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.

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