William McCaffrey, chairman and CEO of MEG Energy Corp. in Calgary, Alberta, was telling analysts about the capital expenditures of his Canadian oils sands development company during its third-quarter 2014 earnings call. “What we’re doing, is we are doing ground field expansion that we are just in the early stages of design,” he said. “When we take a look at our capabilities on that, we focused — our capital programs we focused first obviously on the sustaining and maintenance and that’s really 20 percent of its street 2015 estimate our cash flow.”
Among those listening in on the calls was Joel Litman, a former forensic accountant and Credit Suisse analyst who now runs Valens Securities, an independent debt and equity research firm he founded in New York in 2009. “Highly questionable,” he noted when McCaffrey talked about the capital programs. Litman, who describes his work as forensic analysis, was watching an audiogram on his computer screen using software that his firm developed. The technology notes when a voice sounds stressed and grows louder or softer, changes that can indicate whether or not the speaker feels confident about what he’s saying. From there, Litman and his colleagues interpreted a certain point in the audiogram of the MEG conference call. “This suggests,” says Litman of the statement, “that McCaffrey already knew that the new expansion opportunities may be put on hold and that the capital expenditure programs were already under question inside the company.” MEG held the earnings call in late October, when the oil price swoon was just gathering pace.
“The fall in price was so significant that it had to already have management questioning whether the same projects planned would still be profitable, given where oil seemed to be headed,” says Litman. In mid-December, the company announced it was slashing about $900 million from its 2015 capital spending plan.
Equity and debt analysts long have known that numbers alone don’t tell the whole story of how well a company can cope with big changes. A market sentiment survey from the CFA Institute conducted in October 2014, an international professional association for chartered financial analysts, indicates that investors believe that lack of integrity in financial reporting is one of the most serious concerns for global markets. The deeper investigation that Valens and a handful of other research shops perform spins off of the idea that behind a company’s valuations and profit and loss statements are the judgment calls made by the individuals running the company.
“Data is an outcome, but people create the data,” says Jason Voss, a content director at the CFA Institute in New York and a former portfolio manager for Davis Selected Advisers, a Tucson, Arizona–based fund manager. Much of Voss’s work involves seeking out analytical strategies and ways to train analysts and investors to probe deeper into a senior managers’ psyches. Other research groups working in this field include Business Intelligence Advisors, a Boston company founded by former intelligence officers, which uses a proprietary behavioral assessment model to evaluate the information that a company discloses.
Laura Rittenhouse, a former Lehman Brothers corporate finance executive whom Voss calls one of the foremost researchers in financial forensics, is the president, founder and CEO of Rittenhouse Rankings in New York, a corporate consulting firm that advises clients how to develop their inner detector of corporate spin. Rittenhouse publishes annual rankings of 100 companies in the Fortune 500, known as the “CEO Candor and Corporate Culture Survey.” The survey, which comes out each April, rates companies according to what their executive communication reveals about such qualities as strategy, leadership, accountability and stakeholder relationships. Rittenhouse has found a close correlation between high stock prices and executive candor in the eight years she’s been doing the study. Using a detection method she calls FOG — fact-deficient, obfuscating generalities — she subtracts points for jargon and illogical statements.
One communiqué Rittenhouse found to be high in the FOG factor was the 2013 year-end letter from Joseph Swedish, CEO of WellPoint, which in December changed its name to Anthem. This month the company suffered a massive data breach, and now customers across the country are suing, claiming Anthem didn’t take adequate measures to protect their personal records. Rittenhouse thinks Anthem’s CEO was displaying an evasive style long before this most recent problem, however. The investor letter began with: “Simplify. Stabilize. Unify. When reflecting on my first 10 months as CEO of WellPoint, these three words represent both my initial ambitions as well as the foundation of our company’s most meaningful achievements.” Rittenhouse rates the statement as “circular,” one of the 20 ways of obfuscating under FOG coding system, because it is “an attempt to support a statement by simply repeating the statement in different or stronger terms.” On the other hand, General Motors CEO Mary Barra’s year-end 2013 letter got high marks for candor. The letter began with a straightforward enough statement: “2013 was an historic year for General Motors — a year in which we advanced every part of our long-term strategy for profitable growth. We strengthened GM’s fortress balance sheet. We delivered solid earnings and made a number of strategic investments around the world. We also built on our reputation for product excellence and world-class quality, thanks to our revitalized portfolio of highly regarded new and refreshed vehicles.” More important, from there Barra explained what the balance sheet strengthening entailed and what the strategic investments were.
GM ranked No. 5 in the 2014 edition of the Rittenhouse Rankings, shooting up from 78 the previous year. Rittenhouse found the investor letters from former CEO Daniel Akerson fairly FOG-shrouded, and Barra’s earlier letters weren’t as straightforward as her 2013 note, the most recent available. WellPoint ranked No. 70 in last year’s survey.
Rittenhouse met Litman in the fall of 2013, when he gave a talk to members of the New York Society of Securities Analysts and the National Investor Relations Institute titled “Lie Detection of Earnings Calls.” Since then the two have chatted frequently about how they’d like to help investors decode what senior managers really mean when they use what Rittenhouse calls “tortured grammar” and vague phrases like “accelerate our momentum.” Notwithstanding the title of Litman’s presentation, they know that this kind of nonrevelation isn’t usually outright lying but is more likely an effort to gloss over what the numbers actually mean and which numbers are most important to the company’s value. Senior managers rarely describe the full context of how debt, spending or cash reserves will effect valuations, but Litman says that’s what investors really deserve to know, which is why it’s important to analyze debt and equity together.
In fact, when he analyzed MEG Energy, Litman said the CEO’s obfuscation about potential capital expenditure cuts concealed a silver lining. “Reduction in capital expenditures will provide a healthy cash buffer for MEG’s capital structure, and specifically its debt service,” he says. “There will be more cash from cutting capital expenditures to offset the potential pain from lower oil prices.”
Follow Jan Alexander on Twitter at @jananyc.