Perhaps there is another way to understand why executives look for a steady growth. An erratic growth curve may not do good for the executive’s continued job security, especially when the growth curve is negative. It may not necessarily translate into getting fired, but the emotional distress may be enough to try to avoid it.

Smooth results over the long term, whether earnings or cash flow, should always be mistrusted, as Mr. Madoff has taught us once again. Markets, by definition, are rarely smooth, and results of combative, shareholder-friendly participants in those markets should reflect the ups and downs.

I have not read the research cited in the footnotes, but the article itself leaves out one important factor. As with almost everything related to the investment markets, there is variability in the attractiveness of earnings smoothness to investors, depending on the nature of the market environment.

The implication that the market doesn’t care about smooth results may be true at times and even in general, but there are periods (even fairly long ones) when it’s highly prized on a relative basis.

In my experience, smooth earnings are desirable because it demonstrates the management’s ability to adjust to changes—both “normal” fluctuations and more radical changes in trends—in the environment. “Bumps in the road” are expected by investors, but investors do also expect managements to see the bumps and act accordingly.

An investor would usually split up the rationale for investment into two steps: first which industry, and then which specific company in that industry. At the first step, the investor makes a conscious choice to invest in an industry analysing well the industry dynamics, including business cycles, competition, etcetera. But the decision on which company to invest in that industry is based on one main criteria: whether it will be in the top rung and ahead of industry average in terms of growth in earnings, cash flows, etcetera. Earnings variability, which is typical to an industry, will be a factor in the first stage. But not in deciding in which company to invest within that industry.

I believe that investors prefer predictability and few surprises. So, if one was to expect variable earnings, it would not be a problem. It is a problem if the variations are unexpected.

Even in China, an emerging market, so many companies are on the rise for a long run, their growth rates never become smoother, yet they keep growth YoY, however, while you focus on their financial report, you’ll see the rates never going smoothly. In the solar energy sector, for example, the growth in 2010 significantly dropped from one year ago, so I think the most important is how to keep stable cash flows rather than smooth growth.

I totally agree with the thesis of the article, and we deal with this issue constantly as we help companies design stock-based, long-term incentive plans. Unfortunately, there are a number of bad habits ingrained in the corporate culture:

1 - A dogmatic (and incorrect) belief in Efficient Markets, whereby it is believed that any growth in earning is immediately reflected in the TSR.

2 - An almost total fixation on “beating the analysts’ estimates.” Given that these estimates extrapolate from previous quarters, hence the desire to smooth earnings.

As a result, many companies become highly fixated on micro-managing earnings to please Wall Street analysts’ projections, which McKinsey has shown to be incorrect most of the time anyway.

The almost complete fixation on TSR is only becoming worse thanks to all these new regulations that further empower shareholders to influence executives’ pay. The other problem is that nobody seems to question the many limitations of modern financial theories based on demonstrably flawed assumptions. The final problem is that the largest shareholders groups are now financial institutions with a narrow focus on beating benchmarks on a yearly basis.

This problem was evident during the financial crisis. A bank CEO who may have wanted to reduce risks and exposures to bad derivatives deals would have stood a strong chance of being voted out by shareholders for falling behind competitors in the earnings stampede.

In summary, ‘short-termism’ has become prevalent and pervasive in the corporate culture, partly due to the incorrect interpretation of flawed financial theories. It is a big problem with far reaching consequences, and one that has been eroding the US corporate fabric for a long time.

TRS follows the same risk return principle, i.e. more risk (volatility) means more return. In this article, the relationship between diversification and the return has been established. Companies have various objectives behind diversification strategies like hedging risk (cyclical fluctuation mentioned in the article), investing the surplus, etcetera. The types of diversification plays important role in balancing volatility and return. Volatility needs to be managed by using different strategical and operational techniques. Companies need to be very cautious while using diversification as a tool to maximize TRS; otherwise it will become a risk portfolio instead of an investment portfolio.

I generally agree with the article and with the fact that executives should focus on strategies that increase the revenue and enhance the ROC instead of struggling to smooth earnings over time. However, in some cases there can be a marriage between the two ideologies.

If we consider an upstream aluminium rolling company investing in acquiring a downstream aluminium products company that manufactures premium sheet, foils, and cans, then both the objectives would be achieved together. The earning would smooth since typical commodity cycle crest shocks will be compensated with the revenue generated from the downstream products and the firm ROC will also increase given the boost provided by the new high margin sales.

Of course, the increase in sales would also be recorded during the commodity peaks but variability, if it hurts at all, hurts most during downcycles which will be much less deep after the move than it was before.

Smooth earnings or just in-plan budgets are for me a reason to replace management. Such results are either fake or laziness.

While I do generally agree with the argument you are presenting, I think there needs to be some consideration for stability of cash flows, as opposed to “smooth” earnings. Counter-cyclical assets can of course be included in an investor’s portfolio through stock selection, and there is no point in a company trying to replicate this; however, in some cases having this natural hedging, e.g. diversified miners, enables these companies to deploy capital at lower credit risk. Managers can then invest in the business more effectively (avoiding the risks and costs of hedging contracts for example). Obviously, this is more applicable to highly volatile sectors, such as pure play miners, but it does highlight why, in some cases, earnings stability will allow for more effective deployment of capital, and hence, one could argue, higher returns, assuming of course, earnings are somewhat correlated to cash flows in the given company.

I definitely agree with the article’s assertion: “Nor should they try to reduce volatility through more diversified corporate portfolios.”

The myth of smooth earnings (ex. diversification), however, flies in the face of modern financial theory. Valuation multiples are driven by three factors:
1. Cost of Equity: increase leads to lower multiple
2. Growth: increase leads to higher multiple
3. Investor Sentiment / Emotion (irrational component).
Higher volatility increases Beta, raises Cost of Equity, and results in multiple compression. Cash flow growth has the opposite impact.
It would seem the analysis needs to control for company:
1. Growth
2. ROIC less WACC.
Doing so may help bring the result and implications in line with modern financial theory. Should we make the effort to control for these factors?

Is not the premise that lower volatility should imply higher TRS somewhat flawed? In an efficient market, a less volatile stock needs to deliver lower returns to meet investor expectations. A regulated electric utility will likely be less volatile than, say, a cyclical commodity play, however it should come as no surprise if the utility company’s TRS is lower than that of the commodity company. Less volatile stocks, in general, will likely deliver lower returns.

For valuation purposes, GAAP earnings are not the best metric. Free cash flows suitably discounted get around GAAP smoothing of initial large capital investments and account for the way management has deployed operating cash flows.