It Pays to Write Well

Byoung-Hyoun Hwang is an Assistant Professor of Finance at the Cornell SC Johnson College of Business. Hugh Kim is Assistant Professor of Finance at the University of South Carolina Darla Moore School of Business. This post is based on an article published in the May 2017 edition of the Journal of Financial Economics authored by Professors Hwang and Kim.

In It Pays to Write Well, published in the May 2017 edition of the Journal of Financial Economics, we examine how the readability of corporate disclosure documents affects investors and stock prices.

Corporate disclosure comes in the form of accounting numbers framed or accompanied by a substantial amount of text. While earlier research has emphasized the informativeness of the accounting numbers, our study is part of a relatively new literature stream that looks at the informativeness of the text and the ease with which the text in corporate disclosure documents can be processed.

In our article, we look at the readability of annual reports of equity closed-end funds (CEFs). CEFs are publicly traded companies. Rather than using the proceeds from an initial public offering and subsequent seasoned equity offerings to invest in real assets, these companies acquire portfolios of equity securities. Like all publicly traded corporations, CEFs file annual reports with the Securities and Exchange Commission (SEC) and their shareholders. These reports generally contain: a report to the firm’s shareholders; an investment review; an investment outlook; various pieces of information regarding the firm’s officers, directors, and voting policies; a financial statement; and the firm’s security holdings.

We focus on CEFs because they tend to be small by market capitalization, they are not covered by analysts, they do not stage earnings conference calls, and their managers rarely appear in the news. Annual reports therefore represent the primary channel through which CEFs communicate with current and potential investors. As such, we believe CEFs represent a relatively clean setting to assess the relevance of annual reports.

More importantly, because CEFs themselves are traded on stock exchanges, we can compare the market values of the funds against the market values of the funds’ underlying equity securities. That is, we can assess whether CEFs with poorly written annual reports are punished by investors and trade at a discount relative to the value of their underlying assets.

Our measure of readability draws on the Plain English Handbook of the SEC, which was published in 1998 and was developed to help firms make their disclosure documents easier to read. In the Handbook, the SEC discusses eight language-related factors that make a document less readable: (1) passive voice, (2) weak/hidden verbs, (3) superfluous words, (4) legal and financial jargon, (5) numerous defined terms, (6) abstract words, (7) unnecessary details, and (8) long sentences. We apply a copy-editing software to each annual report and count how frequently five of the above eight writing faults appear in a sentence on average: (1) passive voice, (2) weak/hidden verbs, (3) superfluous words, (4) legal and financial jargon, and (5) unnecessary details (The SEC never defines what constitutes a “long sentence” so we do not consider “long sentences” in our analysis. Our software cannot capture “numerous defined terms” and our software only imperfectly accounts for “abstract words.”).

To provide some examples of the writing faults and how to avoid them:

  • [passive voice] We could write “We must re-think how our resources will be best used to provide world-class customer service.” Or, we could write “We must re-think how to best use our resources to provide world-class customer service.”
  • [weak/hidden verbs] We could write “We had to undertake a re-calculation of our net income.” Instead, we could also write “We had to re-calculate our net income.”
  • [superfluous words] We could write “Our hard product has a requirement for major improvements to compete against the appreciable number of new devices entering the market each year.” Or, we could just write “Our hard product requires major improvements to compete against the many new devices entering the market each year.”
  • [legal and financial jargon] We could use terms such as “forthwith.” But why not say “immediately,” instead?
  • [unnecessary details] Finally, we could compose sentences such as “We consider such actions completely unnecessary.” Or, we could write “We consider such actions unnecessary.”

To assess the validity of our readability measure, we randomly assign undergraduate business students annual reports with “high readability” scores and annual reports with “low readability” scores. We find that students largely agree with the output generated by our readability measure, as they perceive reports with high readability scores to be significantly easier to read than those with low readability scores.

When relating the readability of annual reports to CEFs within a regression framework, we find that CEFs with hard-to-read annual reports trade at substantial discounts relative to CEFs with easy-to-read annual reports. In particular, our analysis suggests that a 10-percentage-points increase in the number of writing faults per sentence, on average, causes CEFs to trade at a 2.7-percentage-points greater discount. Our results easily survive the inclusion of various controls and are robust to research design choices.

In additional tests, we examine whether our findings extend to “regular” publicly traded corporations. We randomly sample one hundred representative firms and assess how the readability of their annual reports relates to their Tobin’s Q; the Tobin’s Q is the market value of the firm relative to the firm’s book value. Our analysis reveals that lower readability is associated with lower Tobin’s Q even among regular publicly traded corporations, albeit the effect is slightly weaker than that found for CEFs.

Overall, our evidence supports the notion that firms can meaningfully increase their market value by increasing the readability of their annual reports. By the same token, firms with poorly written annual reports are punished by investors and trade at a discount. Thus, while there are no official sanctions or fines associated with writing disclosure documents that are hard to read, it appears there are strong economic incentives to produce documents that are easy to read by the general investor population.

The complete article is available for download here.

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