Most investors today tend to ignore annual reports. They are more content with analysing financial data from Morningstar or Stockflare than that in the raw form from annual reports. There is nothing wrong with this but it is important to remember that these fast financial data sites do not contain all the information found in an annual report. For one it doesn’t include any small print or strategy information. For another, it doesn’t contain shareholder letters.
It is imperative for any serious to have a look at the shareholder letter of a company they want to invest in or are already invested in. These letters give a broad overview of a firm, its successes, its shortcomings and a forward outlook of the firm.
In my opinion, the three best insights a shareholder letter gives are how it uses its excess cash, how the company is kept accountable and what it measures of success are and how the CEO describes the company.
How the company spends the excess cash it earns: This is the most important insight of a shareholder letter. It’s great to own a piece of a profitable company – but if the management team squanders the profits, they’ll destroy shareholder value instead of preserving and growing it. Look at a company’s priorities in terms of growing its dividend, growing the business and buying back stock.
When you find the companies that allocate excess capital wisely – like Imperial Tobacco or Phillip Morris have done – well, I can’t stress enough how highly valuable that is to you as an investor. It’s like knowing who’s going to win an Olympic gold medal before the event begins.
How to keep the company accountable and measure its success: Great business leaders want to be held accountable. They want to give you, the shareholder, an objective benchmark for measuring their success.
Consider Berkshire Hathaway, the giant conglomerate run by Warren Buffet. Its shareholder letter provides investors with a crystal-clear set of financial benchmarks they can refer to in the future to make sure management is performing well.
Most shareholder letters aren’t crystal clear about how to gauge success because they fear they won’t measure up. But great management teams believe in what they’re doing. They want to be held to an objective standard.
How the CEO describes the company and what makes its approach to the industry different and better than other competitors: Management needs to be able to explain the industry the company is in and what makes the company’s approach to it different and better.
Letters that explain the company and the industry in plain English provide a free, high-quality (and sometimes entertaining) financial education that will take very little of your time.
Reading shareholder letters of the companies you invest in is invaluable when it comes to understanding the business, the industry, and what you can expect from your management team – especially when you find one that’s sending the right message in a clear, credible way.