Investing Between the Lines - LJ Rittenhouse

Decoding CEO communications to make better investments

Executive communications can reveal a lot about their company’s prospects, plans and performance. In her book Investing Between the Lines, L.J. Rittenouse provides an accessible framework for assessing and intepreting CEO letters to shareholders. We found her ideas a useful checklist and complement to the value-investing research process. Her methods are particularly useful in assessing factors such as managerial integrity, where the utility of financial measures are limited and the need for qualitative judgement necessary. In this post, we briefly review some of the factors Rittenhouse thinks about when assessing executive communications.

“You need mental models—a checklist of procedures… If you’re trying to analyse a company without an adequate checklist, you may make a very bad investment.…”
Charlie Munger

Find great businesses between the lines

Rittenhouse suggests that executive communications can reveal a lot about business’ outlook and sustainability. She proposes a seven step checklist for identifying businesses with sustainable operating models:

Vision
Strategy
Leadership
Accountability
Relationships
Capital Stewardship
Candour.

Rittenhouse suggests that benchmarking the quality of executive communications against these measures can offer additional insight into the sustainability and operating health of a company. We outline some of these dimensions in brief as follows.

Vision and strategy

Vision and strategy describes how management develops and communicates their company’s purpose, direction and opportunities. Rittenhouse notes executives with a vision for their business should be able to communicate it simply. These executives should also report on company ideas, practices and results in a meaningful and authentic manner. Similarly, there might be evidence of sound strategy when executives are able to articulate complex strategies simply, performance targets and its implications for capital discipline. Unsurprisingly, it is a positive sign when executives can communicate their company’s current and future competitive advantages in non-generic ways.

Leadership and accountability

Leadership and accountability describes how management manages risks, respond to errors and report on performance. Rittenhouse suggests that good leaders and great executive communications will educate their readers and provide context about company operations in their communications. Additionally, these leaders tend to report on company problems in a consistent and balanced way. They are also open to opposing ideas and demonstrate a strong understanding of their business’ risks. Similarly, leaders that demonstrate accountability tend to link organisational goals with measurable results. Conversely, we should be wary of executives that do not report earnings on a diluted per share basis, and when results in shareholder letters that do not match their financial statements. Likewise, non-GAAP results that deviate excessively from its GAAP counterpart due to creative interpretation of accounting rules is another red flag.

Relationships

The relationship dimension refers to how well managers recognise and balance different stakeholder interests. This includes customers, employees, suppliers, shareholders, communities and the environment. Relationships are an important dimension given that long run success is often dependent on the company’s capacity to adapt to the changing requirements of varied customers and stakeholders. Furthermore, Rittenhouse notes that executive letters are often telling of how important these relationships are to them, and whether actions are underway to meet these interests. Long-term oriented executives will tend to take responsibility for building an ownership culture, engaging stakeholders, balancing stakeholder priorities and anticipating customer desires.

Capital stewardship

The capital stewardship factor describes how executives are likely to behave with investor capital. Investors need to know whether management is acting efficiently and recognising the average shareholder’s interest. While the company’s financial statements can provide insights on the former, executive communications are usually more telling of the latter. Rittenhouse notes that executives that demonstrate capital stewardship are more likely discuss their company’s cash flow statement and balance sheet. This may also include discussions on net cash positions, cash inflows and outflows, leverage and liquidity. Furthermore, these executives tend to demonstrate capital discipline by discussing returns on investment, risk management, financial goals and operating goals. They are also candid about initiatives underway and their assessments of progress against these goals.

Invest in trust and candour

“In looking for people to hire, you look for three qualities: integrity, intelligence, and energy. And if they don’t have the first, the other two will kill you.”
Warren Buffett

Warren Buffett likes CEOs that communicate frankly and honestly about their businesses. He once noted that “the CEO who misleads others in public may eventually mislead himself in private”. All else equal, long-term economic success is more likely in companies that promote candid communications between employees, customers and management. This is because companies with strong employee-customer relations can empower staff to anticipate market shifts and enable leaders to gather intelligence and execute strategies.

Similarly, companies with cultures that foster honest feedback and debate are more likely to develop solutions to business problems and customer needs. Organisations that fear truth-telling are unlikely to survive in the long-run. It is for these reasons that Rittenhouse gives the candour dimension the biggest focus in her work. The author notes that if trust is important to long-term business success, then candour is the mechanism on which trust is built. Good executives will share the facts that they would like to know if they were an average shareholder themself.

Watch for fact-deficient, obfuscating generalities

Shareholder letters and executive communications can reveal a lot about the CEO’s character and motivation. For example, Rittenhouse suggets that the ratio between facts and fluff is one indicator of the company’s integrity and its capacity to create shareholder value. Similarly, Rittenhouse recommends investors scrutinise communications for the absence of candour. She refers to this as fact-deficient, obfuscating generalities (FOG). Common examples of FOG include the excessive use of weasel words, clichés, jargon, padding, metaphors, imagery, hyperbole and vagueness. Rittenhouse points out that if investors cannot understand what a CEO is saying, then that itself is information about the company’s leadership and accounting. Finally, investors should be careful not to rely purely on financial numbers. Ignoring the red flags in words and our common sense can lead to incorrect investment decisions.

Investing Between the Lines — Rittenhouse on Executive Communications