This post is going to be on the importance of digesting shareholder letters. This is what I consider the first impression of a company I’m looking to know more about. While we may get information from all types of sources such as news articles, macro-economic outlooks or business figures, I believe the letter to shareholders is one of the most overlooked parts of investing.
Generally speaking, the letter to shareholders is almost always optimistic. You’ll see the same lines in many: “The future is bright”, “We are innovating”, “Our employees are our most important asset”. I might raise a few hairs by writing this, but these types of phrases are fluff and don’t mean anything (from an investors point of view). As an investor, there are certain cues to look for in a great shareholder letter.
Who’s voice?
First, it has to be written by the CEO him/herself or Chairman. The more you read, the easier it will be to spot when something has been written by lawyers, PR people or the investor relations department. There is a certain “personal” touch in good shareholder letters. It tells a great deal when the CEO gives the bad news in the letter, and takes personal accountability for mistakes. This is what you wan’t to see. It is telling of the writer’s ego, and that the person is humble enough to set it aside when it’s required.
Focus on Cash Flow
A second thing to look for relates to reporting on results, and especially, how they measure their success. Does the company only talk about revenue or earnings? If so, be careful. Good companies understand the importance of cash flow, and I am always glad when I see the writer talk about its importance. Another big plus is if they state in their financial goals to generate “free cash flow”. After all, this is the lifeblood of a business and in order to remain competitive there has to be cash in the bank. Earnings and revenue, while important, are figures that can be much more easily manipulated (e.g. with timing of registering and by different definitions). I remember my finance professor giving us a great quote: “Sales is vanity, profit is sanity, cash is reality”. Sounds simple, but oh so true.
Attitude Towards Debt
Thirdly, you want to figure out managements attitude towards debt. Debt can aid in boosting earnings, but if things go south, the debt can be crushing. Look for signs that management understands the importance of a healthy balance sheet. If the company you are looking at has debt, compare it to the cash it’s generating. Does the regular cash flow from ongoing operation cover the debt well? e.g. Could they pay all their debts within a few years? To quote the oracle:
“Having a large amount of leverage is like driving a car with a dagger on the steering wheel pointed at your heart. If you do that, you’ll be a better driver. There will be fewer accidents but when they happen, they will be fatal”
I’ll leave the reader with a book recommendation. It will make you a more intelligent shareholder letter dissector, and thus, a more intelligent investor.
Cheers!
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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