Never Trust a CEO Who Does This...

by Matthew Weinschenk Wisdom of Wealth Wisdom of Wealth

Never Trust a CEO Who Does This...

by Matthew Weinschenk, Investment U's Contributing Editor

Thursday, November 4, 2010: Issue #1381

How do you know when a CEO is lying?

We all know the witty answer to this: "When he's moving his lips."

But in all seriousness, this is an important question for investors, as we place enormous trust in the men and women responsible for running America's companies. And remember, as a shareholder, you own part of the business, too.

Consider it this way: If you own a business, you'd thoroughly vet the person you hire to run it - and would expect complete honesty at all times.

But we seldom do the same with CEOs of public companies.

Fortunately, I'm going to share some insights that will help you separate the next Jack Welch from Bernie Ebbers (who's five years into his 25-year prison sentence for fraud, conspiracy and generally lying his socks off).

With so much money sloshing around, plus performance-based bonus payments and other financial incentives, the temptation for executives to lie - or stretch the truth - is clear. And getting away with a fib here and there is pretty easy...

If a company falls just short of an earnings target and the CEO wants to release a better number, it only takes a few creative "accounting changes" to make it happen. He doesn't even have to commit fraud either. He could simply restate the expected life of a factory, for example, and change the depreciation equation.

This kind of thing happens frequently, too...

Members of the Board: Please Take Out Your Calculators

When you look at the results from earnings announcements, the line is skewed towards meeting or beating earnings, rather than falling short. More companies report positive numbers - and that's no accident.

What's interesting, though, is that companies exhibit a statistical pattern of posting earnings surprises in three out of four announcements. They then disappoint on the fourth one. Why?

  1. It's partially due to analysts changing their expectations.
  2. The company finally has to take a hit for those "makeup sales" that didn't happen.

But executives don't have to change a single number. They could simply exaggerate their expectations for the future.

So how can you tell the Honest Joes from the Pinocchios?

You Can't Handle the Truth!

It seems that while executives may be accomplished businessmen, they could use some more practice in the business of stretching the truth.

A recent study from David F. Larcker and Anastasia A. Zakolyukina at the Stanford Graduate School of Business reveals how you can protect yourself from CEOs who want to embellish their companies' numbers or future outlook.

It shows that CEOs and CFOs betray themselves with the words they choose during quarterly earnings conference calls.

Larcker and Zakolyukina studied 26,663 transcripts from 2003 to 2007 and compared the companies that eventually admitted earnings mismanagement to those that didn't.

They focused in particular on the "Q&A" portions of the calls - and for good reason. It's easy to prepare an airtight presentation on your quarterly results, but analysts can ask some challenging, unpredictable questions that are more likely to trip up company executives.

Here's what they found...

CEOs Raise These Linguistic Red Flags

It turns out that there are certain linguistic red flags that executives raise when answering questions. For example...

  • Catchphrases: "Deceptive executives" frequently use phrases like "you already know" or "others know well" - perceived general knowledge, but often done without backing up their claims.
  • Emotions: Pay attention to the emotiveness of the language. Specifically, "non-extreme positive emotions" and "extreme positive emotions." For example, a non-extreme positive claim would be something like, "sales are good." On the other hand, an "extreme positive emotion" would be, "sales are fantastic." The CEO who says "fantastic" is more likely to be embellishing the story.
  • What's Missing? When executives don't mention terms like "creating shareholder value," that's another red flag. Some top dogs understand that their duty is to return value to the shareholders; others are more concerned with their compensation packages.
  • The Leadership Gauge: Watch how CEOs refer to themselves and the rest of the management team. A leader willing to take ownership and refer to himself as "I" is more likely to be telling the truth. But those who use the royal "we" could be prone to deferring future blame when results are below-par or when things go wrong.

And the most striking takeaway from this study?

According to the numbers, this analysis of executive language provides better predictions than traditional financial analysis.

Focus on Cash

There are hundreds of studies focusing on "earnings management" - i.e., how to tell when companies are merely shuffling the numbers to make things look better.

Most of them typically identify areas where the cash flow doesn't match up with the income statement - and for one simple reason:

Companies can tweak the earnings, but barring outright fraud, cash doesn't lie.

But other signs of earnings management include...

  • Rising accounts receivable.
  • Falling unearned revenue.
  • Having a high aggregate accruals ratio.

However, if you don't like to dig that far into a beefy earnings report, you should at least weigh the cash flow statement more heavily than the income statement.

Take a Peek Behind the Stage-Managed Public Image

Nevertheless, the fact that the study into executive language outperforms some advanced financial analysis is telling.

After all, no matter what the numbers show, the companies you invest in are run by real people. Intelligence, values, decision-making, emotions and many other factors come into play every day that affect companies' prosperity - and the value of your trading account.

And make no mistake, analyzing the true quality of a management team these days isn't easy. It's difficult to quantify when executives present a carefully crafted public image.

Still, these guys are only human and there are sometimes glaring insights into their temperament. Take former Enron CFO Jeffrey Skilling, for example, who once blurted an obscenity to an analyst on a conference call.

Other than that, it can be tricky to spot the cracks in executives' armor. But it doesn't mean you shouldn't try - and the tips above should help. After all, these guys are running the companies you own.

Good investing,

Matthew Weinschenk

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