A less-than-candid letter to shareholders could be a red flag. By Jennifer Schonberger, Staff Writer February 6, 2012 Laura Rittenhouse is president of Rittenhouse Rankings, which ranks annual CEO letters to shareholders for candor. She’s the author of an upcoming book, Investing Between the Lines.Why read a CEO’s letter to shareholders? The annual shareholder letter helps you decide whether a company’s financial statements are trustworthy. The letters offer an insider’s view of the corporate culture, and the quality of that culture influences decisions made throughout a company—such as when to count incoming and outgoing cash or how to book expenses. If the culture is one of honesty and trust, employees will likely be more forthright in their accounting judgments and the financial statements are more likely to be trusted. I’ve found a strong link between corporate candor and stock performance. Sponsored Content How can you determine all that from the letter? First, it’s important to know whether the CEO authored the letter. Then you must judge how candid the comments are. I award points for every mention of cash—cash flow, cash conversion rate, cash from operations—because that tells you something specific about the business. I deduct points for clichés—“looking forward to a bright future,” for example. That tells you absolutely nothing. After reading the letter, you should feel as though you’ve met with the CEO, who should have offered a balanced disclosure of the company’s successes and its problems. Why are Berkshire Hathaway CEO Warren Buffett’s letters the gold standard? You can tell he wrote the letter. It’s personal. It’s specific. He talks about problems and takes responsibility for them—something most other CEOs don’t do. Buffett promises investors that he’ll communicate candidly because, he’s said, a CEO who misleads in public will eventually mislead himself in private. Advertisement What are some red flags? If you read the past few shareholder letters of MF Global, you’d have noticed that the CEO of the company changed three times in three years. Each year the letter reported on improving sales and net income, but failed to disclose per-share losses. That’s an unbalanced disclosure. If a letter reads like public-relations spin, it could indicate that the company is not prepared to communicate honestly with investors.