How to Use Shareholder Letters to Find Great Dividend Stocks
The Simple Guide to Shareholder Letters
If you think you want to find great dividend stocks, then you’d better start working with one of the main tools of the trade: the shareholder letter.
Legendary investor Warren Buffett trolls through hundreds of 10-K’s every year, sometimes making billion-dollar deals on the shareholder letter alone. When asked how he finds wonderful businesses, the billionaire once replied, “Other guys read Playboy. I read annual reports.” (Source: “Warren Buffett: How to make $3.5bn on a $500m investment,” Biznews, December 16, 2014.)
I love this “manual” method of finding investment ideas. Most investors nowadays rely on automated stock screens, which miss the intangible qualities of a great company. To find reliable dividend payers, especially in today’s low-interest-rate world, you have to do the homework that most other people skip.
A hassle? You bet. The benefit of reading the shareholder letters, though, far exceeds that of second-hand reports from analysts or the media. For that reason, we don’t even have a television or a quote terminal around our research office. Instead, we prefer to grab a hot beverage, cozy up in a comfy chair, and dig through another batch of annual reports.
Which brings up the next question: “What the heck should I look out for?” Generally speaking, great dividend stocks just jump off the page. The best shareholder letters—those that explain the business and industry conditions in plain English—provide a free, high-quality (and often quite fascinating) investment education.
And it’s easier than you think. When reading shareholder letters, I look for answers to the following questions:
- Does management have a policy for spending excess cash?
- Does management set clear metrics to keep themselves accountable?
- Does management confess their failures as openly as they trumpet their successes?
First, you want to understand management’s approach to cash. Media outlets love reporting on growing companies. But if the management team squanders shareholder capital on expensive acquisitions or ego-boosting side projects, investor returns will suffer. We want to see executives put shareholders first by returning cash through dividends and buybacks, and only afterward looking for opportunities to grow their business.
Take commercial property owner Realty Income Corp (NYSE:O), for example. Management has flat-out admitted that growing the dividend represents their top priority. This doesn’t generate exciting headlines for journalists, but it does generate exciting returns for investors!
Here’s a good excerpt from the 2015 annual shareholder letter by CEO John Case:
“Even though market opportunities and conditions change from year to year, we remain dedicated to our mission which is to manage our real estate portfolio in a manner that supports providing our shareholders with monthly dividends that increase over time. This is the same mission that has guided us throughout our 47-year operating history and one that consistently positions us for favorable results. Achieving our mission involves effectively executing our business plan. That plan is to:
- Pay 12 monthly dividends
- Raise the dividend
- Remain disciplined in our acquisitions underwriting approach
- Acquire additional properties according to our selective investment strategy
- Maintain high occupancy through active portfolio and asset management
- Maintain a conservative balance sheet
- Continue to grow investor interest in The Monthly Dividend Company”
(Source: “2015 Annual Report,” Realty Income Corp, last accessed October 30, 2017.)
Case lays out a clear set of priorities here. First, Realty Income will increase the dividend. Second, it will look for selective opportunities to grow the business. Third, it won’t put the business in jeopardy by taking on too much debt.
Most executives want to expand their corporate empires. This means plowing profits back into new ventures, even when they earn only lackluster returns. But when you find the companies that allocate extra profits wisely, like Realty Income has, you’re well ahead of the average investor.
Second, top executives provide clear metrics. In other words, they want to be held accountable. The best executives give you, the owner, simple, crystal-clear benchmarks to determine their success.
Consider Lowe’s Companies, Inc. (NYSE:LOW), a retailer that operates a chain of home improvement and appliance stores across the country. For years, Chairman and CEO Robert Niblock has provided shareholders with an objective set of financial metrics to measure management’s performance. Here’s what he wrote in the company’s 2012 annual report:
“Based on these priorities and expected improvement in operating performance, our 2015 goals are to:
- Reach nearly $300 of sales per selling square foot
- Increase earnings before interest and taxes to approximately 10% of sales, and
- Achieve approximately 17% return on invested capital.”
(Source: “Shareholder Letter,” Lowe’s Companies, Inc., last accessed October 30, 2017.)
I love these kinds of bullets points. We can track these numbers and know in three years whether management has delivered as promised.
Most executives won’t do this; they don’t want people to track their results because they worry that they can’t deliver. Great CEOs, in contrast, believe in what they’re doing and want to be held to a high standard.
Finally, look for humility. Businesspersons who can’t admit their mistakes won’t last long. On the other hand, good executives who will analyze their missteps at least have the chance to survive and get better. Take this frank and open admission from the management team of Bavaria Industries Group AG (ETR:B8A), an industrial supplier based in Germany:
“Failures offer the advantage of learning something from them. You can only achieve long-term investment success by taking an honest look at your mistakes.
Our purchase of Manitok Energy made us our biggest loss of EUR -0.9 million. At the time of the purchase, the Brent oil price was around $70.00; it was already 30% lower than the previous highs. The valuations reflected twice the cash flow before investments, so a gross yield of 50%. What did we do wrong? We did not consider the prospect of a lower oil price. The argument was: “It has already fallen so far and cannot fall any further” and we ignored the obligations of a fracking company to continue drilling, coupled with the existing debt. Finally, the valuation depended solely on a single external factor, the oil price, which cannot be reliably predicted and thus precludes a real value investment. Overall, we lost a total of EUR 2.6 million on our investments in various commodity stocks in 2015.”
(Source: “Letter to Shareholders,” BAVARIA Industries Group Investor Relations, last accessed October 30, 2017.)
Of course, a good business can have a lousy shareholder letter. You don’t often, however, find the opposite–a bad business with an excellent shareholder letter.
Great letters provide a free, high-quality, and sometimes entertaining financial education. And if you study what to look for—executives dedicated to paying out reliable dividends to owners, keeping themselves accountable, and being honest about their mistakes—you will start to identify great dividend stocks that “jump off the page” as wonderful investments.
How can you get started? With 2017 wrapping up, companies will begin releasing their next round of annual reports in a few weeks. I’d suggest grabbing a cup of coffee, printing out the filings of every stock you own, and giving the shareholder letters a quick read. That exercise will make you a much better investor.