Aurora Borealis
1 December 2014 CFA Institute Journal Review

Is the Optimism in CEO’s Letters to Shareholders Sincere? Impression Management versus Communicative Action during the Economic Crisis (Digest Summary)

  1. Karl Strauss, CFA

During unfavorable macroeconomic conditions, CEOs use their annual letter to shareholders to communicate sincerely about company performance and prospects. Companies whose CEOs take a more optimistic tone, as exhibited in the annual letter, are found to achieve greater past and future financial performance.

What’s Inside?

CEO letters to shareholders are discretionary disclosure vehicles that may be used for impression management—that is, managers strategically obfuscating failures and emphasizing successes to influence audience perceptions—or to foster improved mutual understanding of company results and prospects through sincere communication. The authors examine this issue and identify congruence between the rhetorical tone of CEO letters and firm performance.

How Is This Research Useful to Practitioners?

Previous researchers have established impression management theory, which suggests that CEOs communicate rhetorical language intended to manipulate their audience with the goal of distorting company image and promoting organizational legitimacy. The authors’ findings are in contrast to those of the existing literature; they conclude that the incentive to distort is low and that CEOs actually engage in sincere, transparent communication.

This research would be relevant for investors who use qualitative analysis or rely on company management to provide useful guidance. The authors give credence to CEO letters to shareholders, and thus, investors can be more confident in using them as a resource to help assess firm performance and business prospects. A significant link is shown between optimistic tone and future performance results, which indicates that investors can glean valuable forward-looking information from these letters to aid in their investment decision-making process.

An important caveat is that the authors analyze hundreds of CEO letters using sophisticated language software to rank the optimistic tone. An investor may need to conduct robust analysis using similar resources because the mere presence of optimism or the ranking of a small sample size would not have the same meaningful usefulness as the authors’ findings.

How Did the Authors Conduct This Research?

The authors use a sample of 664 CEO letters to shareholders extracted from the annual reports of Fortune 500 companies for fiscal years 2008 and 2009. To adhere to research design and data collection issues, this initial sample is narrowed to 332 firms representing 17 industries. Corresponding financial data for these firms are collected covering a four-year period (2007–2010) using Compustat. The authors then rank the firms into quartiles based on firm performance, which is primarily assessed using return on assets and future return on assets as the measures of past and future performance, respectively.

The rhetorical tone of the CEO letters is analyzed using DICTION 5.0, a text analysis program that scans text passages for 35 linguistic categories falling under five master variables: certainty, optimism, activity, realism, and commonality. The quantified measure of optimism is increased by the occurrence of language categorized as praise, satisfaction, or inspiration, whereas the occurrence of blame, hardship, or denial decreases the optimism score. DICTION has been validated in prior literature as appropriate for robust empirical analysis of corporate narratives.

Although previous research on the relationship between tone and firm performance has been mixed, the authors improve on prior studies by conducting multivariate analysis with a more comprehensive measure of rhetorical features and several control variables.

The optimism scores of the highest and lowest quartiles are compared with the average and normative scores. The authors conclude that a statistically significant relationship exists between optimism and firm performance.

Abstractor’s Viewpoint

The authors point out that impression management during routine disclosure communications is unsustainable because persistent false representation of firm prospects or performance would be damaging to the reputation of CEOs and cost them their credibility. This claim is logical and supported by their findings, although I would like their research to be expanded in two ways: a longer time frame and inclusion of small- and mid-sized companies. Would these findings hold up under multiple economic environments, other than just during the global financial crisis? Small firms with less analyst coverage and institutional ownership may view the incentives of impression management differently from their Fortune 500 counterparts.

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