may be the next big trend in automobiles.
And back then, Bezos was building out server farms that eventually powered Amazon’s AWS cloud services, a key source of profits now.
“It is funny to think back that everybody was so upset with Bezos for not sticking with trying to be the world’s best online bookstore,” says Lamar Villere, portfolio manager of the Villere Balanced Fund VILLX, +0.24%
Hinmon, at Motley Fool, cites Atlassian TEAM, -0.10% in messaging and collaboration software, and Watsco WSO, +1.19% in heating and air-conditioning equipment, as companies he owns where concentrated voting power helps managers pursue long-term strategies that benefit investors, even at the expense of short-term gains.
Here’s are a few shortcuts to help you identify the autocratic managers who are on your side because they think and invest long term.
• Favor founder-run companies because they often outperform. This makes sense. Founders are driven by the desire to build companies, as opposed to simply getting rich. Their passion for building does not go away once they make billions. So it’s easier to trust them than run-of-the-mill managers who never founded a company but have concentrated voting powers.
• Look for companies where top managers and founders own lots of the stock. As examples, Albert Meyer, portfolio manager at Bastiat Capital, cites Tencent TCEHY, +3.37% IPG IPGP, -1.07% Checkpoint Software Technologies CHKP, +0.55% Seaboard SEB, +0.42% Regeneron REGN, +0.67% and Amerco UHAL, +0.49%
• Be wary when top managers have special voting rights and proportionally less money in the stock, says McGurn, at ISS. This can happen, for example, when managers own special shares that give them 10 votes per share. When managers have little capital at risk but a lot of voting power, that can lead to mischief. Those managers have probably filled the board with cronies. So there could be poor board oversight.
2. Favor companies that suspend quarterly guidance
President Donald Trump wants companies to report earnings just twice a year. This is a bad idea. Moving to twice yearly reports like those used in a lot of foreign countries cuts down on news flow.
“As an investor, you ignore information at your own peril,” says Hinmon. “Having new information to update your thinking is critical.” Meyer, at Bastiat Capital, regularly buys shares of foreign companies but he says he feels less secure in companies that don’t provide quarterly updates.
A compromise here is for companies to eliminate quarterly guidance. You should favor companies that do this, because it gives managers more latitude to focus on the long term.
Berkshire’s BRK.B, +0.28% Buffett and J.P. Morgan JPM, +0.00% CEO Jamie Dimon recently called on CEOs to reduce “short-termism” by asking them to stop quarterly guidance. They said it often leads to “an unhealthy focus on short-term profits at the expense of long-term strategy, growth and sustainability,” in a Wall Street Journal op-ed. Companies frequently hold back on technology or research-and-development spending to meet guidance shortfalls caused by factors outside their control like bad weather, believes Buffett.
A 2006 McKinsey study concluded earnings guidance does nothing to help shareholders. But it distracts managers. Invest in companies that don’t mess with guidance, and you’ll know managers don’t have this distraction.
3. Favor companies whose CEOs are paid by stock returns
In 2010, I asked John Morgan, the CEO of a little company called Winmark WINA, +0.24% why he was buying so much of his company’s stock. He told me he didn’t get paid via stock options. So buying stock was how he wanted to get exposure to upside from his efforts to develop an equipment-leasing business at Winmark.
I liked that he was using his own money to align himself with shareholders. And he had spent a career in this business before launching it inside Winmark, a retailer at the time. So I suggested Winmark in my stock newsletter in June 2010. It traded at $29 then, and now it’s at $148, for 410% gains.
The key lesson here? When CEOs take little or no pay and they get a lot of their reward through stock exposure, it’s a good sign they are thinking long term.
A good example right now is Axon Enterprise AAXN, +2.38% (formerly Taser), says Villere, whose Villere Balanced Fund owns the stock. Earlier this year, founder and CEO Patrick Smith zeroed out his salary for 10 years. Instead, he’ll get rewarded via equity grants that vest in increments as Axon hits profitability and market-cap targets. The stock grants won’t fully vest unless Axon’s market cap rises 10-fold.
“Here’s a guy who is clearly playing the long game, and backing it up by his actions,” says Villere. As an example of Smith’s long-term thinking, Villere cites Smith’s decision to give away body cameras to customers including police. This sacrifices short-term profits. But it attracts long-term customers of Axon’s archiving, cloud and software services that support use of the body cameras.
Ironically, Smith’s no-salary plan is modeled after a similar one used by Musk at Tesla. In Musk’s plan, his option grants only pay out (big time) if Tesla hits aggressive market-cap and profitability milestones over 10 years. That’s a clear sign that Musk is thinking and investing in Tesla for the long haul, which will likely benefit long-term investors in Tesla’s stock.
Too bad they won’t get that payoff if Musk succeeds in taking the company private to shut down the noise from the short-term thinkers.
At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush has suggested TSLA, AMZN, FB, GOOGL and WINA in his stock newsletter, Brush Up on Stocks. Brush is a Manhattan-based financial writer who has covered business for the New York Times and The Economist Group, and he attended Columbia Business School in the Knight-Bagehot program.