“There’s seldom just one cockroach in the kitchen. You turn on the light and all those others start scurrying around. I couldn’t ï¬nd the light switch, but I’d seen one.”
That’s what Warren Buffett (Trades, Portfolio) told the Federal Crisis Inquiry Commission when they asked about his decision to begin liquidating his stake in Freddie Mac in the late 1990’s. Warren has warned about cockroaches many times over the years, and it’s something that I’ve taken to heart. As an investor, I feel that I have very few meaningful chances to judge the character of the managers that are entrusted to run the companies I invest in. As a result, I try to operate under the philosophy that red flags should not be overlooked.
Over time, I’ve refined my process; I now have a couple of areas that I consciously search for cockroaches. You might find it interesting that searching in these areas doesn’t necessarily require any thorough analysis, or even a deep understanding of financial statements. As long as you can read and are willing to put in the leg work, even a beginner should be able to spot these red flags.
I thought it might be helpful to share my experience with fellow readers. As always, please comment if you have other approaches that have been helpful in your experience. So with that, here are a few places were I’ve learned to look for red flags:
(1) Footnotes / Disclosures – The first place I’ve found fruitful are the footnotes and disclosures in SEC filings (primarily the 10-K). As an example, I was researching Exelon Corporation (EXC) a few years ago when I came across the following language in the annual filing:
“Generation also enters into certain energy-related derivatives for proprietary trading purposes. Proprietary trading includes all contracts entered into with the intent of benefiting from shifts or changes in market prices as opposed to those entered into with the intent of hedging or managing risk. Proprietary trading activities are subject to limits established by Exelon’s RMC. The proprietary trading portfolio is subject to a risk management policy that includes stringent risk management limits, including volume, stop loss and Value-at-Risk (VaR) limits to manage exposure to market risk.”
That’s not what I was expecting; as I recognized at the time, that’s an activity I know nothing about. That paragraph alone was enough for me to disregard EXC as a potential investment.
(2) Earnings Release Presentation – Another red flag is when a company changes, without explanation, how they present KPI’s in their earnings announcement; I’m also quite skeptical of companies that have difficultly supplying basic financial statements to shareholders.
A classic example from financial history is Enron. You probably remember that Jeff Skilling, the former CEO of Enron, famously called an analyst an “asshole” on a conference call in 2001. The comment that had Skilling so riled up should’ve caught the attention of investors:
“You’re the only financial institution that cannot produce a balance sheet or cash flow statement with their earnings.”
Here’s a more recent example: When I opened Weight Watchers (WTW) earnings announcement for the most recent quarter, the first thing I noticed was that management failed to include their customary consolidated balance sheet in the release; if management had failed to explain the rationale for this temporary change on the conference call, I likely would’ve sold my shares.
Another way that this surfaces is in annual reports; I’m talking about the section that includes graphs and colorful pictures before the 10-K filing. With the internet, investors can easily pull up 10+ years of old annual reports, allowing them to review what metrics management views as noteworthy – and how that has changed over time. As you complete this exercise, you will often walk away with the feeling that management has become more selective or open with their disclosures over time; in my experience, you should think carefully about the significance of these changes.
(3) Shareholder Letters – These are found in the colorful portion of the annual report as well; in this scenario, I’m usually tracking two separate items: first, what management is focused on in their letters, and second, how that changes over time. The beauty of old shareholder letters is the benefit of hindsight; in addition, a period like the financial crisis gives you a chance to see how management communicates with the owners of the business under stressful scenarios. In my experience, old shareholder letters have been the most useful tool I’ve found in assessing the integrity and rationality of a CEO.
One of my favorite examples, which I mentioned recently in the comment section of Tom Macpherson’s great article “Investor Friendly Management” (here), is from the former CEO of BNY Mellon (BK). In the company’s 2009 shareholder letter, the former CEO spent more time discussing employee donations to Haiti following the January 2010 earthquake (a total of $900,000) than he did on the $1.6 billion in securities write-downs the company took in the prior year under his leadership. For scale, the securities write-down is nearly 1800x larger than the dollar value of the employee donations to Haiti. In my mind, this is simply inexcusable; little things like that are worth remembering. After this gentleman eventually “resigned” in 2011, subsequent reporting showed that this was a cockroach investors shouldn’t have overlooked – and that there were plenty of others in the kitchen.
It’s worth noting that this exercise isn’t always negative. In some cases, it reflects quite favorably on the management team / CEO. As an example, I’d highly suggest that you take the time to review the shareholder letters from Progressive Corp. (PGR) CEO Glenn Renwick; I walked away from that exercise with the belief that Mr. Renwick is entirely transparent with the owners of the business, and that he does not shy away from important discussions even when the company has struggled (like improving customer retention). That’s a big positive in my book.
Conclusion
As a small investor, I literally have thousands of potential investment opportunities in front of me at any given time; I don’t have size or style restrictions that many professional managers are confined by. The beauty of this is that I can simply discard those that make me uneasy. To use my earlier example, there’s probably a near zero chance that Exelon will have any issues with their proprietary trading in the next few years (as noted in the filing, they have a risk management team that’s paid to ensure that’s the case); for me, the simple fact that this risk existed – no matter how small it actually might have been – was enough to pass on EXC.
This may seem too conservative, but that’s a price I’m willing to pay. Personally, I think constantly monitoring questionable activity is likely to be time consuming, and most likely unsuccessful. A skillful executive can hide potential disasters outside the purview of the investing public; if (when) their actions come to light, it will already be too late to get out.
When you spot cockroaches, it’s worthwhile to focus your time on finding a new place to live.
