Investing Between the Lines

Investing Between the Lines: How to Make Smarter Decisions by Decoding CEO Communications
by L. J. Rittenhouse (292 pages, McGraw-Hill, 2013)

Laura J. Rittenhouse is the president of Rittenhouse Rankings, Inc., a firm that specializes in advising companies on strategic communication and investor relations. Her firm also aims to advise corporate leaders on how to sharpen their strategic execution and performance.

Ms. Rittenhouse began her career on Wall Street. From 1981 to 1991, she was an investment banker at Lehman Brothers. Upon leaving Lehman in 1991, she founded Rittenhouse Rankings. Early on, as part of her IR service, she regularly surveyed financial analysts and investors to gauge their perceptions of her clients and their senior management teams. Her goal was to bridge gaps in information and perceptions that were interfering with a client’s ability to achieve its communication objectives. She also compared her clients’ letters against those of competitors to obtain objective baselines of disclosure.

In 2013, Ms. Rittenhouse published Investing Between the Lines, which provides a detailed look at the systematic methodology used by Rittenhouse Rankings to codify and ultimately gauge the effectiveness of CEO shareholder letters. She asserts that a comprehensive review of this key corporate communications vehicle offers insights into the underlying strategic objectives and true performance of large corporations. Often, what is not said is as or more important than what is said. Rittenhouse also uses the knowledge that it has gained from these reviews to advise CEOs on changing their corporate cultures. She claims that those companies that are candid in their corporate communications are more likely to outperform.

Early on in the process of developing her ranking system, she wrote to Warren Buffett, whose shareholder letters are legendary. As a result of that relationship, Rittenhouse wrote her second book, Buffett’s Bites, which is a comprehensive guide to understanding Buffett’s shareholder letters. Mr. Buffett also offered his own insights into how he views other CEO’s shareholder letters. Among them: he is partial to CEOs who write their own letters, because CEOs who don’t are more likely to not know their business(es) very well.

In Investing Between the Lines, Rittenhouse begins her analysis by asserting a link between corporate culture and performance. She offers many examples of companies whose strong cultures made them superior performers. She cites academic research supporting the connection, describing the specific factors that enable superior performance over time. All of this leads to Rittenhouse’s model of a sustainable business which her firm developed using the insights gathered from over a decade of data captured in its ranking system..

In the book, Rittenhouse offers many detailed examples of companies that she believes have been successful communicators (e.g. Ford) and those who have not been so successful (e.g. AIG, Enron and General Motors). It is worth noting that among her examples of companies with strong cultures that produce superior performance is Wells Fargo, which has since been criticized for its management practices. Obviously, circumstances can and do change, so it is important to remain diligent in making these assessments.

In creating her model of a sustainable business, Rittenhouse was first inspired by Charlie Munger, CEO of Wesco Financial Corporation and Warren Buffett’s business partner. Mr. Munger uses 90-100 business models to analyze investment opportunities in a systematic fashion, which he believes is necessary to make effective investment decisions. These models are drawn from a variety of fields, including mathematics (e.g. compound interest) and physics (e.g. critical mass). Rittenhouse used this framework to create her own model of the seven systems that comprise her concept of a sustainable business. These include strategy, leadership, vision, stakeholder relationships, accountability, capital stewardship and candor.

In order to systematize her analysis, Rittenhouse created a large database of more than 1,000 CEO shareholder letters and developed checklists of criteria for each of the seven systems. In total, she identified 130 performance-related topics. For the “Business Opportunities” topic, for example, Rittenhouse considers whether the CEO commentary describes actions taken to boost revenues, identifies specific initiatives – such as new product launches, product line extensions and acquisitions – and focuses on current and future planned initiatives. While the checklists are important, it is the context (i.e. what is actually said) that counts. Some shareholder letters may get fewer checks on the checklists, but they may still be effective if they offer more insightful commentary. The model bridges the gap between checklists and content quality by scoring each of the 130 topics.

Candor is an especially important criteria for Rittenhouse. She has developed telltale signs of what she calls FOG – fact-deficient obfuscating generalities – which result in point deductions in her scoring model. She differentiates between benign FOG, which acts as filler in shareholder letters, and toxic FOG, which is deliberately meant to deceive. Over the years (at least through the date of publication of the book), Rittenhouse suggests that both total FOG and toxic FOG have been on the rise. (I suspect that if she were to publish an addendum to her book, she would say that the increase in FOG has continued beyond 2013.) She attributes the increase in FOG to rising “short-term-itis,” excessively high CEO compensation and a general decline in ethical behavior.

The book devotes a chapter to each of the seven systems, providing specific examples of CEO shareholder letter commentary and how that commentary scored under her sustainable business model methodology. Rittenhouse always tries to draw a link between the strengths and weaknesses of the shareholder letter and the company’s subsequent operating or stock price performance. While her analysis almost always shows a strong correlation between good commentary and superior future performance, I am not sure whether the correlation is quite as strong across the broader universe of corporations.

Within each of the seven systems chapters, the book provides numerous case studies of shareholder letters that scored high and low. Along the way, the reader gets a broad sweep of recent U.S. corporate history – including the performance of General Electric during Jack Welch’s tenure, the Enron debacle, Amazon’s evolution, the fall and rise of General Motors and key milestones for companies like IBM, Hewlett-Packard, Costco, Wal-Mart, Citigroup, General Mills, Sherwin-Williams and many others. In the majority of these case studies, Rittenhouse shows how her ranking system was an accurate predictor of the company’s subsequent performance.

The Rittenhouse Rankings system seems to be such an accurate performance predictor in so many of these examples, I could not help but wonder if its efficacy was based upon a deliberately chosen, small sample size and hindsight. For example, while she does acknowledge AIG’s candor in its description of the potential impact of losses associated with its derivatives portfolio, her negative spin on the deficiencies of the analysis clearly benefits from the knowledge of AIG’s subsequent collapse. It is of course easier to pick apart a shareholder letter after the fact. Likewise, it is much harder to assess the quality and accuracy of the CEO’s shareholder letter in advance of consequential events, especially in instances where the CEO appears to be communicating with candor.

Rittenhouse also acknowledges, as many cynics have pointed out to her, that CEOs who learn her “formula” will simply follow it to get a high score. (This would qualify, I suppose, as a form of toxic FOG.) In defense, she argues that “the most memorable shareholder letters are those that are original and thoughtful, not formulaic.”

Along the same lines, Rittenhouse does not provide any examples where her system produced false positives or negatives. Surely, however, there must be instances of a poor correlation between the quality of the shareholder letter and the company’s subsequent performance. This is perhaps where her book lacks candor. A chapter or two devoted to the limitations of a systematic analysis of the shareholders letter would have added considerable value to her analysis, in my view.

That said, Investing Between the Lines illustrates the importance of the shareholder letter, which most seasoned security analysts already recognize. Readers of the book will undoubtedly gain new tools for evaluating the shareholder letter, which will aid them in their analyses. Rittenhouse’s systematic approach and database is also useful to institutional investors who seek a comprehensive and independent analysis of CEO shareholder letters. From my perspective, however, those analysts who follow a company closely, who regularly evaluate all of a company’s disclosures over a multi-year period, are almost always in the best position to gauge the veracity and completeness of its shareholder letters.

Readers of this book review may also be interested in my review of Weekend With Buffett.

August 3, 2017

Stephen P. Percoco
Lark Research
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