Doc's note: Finding a company to invest in is a daunting task. There are more than 3,000 companies listed on major public exchanges in the U.S. alone.
Today, I'm sharing an essay from my colleague Dan Ferris (originally published in March). In it, Dan explains three clues to look for to help you find stocks worth investing in...
It was an unusual research project...
Not one in 1,000 investment advisors or newsletter writers would ever consider it.
My research partner and I (Dan) read every shareholder letter issued by companies in the S&P 500 Index.
I got the idea from billionaire superinvestor Warren Buffett. Several years ago, Buffett talked about a one-page fax he got from the CEO of a potential acquisition: The quality of the business, he said, "jumped off the page."
During our project, we found a few shareholder letters that were that good. And if you study what I'm about to teach you... you, too, will be able to identify companies that "jump off the page" as wonderful investments you'd like to own one day.
You won't have to pick stocks anymore. They'll pick you!
And it's easier than you think...
I found three valuable types of insight in the best shareholder letters...
|1. How the company spends the excess cash it earns,
2. How to keep the company accountable and measure its success, and
3. How the CEO describes the company and what makes its approach to the industry different and better than other competitors.
The first and most important insight a great shareholder letter will give you is about the company's approach to cash...
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.
Take Wall Street mega-bank JPMorgan Chase (JPM), for example. To this longstanding member of the S&P 500, growing its dividend is the most important thing it does with excess cash – even more important than growing the business!
Here's the relevant passage from an annual shareholder letter by CEO Jamie Dimon...
Our fortress balance sheet... provides us with excess capital to invest, and we always are thinking way ahead about the best ways to deploy it.
As we have said in the past, after steadily increasing dividends, our favorite deployment is in growing our businesses. After investing in the growth of our businesses, we look at other ways to use the remaining excess capital. One use we consider is buying back stock – but only at a price we think is good for shareholders.
The priorities for investing excess cash couldn't be clearer. First, JPMorgan will grow its dividend. Second, it will consider ways to grow the business. Third, it will look to spend cash in other ways, including buying back its stock.
When you find the companies that allocate excess capital wisely – like JPMorgan has – 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.
Second, great business leaders want to be held accountable. They want to give you, the shareholder, an objective benchmark for measuring their success.
Consider 3M (MMM), a conglomerate that produces everything from Post-it notes to welding goggles.
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.
Here's what 3M Chairman and CEO Inge Thulin said in a shareholder letter...
Finally, we set out financial goals for the next five years. We now have targets that are both realistic and aggressive, and that provide a real possibility of upside.
The five-year goals are as follows:
• Grow earnings per share 9%-11% per year, on average.
• Grow organic sales 4%-6% per year, on average.
• Maintain return on invested capital above 20%.
• Free cash flow conversion of 100%.
Shareholders can note these objective benchmarks and know in five years if management is performing up to speed or not.
Most shareholder letters don't do this. They 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.
Humans are ego-driven. They want recognition... But they like their recognition to come with as little effort and commitment as possible. So it takes a special kind of person to draw a line in the sand and let the world know that's the point from which his future progress will be measured.
Many good shareholder letters contain one additional big idea. Simply put, you want a manager who can explain the industry he's in and what makes his company's approach to it different and better...
For example, here's a clear explanation of how and why apartment real estate investment trust ("REIT") Equity Residential (EQR) changed its business...
Approximately 10 years ago, we made a monumental shift in our company's investment strategy away from two- and three-story walk-up garden apartment properties with surface parking in suburban locations across the 50 largest cities in the country, towards higher density, urban properties in a handful of gateway cities in the northeast and West coast...
We also wanted to invest where the construction of new housing would likely continue to be constrained, such that demand would exceed the supply of all forms of housing.
Letters like this – 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.
Those are just three examples of several great shareholder letters we read during our project. We found 79 that show the companies are dedicated to paying out their excess cash to shareholders... keeping themselves accountable... and explaining their business and industry in plain language.
Of course, there are great companies that don't have great shareholder letters. But it's hard to find the opposite – a really great shareholder letter that isn't written by a great CEO of a great business.
I've never heard about anyone undertaking a project like we did... But I believe in those kinds of "manual" methods of stock screening. It's easy for computerized screening tools to miss things an experienced human being carefully poring over the same data would find.
To be a great investor, you have to be willing to look at the stock market in ways most other people don't.
Reading the 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.