a refreshing reminder of what matters in investing

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A Refreshing Reminder Of What Matters In Investing

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By Investopedia.com | 24.01.2013

For the most part, investors would do well to take anything that the management of a publicly-traded company has to say with a grain (or two) of salt. After all, CEOs are evaluated in large part on the price of the stock, and keeping investors enthusiastic and positive is a larger part of the job description than most would care to admit.

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That said, every once in a while investors can find straight-shooting companies that offer insights that go beyond the fundamentals of the particular company in question. Berkshire Hathaway CEO Warren Buffett's annual letters to shareholders are rightly famous for their far-reaching discussions of management and investment philosophy, and the CEOs of other companies including Coca-Cola, General Electric and JPMorgan often pen high-quality letters as well.

A few months ago, however, I read a presentation from a small company, Contango Oil & Gas, that I found refreshing and well worth reading for most investors. At a minimum, it's a valuable reminder of what investors ought to hold as important when approaching long-term investments.

Honesty and Integrity

It's unfortunate that it still bears repeating, but a central obligation of the management of publicly-traded companies is to conduct themselves and communicate with honesty and integrity.

Companies have an obligation to communicate honestly, clearly and promptly with their shareholders. There is no excuse to "sit" on bad news, spin it or otherwise misrepresent it, and yet all too many companies bury bad news in SEC filings while using conference calls to celebrate non-accomplishments and puffery.

At the same time, companies should avoid jargon and make their accounting as simple as possible. In the case of Contango, for instance, there are certain unavoidable accounting concepts and reporting requirements that go with energy companies that are not intuitive. Here, however, management, takes the time to explain what the terms mean and how they are calculated, so that investors can understand the numbers that the company reports.

Along those lines, company executives would do well to lay out just what they believe matters. Managers should explain the metrics that shape their decision-making and what they believe builds value within the industry (without resorting to meaningless babble such as "delivering high levels of customer service" or "responding to the needs of our clients"). This is especially true when it comes to executive compensation; investors ought to be wary of companies that are either vague when it comes to how they evaluate and compensate executives, or rely on short-term and/or easily-manipulated factors such as reported EPS growth and near-term stock price performance.

Of course, investors have their own part to play here. Investors ought to push for clear disclosure and reporting, whether it be through communications with executives, proxy voting or supporting relevant legislation. Investors also need to realize that open communication can come at the cost of near-term performance - frank communication isn't always conducive to getting the market fired up about a stock, and investors need to accept that buybacks and dividends aren't always the best uses of corporate cash, and/or that it makes little sense to sell after one bad quarter if the long-term plan still makes sense.

Margin of Error

One of the parts of the Contango presentation that leaped out at me was how frank the company was about the probability that some (or all) of management's forecasts were likely to prove inaccurate to some extent. In the particular case of Contango, it's virtually impossible to predict where oil and gas prices will be next year, and it is likewise difficult to predict where service and equipment costs will be more than a quarter or two ahead.

While that may be specific to Contango and/or energy companies, the reality is that corporate forecasts are going to be wrong. Suppliers, customers and competitors are always in motion, and only a fool believes that he or she can unfailingly predict all of the independent and dependent actions that follow. Investors need, then, to accept that forecasts are "best guesses;" they are not set in stone or guaranteed forevermore. While some businesses are inherently harder (or easier) to predict than others, and some management teams are better (or worse) at forecasting, investors should realize that every prediction has a margin of error and they should always consider the "what if" scenarios of things going better or worse than predicted.

Successful investors and traders learn that there is a margin of error and uncertainty that is simply ever present. It is impossible to know everything about a company and it's really not worthwhile to try. More to the point, if you wait until you know everything (or think you do), you'll likely fall victim to an investment phenomenon known as "paralysis by analysis" and never end up investing at all.

Along similar lines, it's important to avoid a false sense of security. By all means, conduct thorough due diligence, but understand that no investor can find all of the information he or she wants, and there is always the possibility that the analysis/conclusion will still be flawed. This is particularly true when it comes to areas such as modeling or fundamental product research. Knowing the pharmacokinetics of a drug backwards and forwards and/or creating a highly detailed line-by-line financial model is all well and good, but be sure that you're not simply substituting dozens of smaller guesses for one big guess and thinking yourself somehow safer.

Investor's Responsibilities

To close this article, it is also important for investors to acknowledge and fulfill their own responsibilities in the process. It doesn't really matter how honest or thorough a company is; if shareholders are careless or lazy, their investment decisions are not likely to end well.

Do Your Homework!
As Contango's management urged in its presentation, it is critical for investors to read a company's financial filings. No company can put everything an investor needs to know in a press release or investor presentation. That's not an excuse for executives to bury bad news, but rather just an acknowledgment that almost no investor is going to regularly read a 20-page quarterly financial results press release.

Along with reading the financial filings and understanding recent events in the company's business, it is vitally important for an investor to understand the business and industry as well as possible. A great deal of information can be gleaned from corporate websites, annual reports, investor presentations and financial filings.

Likewise, an hour or two on the internet can usually uncover invaluable information about the target company and its industry. In so doing, it's also vitally important to read the filings and presentations of rivals, competitors, suppliers and customers. Pay particular attention to what information other companies include or omit, and an investor can walk away with a good sense of not only what makes a business tick, but whether a given company's executive team is realistic and communicating openly and honestly with shareholders.

Be Realistic!
One of the most important investor responsibilities is to approach every investment with a realistic sense of the potential risks and volatility of a company and its stock. For instance, most experimental drugs fail, few tech companies succeed in more than one market, and few small companies can elbow aside the giants in an industry and become major players themselves.

Companies do not grow at a 20% or greater clip indefinitely, nor are huge returns on equity typically sustainable. Remember, then, that if something looks too good to last, it most likely will not. Likewise, be wary of company valuations that essentially predict a small company becoming an industry titan in less than a decade.

Understand What Matters
As Contango's management said in its presentation, per-share shareholder wealth creation (including dividends) is really the only thing that matters in the long term. It doesn't matter if sell-side analysts love or hate a company, it doesn't matter if writers like myself love or hate a company and it doesn't matter if there are shortsellers out there hoping for the company to fail. If a company can deliver an in-demand product or service better than its rivals, do so in a profitable way and prudently reinvest the capital generated by the business in a way that builds shareholder wealth, the company's long-term investors will be rewarded.

Understanding what matters is a pretty comprehensive concept that incorporates much of what has already been said here. At a minimum, investors need to understand how a company builds value - not only for shareholders, but for its customers/clients as well. Metrics such as return on invested capital (ROIC) do help point to value-creating management teams, but it is arguably more important to know why a company's ROIC is what it is (particularly relative to its peers) than just the absolute number.

The Bottom Line

There's nothing better than identifying a company where management communicates clearly with shareholders (telling them not only how the business is performing today but also how it evaluates its relative performance), lays out clear expectations for the business, and prudently marshals and deploys the firm's capital to build value. I've been fortunate enough to find several such companies over the years, and they've been significant multi-baggers for me (despite operating in what are, in some cases, industries held to be low-growth opportunities).

As the Contango presentation reminds me, wisdom can come from many different corners of the market. Oftentimes, investment wisdom is disarming in its simplicity and logic: be honest, be thorough and be realistic. If investors keep these ideas in mind and make a point of focusing on companies that communicate clearly, lay out measurable metrics and standards of performance, and hew to logical, shareholder-friendly policies, the long-term results can be surprisingly lucrative.

Disclosure: At the time of publication, Stephen Simpson owned shares in JPMorgan