When analyzing companies, equity analysts tend to overlook an important source of wisdom: the annual shareholder letter. The purpose of this article is to explain the traits and characteristics of a good shareholder letter based on an examination of 601 companies included in the S&P SmallCap 600 Index. This article will direct readers to the best less-known shareholder letter to add to their reading list.
Why the SmallCap 600 Index
Once pertinent information is made public, the price of a stock reflects all that information. So goes shareholder letter wisdom. The Bezos, Buffet, and Dimon letters are well-known. However, the smaller cap wisdom (which is growing rapidly) seems to be unread. It’s a great way to gain an advantage over the competition. I also thought that smaller companies were younger, faster, and more enthused. I hoped to get a little bit of enthusiasm and honesty from them, as opposed to a company with a market capitalization of over $10 billion.
How Can You Find Shareholder Letters?
As a reference, we reviewed all 601 S&P SmallCap Index Companies for their annual shareholder letters. About 63% of companies in the Index had a shareholder’s letter published or one that could be easily found. I spent about two minutes searching for each letter. The search methods I used were Googling “company name + annual letter,” “company name + shareholder letter,” and “company name + annual report,” and visiting the investor relations page of the company and doing a search there. AnnualReports.com is another website that I used. It does a good job of combining recent annual reports. However, many companies aren’t available.
There isn’t a simple way to find them. You can search for “ARS” on the SEC’s EDGAR site. This will give you the date the last annual reports (annuals include the shareholder letter, unlike 10-Ks, but it doesn’t always have the document itself) were filed.
How were the companies assessed?
I graded the 377 publicly available shareholder letters on a scale of 1-10, based on the traits that were most evident in the Berkshire Hathaway letter, as reported by HBR, and the Rittenhouse rankings’ CEO Candor & Culture Survey. I divided all our criteria into five categories. (1) Define the company and its strategy, (2) Be Candid, (3) Educate, (4) Tell a story (the investment thesis story), and (5) Entertain.
Impressive & Insightful (8-10): If an organization has at least two of the “Best Traits” or if it has done one element exceptionally well.
Middle of the Road (5-7): If an organization did one of the “Best Traits.”
Back Of The Pack (4-4): If an organization did not do any of the “Best Qualities” or did something “No No” (e.g., loudly congratulate their management team or transform a financial statement into words).
The Index outperforms companies with the best shareholder letters.
In Figure 1, the companies with a “10 rating” outperformed S&P SmallCap on a one-year, three-year, and five-year basis. This result shows that reading shareholder correspondence is a crucial part of any investment strategy. This result was also revealed in the Rittenhouse Rankings’ CEO Candor & Culture Survey and Standard & Poor’s study, which are both discussed below.
Only 3% Of Letters Are Worth Reading.
The majority of companies scored as Middle of the Road (43%), while only a small percentage received the Back of the Pack grade. This grade was reserved exclusively for letters that made me feel that I was wasting time or that someone was playing shareholders for fools (We’re great! Their stock is down by 50 %…). Around 17% of the letters scored as Impressive or Insightful, and only 3% were deemed Must Reads.
Many companies choose not even to write a shareholder letter.
About 37% of the companies included in the SmallCap 600 Index did not have a shareholder letter or had one that could be easily located. The term “readily findable” refers to the fact that it was not possible to identify the letter in less than two minutes using the search method described above. Utility companies were the most active (although it was a very small sample), followed by consumer staples, energy, and healthcare. There were no statistically significant differences between the stock performances of companies that had a shareholder’s letter and those without.
Why bother reading them?
It is important to read a shareholder’s letter in order to gain an insight into the corporate culture. This step does not have to be a mere “nice-to” item. The stock price is directly affected by how well the CEO relates the story of the company. A study by Rittenhouse ranking showed that in addition to my research, which showed companies with the strongest shareholders letters outperformed their respective Index, the average price changes for companies in its top quartile in its Candor & Culture Analytics Survey between 2007 and 2015 outperformed S&P 500 every year in the last ten years.
Standard & Poor’s also found that in a landmark, leaders who communicated honestly and with utmost clarity in their annual reports showed a strong correlation to a lower cost of capital and superior financial performance.
There are several ways to use shareholder letters. You can use them to find out if the management team is trustworthy and if it is able to distill its essence into a short, candid (under ten pages) shareholder letter. This is called an elevator pitch. One way to learn from the best managers is by reading their shareholder letters, no matter what stock you are interested in. These letters are known as the Bezos or Buffett letters.
The Shareholder’s Letter as an Elevator Pitch
Analysts on the buy-side have access only to research conducted by sell-side firms. Ordinary investors do not have this access. Buy-side analysts are able to talk with an expert about the company in ten minutes and learn important qualitative traits quickly (quality management team, importance of “beating the number,” long-term strategies, capital allocations, past hiccups). By incorporating much of this data into the annual shareholder letter, good shareholder letters can help democratize investing. Investor sentiment is the most difficult to capture in a shareholder letter. However, addressing issues raised by shareholders would be a good idea.
Around 37% of equity investments are still made by households and non-institutional entities who must traditionally conduct their equity research – reading SEC filings, listening to press reports, reviewing investor presentations, creating their models, etc. They don’t get to read the research done by analysts who have been studying the stock for many years and have played golf with management. It is, therefore, in the best interest of management to ensure that their story can be easily understood and told. Nobody should be better able to sell a company’s merits than its leaders. This is the perfect time to do so.