Book Review #44: Investing Between the Lines: Author: L J Rittenhouse

I have so far reviewed 43 books in my series on 50 Finance Books. The books reviewed so far falls into different genres like Personal Finance, History of Finance, Wisdom and Investing Fundamentals. The

book 'Investing Between the Lines - How to make smarter decisions by decoding CEO Communications' written by L J Rittenhouse falls into the genre of CEO Communication. This may be the only book of this genre in this series.

Why does CEO Communication matter?

The goal of Rittenhouse Approach is to create a gold standard for CEO Communication, by culling examples from thousands of such communications. The way CEO communicates is very important due to the following reasons.

• It reveals the character of the CEO. Authentic leaders write trustworthy letters
  
• Warren Buffet uses it to identify the integrity of senior management, which is one of his main investment criteria. He reviews past CEO communications to see if the commitments and plans made in the past has been followed up in later years.
  
• It instills confidence in the shareholder's that their company is managed prudently. It assures that the the mission, vision and core values guide the management in their decision making.  
• It provides transparency on the running of the company 
• It helps investors anticipate serious problems at their inception before them become 'news'
• It helps align investor and management expectations
• Transparent CEO communication has a direct and positive correlation with investor returns
  

About the author.

Laura J Rittenhouse is a financial expert.  She is named as one of the top 100 US thought leaders in trustworthy behaviour.  She is the founder of Rittenhouse Rankings Inc, which helps its customers increase their valuation by providing trust building corporate communications. In addition to the above book, she has written two more, Buffet's Bites and 'Do business with people you can trust'

About the book

The goal of every CEO should be to create sustainable businesses. By analyzing how CEO communicates, an investor can know if the CEO is progressing towards that goal. A successful CEO communicates with candor and specificity. She links the present decisions to the culture and values generated over time and is candid about the mistakes made and lessons learned from them. Most importantly she appreciates the contribution of the three groups of stakeholders - Employees, Suppliers and Customers - to the success of the company.

Her communication can be looked upon as an evolving story. Investor can easily connect the dots.

CEO makes decisions that involve making judgements between multiple options. Corporate culture and values act as a bedrock in making these judgements. The culture can be transparent or opaque. Since the CEO can strengthen or modify the culture and values of the company, the CEO communication points to the direction of the company. A transparent CEO informs and educates. She explains how the revenues were generated, specific plans for the present and the future, the challenges faced and how they were addressed and expected risks and how they will be addressed. She is consistent over the years and communicates progress on the goals announced in the previous years.

How will an investor analyze the CEO Communication? What are the parameters to look for? What are the clues or signs under each parameters that informs them if the CEO is competent? How can they identify the potential pitfalls? 

To answer these questions, the investor needs a mental model, an approach or a framework. This is where Rittenhouse Approach comes in.

The Rittenhouse Approach

This book provides a structured approach to analyzing CEO Communications. The focus is entirely on the text of CEO's annual letters to shareholders. The goal is to analyze the CEO communication to develop a model of sustainable business To come up with the criteria, the company analyzed over 1000 CEO communications. Based on this they came out with 130 topics. These topics are divided into seven parameters as shown below.

Rittenhouse Rankings Approach

The book provides a set of four or five clues that investor can use to evaluate each parameter. Scores are given for the performance on each of the clues. It also provides relevant examples from CEO communications to illustrate the points. Communication supported with numbers gets higher scores. There are negative scores as well. Finally, the approach comes up with one score to rate the CEO communication. 

While the score itself is important, the components are far more important. For example a higher overall scores with high scores on Capital Stewardship and Candor is better. 

The analysis could be as simple as counting the number of times a specific word is used in a letter. One of the criteria in the parameters Capital Stewardship is to count the number of times the word 'Cash' is used in a letter. They also look for FOG, the number of times platitudes ("We are going to be the best version of ourselves") is used in the letter. Needless to say more the number of the word 'CASH' it is good, more the proportion of FOG in the letter, that is a cause of concern.

The summary of the approach is given in the diagram below.

As an example of  Parameter and their evaluation criteria, let us look at the parameter 'Capital Stewardship'. It is measured by the following criteria (the book calls them Clues)

1. Cash and Cash flow
2. Operating and Financial Goals
3. Capital Discipline
4. Balance Sheet Measures
5. Risk Awareness. 

A Cash Flow Statement consists of three groups. Cash Flow from Operating Activities (also known as Operating Cash Flow), Cash Flow from Investing Activities and Cash Flow from Financing Activities. There are two different terms that CEO uses about Cash and Cash flow. Free Cash Flow (FCF), which is the net cash available after providing for Capital Expenditure. This the cash that accrues to the investors and which they use for valuing a business. A good CEO focuses on FCF. However if the management focuses on 'Operating Cash Flow' then it a red flag. It is possible that there are negative flows related to Investing and Financing that impact the investors. An investor should know why the CEO is focusing on OCF and not on FCF.

The Rittenhouse approach reviews CEO communication to look for words like Goal, Objective, Target and Aim, all of which suggests a focus on goals. They divide the goals into three types. Motherhood goals are generic statements of intention like 'we want to be the best in our industry'. Serious goals combine intentions with measurable outcomes like 'we want to increase sales by 20% next year'. Superior goals wraps a context around the goal. They generally contain a performance matric (increase RoI by 2%), a performance benchmark (compared to industry standards), and specific set of actions to be taken to achieve this goal.

Capital Discipline of the company can be evaluated in two ways. One, how often CEO talks about ROI (Return on Investment), ROIC (Return on Invested Capital) and ROA (Return on Assets). The second way is to see if the CEO focuses on Book Value, which is more predictable and dependable, or on market value, which is more at the mercy of external factors. A good CEO will focus on Book Value, leaving the investors to take care of the market value. 

An analysis of the Balance Sheet will show its liquidity position as well as the Debt to Equity ratio, two key parameters from an investor's perspective. Despite its importance, most of the CEOs do not discuss it much. Any company, whose CEO communicates the status of the Balance Sheet and actions taken to strengthen it, should get a higher investment rating. 

Risks are inherent to any business. It is the duty of the CEO to communicate potential risks and mitigation plans to the investors. For many companies, like insurance and banks for example, Risk management can be a significant competitive advantage. Recognizing the importance of risk. Rittenhouse approach looks for references to the word Risk in CEO communication, with more references displaying competent leadership

Similar detailed analysis is done for all ten parameters mentioned above. 

The strength of this approach is its detail and its consistency over the years. Analysing the CEO communications for the same company year on year can demonstrate the integrity of the management, whether they act on their promises or keep shifting goal posts. In addition, this approach could also focus on changing managerial styles as the company replaces CEOs and helps the investors analyze what works and what doesn't.

How will this book help?

This is a book for all retail investors. The approach is intuitive, easy to understand and easy to put into action. The 'CEO Speak', with surfeit of jargon and numbers can be intimidating to a lay investor. By following the simple but detailed approach mentioned in this book, a lay investor can take informed investment decisions. 

This book is different from all the other books I have reviewed so far in my 50 books in finance series in that this has almost zero math. Numbers if any, add intuitive context to the points mentioned. Any layman can read the book and almost immediately start reading CEO communications with a new and enlightened eye. 

If only for that, I will give this book a 5/5 rating.