How to Pick the Best Stocks: CEO Candor Predicts Performance

Alcoa CEO Candor SurveyProfit margins, revenue growth, and a litany of ratios are the traditional tools investors use to evaluate companies. But also inside those annual reports and quarterly findings is more subtle, less quantitative information that can be just as useful in evaluating a company's performance and prospects.

Letters to shareholders aren't just window dressing -- they reveal a lot about the management team's candor.

Candor may not seem like a factor that can make a material difference in a company's performance. But there are some interesting correlations revealed in the results of the annual Rittenhouse Rankings Corporate Culture and Candor Survey.

Candor Builds Credibility ... and ROI

"When leaders clearly communicate the company's principles and profit expectations to customers and investors, they build confidence in the company," writes Rittenhouse's founder, Laura Rittenhouse, in her book "Do Business With People You Can Trust." "When they walk their talk, they are more likely to extract better performance from their employees. These CEOs can draw on 'credibility currency' when times get tough."

Based on the most recent Rittenhouse survey results, building a culture of up-front communication pays dividends for a company in several ways. The survey evaluates how frank the leaders of 100 leading companies are, and how well their stocks have performed. The results are impressive: The companies in the top quartile of the group saw their stock rise an average of 9.9 percent, while those in the bottom quartile experienced a drop of 5.7 percent.

This is the sixth consecutive year that the most candid companies have outperformed the least candid ones.

Adopting a policy of frank, honest communications can make a big difference in growth. The five companies with the greatest gains in rank (over year-earlier levels) had stock gains averaging 12.4 percent, vs. a 5.7-percent loss for the bottom companies and a gain in the S&P 500 of only 3.1 percent. The five big improvers are Home Depot (HD), Intel (INTC), Foot Locker (FL), Franklin Resources (BEN), and Citigroup (C).

Winners and Losers

Among the 100 large and midsize companies that Rittenhouse studied, here are the best and worst by rank:

The Top 5
1. Church & Dwight (CHD)
2. Alcoa (AA)
3. Southwest Airlines (LUV)
4. Google (GOOG)
5. Ford Motor (F)

The Bottom 5
96. Hewlett-Packard (HPQ)
97. CSX (CSX)
98. Cisco Systems (CSCO)
99. Bank of America (BAC)
100. AIG (AIG)

By way of example, let's look at two of those stocks: Alcoa and Hewlett-Packard.

Alcoa's stock lost ground over the past year, as it has over the past decade (though recently reported Q4 earnings exceeded analysts' expectations). CEO Klaus Kleinfeld, in his 2011 letter to shareholders, didn't try to sugar-coat. He led with bad news right in the first paragraph:

"Whenever someone tells me, 'I have good news and bad news,' I always ask for the bad news first. ... We are acutely aware of the dramatic impact that Alcoa's share price drop had on so many people."

As he wrapped up the long letter, there was more candor:

"As we enter 2012, we remain cautious in the short-term and highly optimistic in the long-term. Volatility persists in Europe; political uncertainty could stall the U.S. recovery; and there is a possibility that the meteoric pace of economic growth in China may slow."

Near the bottom of the list is beleaguered technology company Hewlett-Packard. CEO Meg Whitman hasn't been at the helm for even a year and a half yet. But in 2012, her first full year, the company's stock fell some 45 percent, making it the worst performer in the Dow. Clearly, the company had problems preceding her arrival, but under her watch, there hasn't been any major turnaround yet, either.

In her 2011 letter to shareholders, she led positively: "First, let me say how confident I am in the future of Hewlett-Packard." To her credit, early in the letter she acknowledges some of the company's problems in very broad terms, saying, "My initial focus as CEO has been to get HP out of the headlines and back to being the reliable, trusted company that you can count on."
Near the end, she concedes that, "While I'd like to say that we're through the tough times, many of the fiscal 2011 headwinds are still with us as we enter fiscal 2012, and our near-term focus is on stabilizing the business." She also points to the company's substantial free cash flow, but doesn't mention that it has dropped in recent years.

