After this past week, many investors are asking themselves what to do now or what is in store going forward. As a follow up to my post last week on evaluating management using ROE, this post will touch on an additional management evaluation tool. Before I do that though, these are extraordinary investment times and many an investor are unsure of what to do next. Many factors will go into that ultimate decision, but I believe Warren Buffett said it best a few weeks ago: The best letters provide business details in simple, but never simple-minded, language. And they explain how these investment opportunities will produce profits. A CEO who wants to show that he or she is trying to be accountable to investors and other stakeholders is going to tell you about their corporate goals. Financial goals reveal the financial targets that CEOs want their companies to achieve; operating goals reveal the CEO's aspirations to improve the way the work gets done. Even when CEOs do report company earnings, it's often hard to figure out what they mean. You can blame part of this problem on accounting. Earnings can be reported at different "layers." Many CEOs choose to report their earnings in shareholder letters several layers up, typically at a level that lets them show their company's earnings in the best possible light. This is not illegal. But when companies offer these customized pro forma earnings, you'll want to examine the underlying assumptions the company is using to calculate them. To judge management's accounting integrity in the shareholder letter, look for: The topic that is most frequently cited in a shareholder letter is "corporate strategy." This should be no surprise—when we learn about a company's plans to make money from tangible assets, like plants and equipment, and intangible assets, such as patents, brand recognition and new technology—we get to the heart and soul of financial analysis. Many companies describe the corporate strategy as a list of action steps they intend to take. But such a list only tells you what a CEO plans to do. They don't show how these steps are being acted out in real-life situations.... "You know, five years from now, ten years from now, we'll look back on this period and we'll see that you could have made some extraordinary (stock market) buys. That doesn't mean it won't get more extraordinary a week or a month from now. I have no idea what the stock market is going to do next month or six months from now. I do know that the American economy, over a period of time, will do very well, and people who own a piece of it will do well."
A key aspect to the success of a company and its stock price is the strength of the company's management. In fact, if this one element is missing, no matter how good a company or its competitive advantage, the lack of strong management can lead to poor company results.
In addition to evaluating the company's ROE, investors should review the company's shareholder letter that accompanies the firm's annual report. The American Association of Individual Investors recently wrote an article on elements to look for in the letter. The article notes:The one window into a CEO's perspective and goals is the shareholder letter contained in the annual report. But upon reading one, you might find that you can't understand what the CEO is trying to say. Often, shareholder letters are riddled with jargon and glossy prose that convey no information. Six of the most popular CEO letter clichés:
The article indicates investors should read the shareholder letter and circle in red the cliché phrases outlined above. If one sees more red than black, be forewarned. Once the company passes this test, there are seven criteria an investor should score. The AAII article contains more detail on each criteria, but a summary is listed below:
A key investor takeaway from reading the letter is whether or not you feel comfortable entrusting your investment dollars to a company's particular management. So when you receive an annual report, read the shareholder letter first.
Source:
Shareholder Letter Revelations: Can You Trust the Leadership?
American Association of Individual Investors
AAII Journal
2008
http://www.aaii.com/includes/DisplayArticle.cfm?Article_Id=2310&digit=524
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