I Hate Guidance

I love transparency. I hate guidance. Transparency is when management teams are open and honest during good times and bad times. In fact, something I look for is how management communicates and acts during the bad times. If they are transparent in the bad times, it allows you to trust them in the good times.

Transparency ≠ Guidance

I talk to microcap CEO’s about “Guidance” at least once per month. I get it. They are under pressure to perform. Many CEO’s think if they let investors see the future, then they will get paid for it today. But it rarely works that way. Especially when you consider that microcap companies, are small(er), more fragile businesses. A microcap’s future has another standard deviation of outcomes (mostly worse outcomes) when compared to larger more robust businesses. 

Ironically – quarterly and annual guidance doesn’t make sense for larger businesses either. There have been several studies analyzing the impact of quarterly or annual earnings guidance by public companies. 

One of the most recent was a 2020 study by three economists at the Federal Reserve Bank of Cleveland. They analyzed S&P 500 companies from 1994 to 2015. The sample included over 24,000 firm-year observations. The study found that companies providing quarterly guidance had significantly higher stock price volatility, by 5-10% depending on the model used. The authors argue this shows how frequent earnings guidance facilitates herding behavior among analysts and investors, aligning expectations over short periods in a way that increases volatility.

Furthermore, the study found that quarterly guiders focused more on hitting near-term targets rather than long-term value creation. Guiding firms had lower R&D expenditures, lower capital expenditures, and were more likely to cut R&D spending to meet quarterly estimates. Given these findings, the economists conclude that companies should reduce guidance frequency and instead focus on conveying long-term strategic vision to shareholders in order to refocus attention on intrinsic business performance.

I would take it a step further. Guidance is a lose-lose proposition whether the company meets guidance or misses guidance. Here are a few points to consider:  

1. You get the shareholders you deserve. The timeframes management uses to discuss the business are the same timeframes investors will use to judge them.  

2. Guidance produces lower multiples. Microcap/smallcap companies that are executing will get a higher multiple if they don’t cap expectations. Whether we microcap investors want to admit it or not, a big part of our love of microcaps/smallcaps is our anticipation of the unknown. It isn’t management’s job to set short-term expectations. The job of management is to articulate a longer-term vision, strategy, goal and provide shareholders with a framework on how to judge the progress.

3. Guidance puts management in a position to lose credibility by not hitting short-term targets. If you aren’t going to get paid with a higher multiple for giving guidance, then why bother. By not providing guidance, the investor is left to do the work themselves and form their own opinions. If the company doesn’t hit my own bullish scenario that I’ve let percolate in my mind’s echo chamber – I’m to blame. Not the company. 

4. Guidance attracts short-term lazy investors – the type of investors that can’t or won’t do their own work to form their own opinions.

A company that is executing will attract a higher quality investor, get a higher multiple, and never look dumb, if they don’t give guidance.

What should a company do? Should a company do nothing?

My main valuation hurdle is – Can I at least double my money in 3 years (25% CAGR) from the current price based on fundamental reasoning? Whether your goal is to double or triple or whatever your money in three years, I believe a three year timeframe aligns best with how investors should think about valuation, risk, and reward when investing in a microcap.

If a company feels compelled “to do something” provide a three year goal.  It’s important that it’s a genuine goal, and not an embellished one to sell investors. I think if it’s done with sincerity it can be a great tool for management teams and allows them to get off of the quarterly and annual guidance treadmill. 

On December 18th, 2011 I profiled NAPCO Security Technologies Inc (NSSC) on MicroCapClub at $2.15 per share ($1.07 split adjusted). At the time management gave a three year goal. The goal was to grow revenues from $70 million to $100 million. At $100 million in revenues management believed they would earn $1.00 per share. They expressed that quarter to quarter results would be lumpy.

It was the perfect timeframe and messaging. Growing a company from $70 million to $100 million in three years seemed rational. The upside of a $2 stock that “could” earn $1 EPS in three years was clearly visible. Since it was a goal, investors weren’t going hold management’s feet to the fire in the interim. It was the perfect carrot.

So what happened? Did they reach $100 million in sales by 2014?

No.They hit $74 million in sales. They extended the goal again.

They finally hit $100 million in sales in 2020. The delays didn’t matter. The stock is up 2000% since 2011.

I can’t help but chuckle at how bad companies are at predicting the future. I hate quarterly and annual guidance, but if a microcap company feels they have to do something –  provide a genuine 3 year goal and be transparent with the progress.

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