FOOL ON THE HILL
Lessons From Letters

Don't skip over the letters to shareholders when researching companies. A careful reading may raise a few red flags and provide clues about management's veracity and competence.

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By Rex Moore (TMF Orangeblood)
June 12, 2002

Most investors in individual stocks are familiar with the annual 10-K and quarterly 10-Q earnings reports generated by public companies. These documents provide most of the financial information we need when doing our research, as well important non-financial info about the business, how it is run, and what its goals and objectives are.

One section largely overlooked in the annual reports, especially by those who only access them online, is the letter to shareholders. This was true for me until I read Thornton O'Glove's Quality of Earnings. The book mostly concentrates on ways to make sense of the numbers you'll encounter in SEC filings and what they tell you about the real earnings potential of a company. There's plenty of other good advice in there, however. Written 15 years ago, O'Glove must have had a crystal ball when laying out the book. Some of the chapter titles are "Don't Trust Your Analyst," "Don't Trust Your Auditor," and "Differential Disclosure."

Those are important topics, and have been widely covered in the financial media, but O'Glove's thoughts on shareholder letters are largely unknown. He believes the letters can be helpful to investors in several ways, especially when taken as a piece of the big picture: "The poetry of the letter should be compared with the prose found in statistics presented elsewhere in the report."

Red flags
One of the major things to look for while reading a letter to shareholders is an unintentional red flag, flapping lazily among the paragraphs. As an example, the book uses the 1980 letter written to International Harvester shareholders from CEO Archie McCardell. The previous year had been a rough one as the then-150-year-old company lost money and saw its stock price cut in half.

Though McCardell painted a promising picture for the future, O'Glove focused on the third paragraph of the letter as a clear warning sign. It begins: "International Harvester enters 1981 following a tightly focused long-term strategy to improve our cost structure..." Though not explained in detail, that sentence presumably portends an internal upheaval as the company undergoes a restructuring. (It must be noted that this book was written long before the Internet explosion, when investors had far less information at their disposal than we do now.)

In the same letter, McCardell proudly recounts how the company was able to reduce its debt by $488 million from "peak third-quarter levels." The red flag would have hit investors who dug into the rest of the annual report and found that total debt had actually increased by $948 million year-over-year. The letter painted a much better picture of debt than the balance sheet showed. Over the next couple of years, International Harvester (now Navistar International (NYSE: NAV)) plunged in value as it had trouble servicing its debt.

Believability
Investors always want to know about the quality of management and whether it can be trusted. Looking through three or four years of letters to shareholders can tell us a lot about credibility. For example, O'Glove was first alerted to possible troubles with video game maker Coleco through such comparisons. Several times throughout the 1970s, management predicted more in its letters than it actually delivered. At the very least, investors should have wondered about management's grasp of the company's business and the industry as a whole. The stock price would have its ups and downs before Coleco finally called it quits and went bankrupt. A comparative reading of the shareholder letters should have steered investors away from this whole mess.

Those are a couple of 20-year-old examples, but there are still warning signs present in some of today's letters. Take Enron (please). Its management was accused of focusing on earnings per share to the exclusion of all else, and it was that narrow-mindedness -- that near-term focus as the expense of the long-term -- that did the company in. But could you have known about this shortsightedness in advance? Perhaps, especially in light of this sentence from the 2000 letter to shareholders: "Enron is laser-focused on earnings per share, and we expect to continue strong earnings performance."

With the admission that it's extremely easy to go back and pick out such examples after the fact, this sentence should have raised some eyebrows. Besides the fact management should be "laser-focused" on the long-term health of the company, it's dangerous for a business to focus on earnings to the detriment of everything else. Compare Enron's philosophy with that of eBay (Nasdaq: EBAY), revealed in its latest annual report:

"... Balancing investment for the future while driving increased profit to the bottom line has always been a consistent theme at eBay. The investments we make today are designed to bear fruit in the years ahead, just as many of the investments that we made in the past are now yielding results that we expect to see reflected in the bottom line over the course of 2002."

What are some other positive signs to look for in these letters? Though we all expect to see optimistic talk of the future, it must be mixed with a healthy dose of reality. "Above all," says O'Glove, "difficulties should be dissected, not hidden or ignored." He holds up as good examples two CEOs: Warren Buffett of Berkshire Hathaway (NYSE: BRK.A) and the late Charles Pullin of Koppers Co. Buffett wrote of his company's good year in 1983, but admitted, "This sounds pretty good, but actually it's mediocre," and then proceeded to explain why. Similarly, Pullin explained in his shareholders' letter why Koppers' 1983 results were not quite as good as they appeared.

Granted, this is all more art than science -- as is most of investing, of course -- so don't expect to always find clear help in these letters. Even O'Glove admits that most of the time they won't reveal anything special. However, he says, "Investors should always take the time and trouble to make these comparisons. Nine times out of ten little will come of it; the tenth occasion could save you a bundle."

Rex Moore has been there, done that, but forgot to buy the T-shirt. At the time of publication, he owned shares of eBay (among others). The Motley Fool has a disclosure policy, as well as T-shirts.