Investing Between the Lines

The “Individual Investor” columnist Jason Zweig (who has since moved from Time Inc. to The Wall Street Journal) interviewed me for a story in 2004.  He asked, why do you read CEO shareholder letters, the ones in corporate annual reports?  Aren’t numbers more important than words?

Absolutely, I said, numbers are important, but you want to know if they can be trusted.  That’s why I read executive communications.  You want to size up the values in the corporate culture.  Why is this vital information?  Because accounting numbers are based on human judgments.  Employees throughout a company decide when to count incoming and outgoing cash, where to book expenses, and how much to report. Over time, these decisions become the numbers we see in income statements and balance sheets.  Smart investors want assurance that these judgments are trustworthy.

Jason Zweig

How can you tell?  Examine the words of the CEO and ask yourself:  Are the executive’s communications candid or confused?  What does the CEO stand for?  What kind of corporate culture is he or she building?  What are the company’s values and do they inspire responsible or irresponsible behavior?  It’s not always easy to see.  Over the years I have developed a taxonomy and scoring system to help me analyze and quantify the presence or absence of candor in these communications.

I told Zweig that my CEO candor analyses show that leaders ranking high in candor will win investor trust and dollars.  He interrupted, “Could you repeat that?  “Why?” I asked.  “Because I’ve been trying to find someone who has been measuring that.”

I told him that my research shows a consistent link between measures of CEO candor and stock performance.  Each year the stocks of top-ranked companies in my annual CEO Candor survey have outperformed, on average, the stocks of those at the bottom.  This connection between candor and performance seems obvious.  Candid CEOs are going to encourage prudent judgments and actions, while discouraging reckless ones.  (BARRON’S REPORT)

It pays to know the difference.  When Enron’s shareholder letter was published in early 2001, the stock was trading at about $60 a share.  But that year’s letter revealed serious lapses in candor.  Just eight months later, the stock plunged to $0.60.  AIG is another example.  From 2005 to 2007, the company’s candor scores fell steadily, but the price of the AIG’s stock hardly budged.  In September 2007, the stock traded over $70 a share.  A year later, taxpayers ponied up $85 billion to save the firm.  The stock traded at $1.25 a share.

Over the next three months, CEOs and their investor relations and communication teams will be busy working on 2011 shareholder letters.  During this time, I will feature the Dynamic and Dubious Dozen, twelve companies that have investors on the fence.  I will show how each company’s CEO Candor Ranking is linked to its stock performance.  I will explain how to read between the lines in their shareholder letters.

When the 2011 letters are published, you’ll be ready to size up CEO Trust and Candor.