How to Understand Shareholder Letters

Why would anyone read shareholder letters? Well, if you want to be a smart investor and own the best investments, you’re going to have to invest for growth. One way to do that is to invest in safe (or healthy) stocks. If that’s the route you go, you owe it to yourself to do a little research. People take flyers on stocks all the time without doing any digging. This doesn’t bother me much. It only bothers me when they make money investing without doing any thinking.

(No, I’m not an envious fool. I just know that if someone makes money investing blindly, they’re apt to do it again. And again. And again. That behavior sets people up for investment and financial failure. And that bothers me because it’s completely unnecessary.)

So how do you research stocks?

It’s very similar to mutual fund evaluation. The best way is to dig inside the company’s financial statements. You might already do this, but what you might be glossing over is the “Letter to Shareholders.” It’s a mistake to dismiss this letter. It contains an inside look into the kind of management your company really has.

The shareholder letter references the data within the financial statements. That way you know that the directors of the company are being straightforward. If they fill the letter with nebulous hopes and dreams, they might be trying to misdirect you. The shareholder letter should give you an indication about the strength and quality of earnings. (Is the company profitable from ongoing operations? Are sales and margins expanding? Or are they selling assets and laying people off to slash costs in order to boost the bottom line. The former indicates that the company is healthy. The latter does not.)

The shareholder letter will also tell you how the company sees its future – what the opportunities and challenges are and how they’re going to approach each. The management should also spell out how they plan to maximize shareholder value in this letter.

You can and should read between the lines when you go through the shareholder letter. Does the letter honestly disclose the debt levels the company has? Do they have enough working capital? Do they disclose cash flow problems when you know they have them by reviewing the statements themselves?

Let’s say you notice in the financial statements that sales are down compared to last year. Does the letter talk about this, or is important information left to footnotes (that nobody reads)?

Is the company investing in its future despite a slow business cycle? Do they discuss it openly? Has the company followed through on previous plans, or do they seem to be twisting in the wind? Do you get a sense that these people know how to make a business successful? Obviously, you need to read the shareholder letter for a number of years to get the real sense of these and other items. This is easy to do. You can usually find previous shareholder letters on the internet.

Look for a company that is honest about its challenges. Also, make sure the firm’s management has the fortitude to forge and execute important strategies that result in success. You get a sense of all this by what you find in the shareholder letter and also by noting what the management chooses not to discuss in the letter.

Get a sense of how honest and transparent the management is by reading this letter carefully. Read it as if you are an IRS auditor, not a “true believer.”

This takes work. Just like it takes work to make money. By reviewing the financial statements and the shareholder letter, you’ll be showing respect for the work you put in to make the money in the first place and give yourself the best shot at holding on to it.

If you are not willing to do this work, the best investments might be mutual funds or Exchange Traded Funds. ETFs don’t really do this work for you, but actively managed funds ostensibly do. They do charge more, but they save you a heck of a lot of time going through the process above. Of course, you can choose to continue investing in individual stocks without doing any due diligence. It will save you time and money in the short run.

I think that’s where they got the expression of being penny-wise and pound-foolish.

What do you look at when you buy individual stocks?

P.S. If you liked this post, you might also enjoy “How Much Money Do You Need to Retire?”