Lots of CEOs don’t tell the whole truth. They mislead analysts, the media and their own employees. They refuse to admit problems to shareholders and perhaps even to themselves. And eventually, in many cases, their company stock suffers because their deception is exposed and/or their attempts to sugarcoat reality undermine corporate profits.
It’s important to evaluate how truthful top managers are before you invest in a company because there is a convincing correlation between a CEO’s level of candor and how well his/her company’s stock performs.
Bottom Line/Personal asked L.J. Rittenhouse, a leading expert on CEO communications, to explain how you can judge corporate candor and use it to identify winning stocks…
Getting a handle on a business’s quality of leadership is one of the hardest parts of investing. I have known Warren Buffett for many years and consider him the gold standard for CEO candor and honesty. When he considers investing in or buying a business, the first thing he does—even before looking at a company’s financials—is read the CEO’s letter to shareholders in the annual report.
Annual shareholder letters help Buffett decide whether a company’s growth forecasts, income statements and balance sheets are going to be reliable. If he doesn’t feel he can trust the CEO, Buffett doesn’t bother to look any deeper.
I have analyzed thousands of annual report letters and developed a scoring system to rank the candor of leaders at companies in the Standard & Poor’s 500 stock index. I also look at other CEO communications, such as earnings announcements, speeches and media interviews. Words can be as revealing as profit margins and revenue growth because they offer clues about the integrity of a corporate culture. A CEO should frankly and clearly discuss his company’s operations and how he plans to build on triumphs and address challenges. Result: A more efficient and productive company with more satisfied employees.
Over the past seven years of rankings, the share prices of companies in the top quarter of my survey have gained 7.6% per year, on average—nearly seven percentage points better than the 1% annual gains of companies in the bottom quarter and 3.5 points better than the 3.6% gains of the S&P 500.
Note: While this is a valuable tool to screen problem companies and identify good ones, I still recommend that investors examine more traditional factors such as revenue and earnings growth, debt levels and price-to-earnings ratios before buying and selling stocks.
Here are the clues to look for when you read shareholder letters and other communications…
Accountability. Does the CEO take responsibility for company mistakes and/or lackluster performance instead of pointing to external factors? When executives are able to balance reports of company successes with failures, they are more alert to emerging business risks. They also are more decisive and execute more quickly.
Positive example. Buffett reports on problems and also takes responsibility for his mistakes. From his 2008 letter: “I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-to-$50 price. But so far, I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.”
Negative example. In the last quarter of 2012, Bank of America CEO Brian Moynihan reported that the company would take write-offs of $5.2 billion in mortgage-related charges and other charges. He offered no specific explanation for this staggering number, then attempted to ease shareholder concerns by stating that the company was “strong and well-positioned for further growth.”
Respect. Does the CEO address you, the stock holder, forthrightly as if you are a trusted business partner? Or does he downplay serious threats to the company’s health? Does he tend to display arrogance or humility?
Weasel words. These are clichés, hyperbole and what I call F.O.G. (fact-deficient, obfuscating generalities). Examples: “A powerful culture of innovation.” “We are leveraging our competitive advantages to create significant value for our shareholders.” “We are building momentum for sustained profitability and growth.”
In my rankings, only one-third of the CEOs in the S&P 500 do a good job communicating with shareholders. Here, three highly ranked companies in my Corporate Culture and Candor Survey…
Amazon.com (AMZN). CEO Jeff Bezos has transformed his business from an online book company into a retailing giant. His annual letters translate complex business concepts into understandable principles. The stock price has soared by more than 14,000% since it went public in 1997.
The Home Depot (HD). When former GE executive Robert Nardelli became CEO in 2000, he brought a reputation for tight, efficient operations. But his arrogance and poor communication skills drove down the stock price and let Lowe’s become a serious competitor for the next six years. He ignored shareholder and customer complaints as he replaced full-time knowledgeable store associates with part-time, inexperienced workers in a relentless drive to cut costs. In 2006, Home Depot’s annual shareholder meeting lasted only 30 minutes, and each shareholder’s question was limited to one minute, after which the microphone was cut off. The company’s share price fell by nearly 9% during his tenure.
In contrast, since Nardelli was ousted in 2007, current CEO Frank Blake’s shareholder letters and other communications have been straightforward and consistent, with a sharp focus on shareholders, employees and customer service. Over the past five years, Home Depot stock has returned an average of 22.8% annually, double the performance of Lowe’s stock.
Ford Motor Company (F). Straight-talking CEO Alan Mulally was hired in 2006 after Ford reported a nearly $18 billion annual operating loss. He turned Ford around by transforming a work culture that avoided addressing problems into one that fostered candidness and unity through a simple plan known as “One Ford” that employees worldwide and shareholders could grasp. Ford’s stock price has risen 61% during Mulally’s tenure. He plans to step down in 2014, but his likely successor, chief operating officer Mark Fields, shares Mulally’s reputation for unflinching honesty.
Near the bottom of my survey…
Cisco Systems (CSCO). CEO John Chambers often is lauded for his customer-oriented, collaborative management style at the leading supplier of data-networking equipment, but his communication efforts are lacking. The stock has trailed the S&P 500 over the past five years by nearly six percentage points a year, on average, because shareholders and investors are confused and mistrustful about his vision for the rapidly changing technology market. In his 2010 shareholder letter, Chambers describes his attempts to realign the business, but not many readers understood his use of terms such as “Smart+Connected Communities” and “virtual healthcare.”
Hewlett-Packard (HPQ). The company has had six different CEOs since 2005, all communicating different messages and visions. Last year, HP revealed it had made one of the worst corporate deals ever, paying $11 billion for the British software maker Autonomy and then writing down $8.8 billion of that after realizing that Autonomy was worth drastically less than HP paid. Current CEO Meg Whitman has acknowledged many of HP’s problems as she tries to stabilize the business, but her solutions often are laden with F.O.G. From her 2011 shareholder letter—“We’re going to double down on quality and service delivery, ensuring customers have a great experience from the first time we sit down with them until their solution is up, running, and delivering value.” Too much generality, not enough reality.
