Leadership Strategy

The Big Mistake Warren Buffett Won’t Make

To understand the big mistake that investors make, you need to know about Candor AnalyticsTM. It is a financial linguistics technology based on proprietary codes and scores. These allow analysts to measure the amount of trustworthy and trust-deflating statements in a CEO communication.

This technology was inspired by Warren Buffett’s candid and informative letters to shareholders.

For over a decade, this strategy has consistently delivered returns that on average are two times greater than the S&P 500 Index. In fact, the prestigious Chartered Financial Analysts (CFA) Institute was so impressed with these results, they chose Candor Analytics in 2016 as one of their “Future of Finance” innovations.

How does Candor Analytics consistently create market-beating portfolios? Because this technology avoids the big mistake investors make.

Investors get derailed when they imagine the financial numbers of a company are more trustworthy than a CEO’s words. They say, “I can trust the financial accounting numbers, but I can’t trust the words of a CEO.”

It is true that numbers ARE more precise than words. A number “4” is always a number “4”. And words are ambiguous. The word “four” could also be spelled “for” or “fore”. When they rely on numbers, investors forget that precision does not mean numbers are accurate. They conflate the precision of numbers with accuracy.

Where do financial accounting numbers come from? They result from countless decisions made within a company about when to count cash, when to recognize it as earnings, and how and where to report it. These accounting judgments can be conservative and trusted like those in a Berkshire Hathaway company – or they can be manipulated and untrustworthy like those at Enron before its spectacular collapse in 2001.

In other words, when accounting numbers reflect the values and norms of the culture, then investors gain confidence in the accuracy of income statements, balance sheets, and quarterly earnings.

How can investors know if a corporate culture is trustworthy? They can analyze the words of CEOs in their letters to shareholders.

Why study CEO words? Because they are powerful. CEO words create the company’s future; just as our words, create our future.

CEO words can be direct or evasive; clear or confusing; informative or superficial; and true or false. Investors who see these differences, gain a unique advantage.

When analysts total all the positive candor points for clear, substantive reporting, and then total all the point deductions for CEO FOG, [Fact-deficient, Obfuscating, Generalities], they get a measure of the percentage of FOG in the CEO letter. This is a proxy for the trustworthiness of the corporate culture.

Our annual surveys show that some CEOs write shareholder letters with as little as 10 percent FOG, while other executives publish letters that can score up to 100 percent FOG.

Correlating candor scores with annual returns shows that candor is associated with healthy cash and earnings growth, as well as respectful stakeholder relationships. This research also confirms that CEOs who score high in FOG typically underperform the market.

Candor Analytics is based on a model of corporate culture that recognizes the dynamism of a networked – not a linear – organization. It looks like this:

Years ago, when Jack Bogle, the legendary founder of Vanguard Mutual Funds, saw this model, he said, “Like Copernicus, you have discovered the true position of the sun!” He believed capital stewardship was revealed when a CEO put investor interests before their own.

Like other management models, Candor Analytics focuses on corporate strategy. To see how strategy is being executed, we review the company’s accountability statements – does a CEO report on progress in meeting corporate goals? Does he or she set credible and insightful expectations for the future? How relevant and persuasive is the corporate vision and purpose?

Candor Analytics shines light on the quality of stakeholder relationships which are supported by a CEO’s informative descriptions of customer, investor, and employee needs and wants. Can a CEO be both strategic and empathetic? These are all clues to uncovering the norms and values of a value-creating, trustworthy corporate culture.

Years ago, I met with a seasoned financial analyst to compare our different investment analyses of PepsiCo. We compared the company’s leadership qualities, financial projections, strategy, business opportunities, competitive advantages, and stakeholder relations. We agreed our conclusions were surprisingly similar.

He said, “Your analysis is interesting, but it does not add much to my understanding of Pepsi’s investment merits.”

I agreed. “Yes, our results are strikingly similar, but you have access to management; you read sell-side analyst reports and talk with analysts; you attend company roadshows; and you have a team to run numbers and project earnings scenarios. What did I do?

I analyzed the words of the CEO in the shareholder letter.”

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