The Bottom Line

What the Culture and Candor Survey shows is that investors would do well to pay attention not only to a company's profit margins and revenue growth, but also to what its management is saying and how candid it is.

Motley Fool contributor Selena Maranjian owns shares of Google, Intel, Ford, and eBay. The Motley Fool recommends American International Group, Cisco Systems, eBay, Ford, Google, Intel, Southwest Airlines, and The Home Depot. The Motley Fool owns shares of American International Group, Bank of America, Citigroup Inc , Ford, Google, and Intel and has the following options: Long Jan 2014 $25 Calls on American International Group.

Related Articles:

Increase your money and finance knowledge from home

Investing in Startups

The lucrative and risky world of startups.

View Course »

Investing in Emerging Markets

Learn to invest in a globalized world.

View Course »

Add a Comment

*0 / 3000 Character Maximum


Filter by:
Ronald King

There are some BIG assumptions here, the main one being the investment strategy of the investor. Are they buying stock to participate in the revenue distributions (dividends) and ownership of the company in question or are they buying the stock speculating that the price per share will go up enough to cover their overhead?

If you buy stock for the dividends/ownership then stock price is irrelevant, except that a drop in price is an opportunity to increase your holdings. A high VIX is your friend; panicked investors dumping their shares to "save" their investment are gifting you their wealth. The actual value of the company has not changed; just what some poor Chum is willing to take for his property in a "fire-sale."

A dividends/ownership investor should be looking to two characteristics of a company; 1) history of dividend disbursement, and 2) net assets (assets - debt) to Market Capitalization. If a "blue chip" never pays dividends then the dividends/ownership investor has little reason to buy it even if the net asset : MktCap is favorable. The only reason to do so would be to take over management of the company ensuring that dividends are paid. A favorable MktCap would be where the assets are enough greater than the MktCap that buying the company becomes attractive regardless of your plans after you gain control.

Corporate raiders have used this technique forever. Case in point from the late '80s; Zellerbach Paper (CZ). One investor purchased a majority stake in the company, sold off assets to fund dividends that more than recouped his investment then dumped his shares. Prices soared from the dividends and plummeted from the dump.

The Speculator doesn't care about anything but the volatility of the stock, how it moves and how often. S/he might buy and sell the same stock several times in one day, depending on its movement. The Speculator LOVES a high VIX. Volatility = high profits. A rising DJIA is just a signal to sell; a crash is an opportunity to increase holdings.

The dynamic in this article might be useful in a limited fashion, but it really should not be relied upon exclusively for investment signals. A dividends/ownership investor should consider their stock of zero value until they are ready to sell it. Otherwise s/he might become the chum that the sharks feed on.

January 21 2013 at 8:39 PM Report abuse rate up rate down Reply

Honest.... CEO..... THAT's an OXYMORON if I've EVER heard one!!!

January 17 2013 at 12:44 PM Report abuse rate up rate down Reply

Jaime Dimon could learn something here if he wasn't such a ass*ole.

January 16 2013 at 10:52 PM Report abuse rate up rate down Reply

Being candid (telling it as it is) not only creates share price damage but also establishes a baseline that can be used to see whether the CEO is doing anything to improve the company. This is not what the CEO wants. Blowing smoke up investors butts is the name of the game for many of them.

January 16 2013 at 1:32 PM Report abuse +1 rate up rate down Reply
1 reply to jerald3739's comment

Lessssseeeee...... Megacorp Oil made 45 BILLION dollars in 2010, but "only" $40B in 2011. In my company, that would be "Hey I made 40 billion!!". In Capitalisism-run-amok USA, that's "Oh, no.... they lost more than 10% and the EPS shrank from 110 bucks per share to ONLY 100.... that's sacrilege to the pundits on Wall (RIPOFF) Street...

January 17 2013 at 12:48 PM Report abuse rate up rate down Reply