Robert Olstein of Olstein Capital is no different and has built a successful career as a value investor by attempting to separate the winners from the losers with his Quality of Earnings Reports. Olstein is known for looking closely at the financials or looking “behind the numbers,” watchful for aggressive accounting techniques, essentially scouring all of the SEC filings with a skeptical eye as he completes a thorough forensic analysis.
Olstein had penned an article last year for Morningstar that came across my path recently entitled, “A Careful Reading of Shareholder Letters.” In the article, the great investor encouraged all investors not only to read each of the SEC filings, but to critically read and comprehend the “glossy” CEO shareholder letters at the beginning of each annual or quarterly report. Olstein argues that the letters can contain significant or vital information that can be uncovered by scrutinizing them closely.
He goes on to say that he’s looking for “heat” or “trigger words” that may indicate a significant fact that is either being omitted or may provide a warning to an upcoming change that could affect cash flows and ultimately the value of the stock. While acknowledging that the difficulty of investing the last few years should have the effect of encouraging investors to go the extra mile by reading these letters, he states that there’s an edge to reading them regardless of the economic headwinds at any particular time. That is, make it a habit under all circumstances.
Olstein mentions the following items that should be considered during the reading of the letter:
Does management or the CEO discuss financial strength?
Does the CEO address debt levels?
Is cash flow addressed?
Is cash addressed?
Are cost controls considered or addressed?
Do they indicate how they intend to mitigate the economic headwinds for their specific company?
Do they address cost cutting which may either give them a competitive advantage or perhaps become a disadvantage?
Are they making changes from the last few years? He suggests reading several of the letters from previous years, searching for new direction or deviation from their earlier goals.
Is the CEO forthright and honest in discussing company problems? Do they talk about any blunders created by management?
Are problems that the company may be facing indicated clearly or are they absent from the letter?
Is there a discussion on capital or return on invested capital?
Is there a discussion on goals?
Does the CEO talk about the competition?
More specifically, Olstein states, “…we read shareholder letters looking to answer two key questions: (1) what positive or negative factors arose during the reporting period that may affect future free cash flow; and (2) is management deploying the company’s free cash flow in ways that will benefit long-term shareholders? "
CEO shareholder letters are usually glowing reports for their company’s shareholders and rarely can you find all of these elements in any one letter. In fact, they are too often nothing more than cheerleading. You are not about to find a CEO that states that “we had one of the worst years in our history” or “the competition is doing a much better job than we are.” You are more likely to see them pronounce that they have attained a “record year” in sales or revenues, omitting the fact that earnings were down, sending margins down also. Sometimes, it’s what is not said that is just as important, so read carefully. So does it work?
After reading the article, I placed two shareholder letters before me with Olstein’s list looking at the efficacy of using the list.
The first company was Peabody Energy (BTU), which is the world’s largest private sector coal company and chosen because it has had a horrible few years facing an incredible amount of regulatory controls. The CEO, Gregory H. Boyce, performed quite admirably. Here was a CEO that discussed goals and headwinds before them and the plans to mitigate these issues. He talked about driving down costs and reduction of debt. You could see a much clearer picture of how free cash flow might be affected or how they intended to maximize shareholder value. You may still conclude that it is an unwise investment, but the CEO was certainly forthright and honest about the company’s position.
The second company bragged, “Our performance and capabilities cannot be compared to a traditional (blanked out) peer group. Our results put us in the top tier of the world’s corporations. We have a proven business concept that is eminently scalable in our existing businesses and adaptable enough to extend to new markets.” They went on to state that their performance for the year was “a success by any standard as we continue to outdistance the competition.” It was a letter strictly of cheerleading and bragging with nothing offered for the investor to gain knowledge. The company was Enron and the year was 2000.
The Olstein list is definitely worth keeping next to you as you read the CEO shareholder letters.
“Waiting for a catalyst to appear before buying an undervalued stock will usually result in the purchase of a fully valued stock.” Robert Olstein
“Paying the wrong price for a good company is the equivalent of buying a bad company.” Robert Olstein