Trust the leadership?

Trust isn't implied in the numbers of a company. In fact, untrustworthiness can be hidden in those numbers, as anyone who bothers to read the revealing notes to the company accounts will know.

Company reports are one of the more obvious place to look for dodginess. We've written about it here and over here. Nevertheless, you won't always find dishonesty in reports and, if you don't, that doesn't mean you can trust the leadership. We need to consider what other signs there are and add them together.

Positive signals

That said, the opening pages of a report might give us some tips. Typically, these pages are reserved for the highlights, with all the negative stuff buried after the numbers and towards the end of the document. If a company is being forthright on everything that it's done well and badly, this is a potential sign of trust.

Some companies go to greater lengths than most to give you information, perhaps by supplying you with a lot more detail than they are legally required to do. This is another positive signal.
Occasionally there is a report into how trustworthy a company is from the shareholders' point of view, such as Forbes' 100 Most Trustworthy Companies list, which looks for transparent and conservative accounting, and prudent management. The researchers for this report sometimes find what they wouldn't want to see in companies on the list, and note the potential problems at Lehman and AIG as early as 2005, for example.

How the company treats its customers

You can also look to the customer-facing operations of the business such as sales and marketing.
Take the marketing problems of the probiotic yoghurt industry. According to the BBC, Europe tightened up on medical claims in marketing and, after conducting tests on almost 200 claims of the positive effects of the bacteria within these yoghurts, it rejected them all for being either wrong or lacking in evidence.

Danone and Yakult are responding with new or more tightly worded claims and perhaps they'll have enough evidence to support them this time, yet I think this case shows that investors should be asking whether a business is deceiving its customers, intentionally or otherwise. If health claims collapse and customers dissipate, so will forecast earnings.

Similarly, there is sales. The finance industry is an easy and obvious example, as it is constantly inventing expensive products of dubious benefit, and its sales practices are often criticised. A backlash could harm shareholders.

Where not to look

If you're anything like me, you could end up finding suspicious and dubious practices everywhere you look and that will leave us nothing to invest in. We need to know which suspicions to dismiss.
Dubious PR statements and legal responses might be such misleadingly negative signals. PR teams will always look to present things as favourably as possible regardless of the truth, and it may well be that the PR response is developed externally. Hence, we should probably give dubious PR positions less weight.

Legal responses are similar. Lawyers are trained to give a one-sided response, so, if there is an issue, e.g. with volcanic-ash clouds, airlines, and calls for all delayed travellers' expenses to be repaid, lawyers will say 'We don't interpret the law like that,' probing what the boundaries of the law are.

Provided they know if and when to back down, like Ryanair (LSE: RYA) swiftly did last week, what they have tried to do has possibly been in the shareholders' interests.

It's Bolton again

Previously I wrote about Anthony Bolton's book, Investing Against the Tide, so it's kind of sticking in my head at the moment. I barely had space to touch on trust in my book review, but it was a big deal for Bolton. 30 years of experience running money taught him this:

"In my early years of managing money I might have bought shares in a company where I liked the franchise but maybe had some doubts about the management integrity. But not any longer...Despite the protection offered by outside directors and independent accountants, if a management really wants to mislead investors it has plenty of scope to do so and can get away with it for many years. Even if the management appears very competent, if they are not open then this is a significant disadvantage."

We can choose to take a chance on trust and stick with more standard criteria, but that will definitely lead to some blowouts and underperformers in our investing lifetime.

Alternatively, we can add criteria to our checklist that attempt to suss out the management's integrity. If our gut tells us there's something not right, we can look to other companies to invest in.