Reading & Writing Annual Reports

I recently asked Mikel what I ought to write. He suggested I write about writing the annual report for Little Engine Ventures or write about reading annual reports. While it seems rather metacognitive to write about reading and writing, I’ll give it a whirl –please bear with me. As with all my writing, my hope is to clarify my own thinking and perhaps help my fellow business owners learn from some of my experiences. I’m grateful for others that put in the effort to write.

My 2020 Annual Letter to partners was eleven pages of text followed by our financial statements. Margins were narrow and there were two charts… both formatted by Microsoft Word in two simple tables. Zero color. Zero logos. One chart displayed results by year. The other chart displayed our investment schedule of private companies. This was my 19th annual letter. The first 15 letters had a narrower audience –my future self, my wife, and occasionally a banker or family member. The formatting was similar. The primary question remains unchanged: “What the heck were you thinking?”

I think that question prompted me to write the first one. I wanted a cover letter for my personal financial statements that would outline what happened and what I was working on. Over time it grew into a habit and something I take very seriously. I’ve also allocated more time to reading other’s annual letters. I learn something new almost every time.

Today I don’t let myself start writing until Q4. I finish in mid January when our financials close. I start by revisiting my quarterly reports to partners and my past letters. I look over notes I’ve taken during meetings with managers and records I have kept on various investment ideas –some executed, some pending, some passed over. I also review board meeting minutes of our various control companies. Basically, I start sketching key elements and start feeling around for a theme. What big ideas are shaping my actions? What has changed in the last year? What remains the same? What the heck were you thinking?

At Little Engine Ventures my audience has grown to about 40. I say “about” because there are spouses and financial advisors that are copied into the email at the request of the partners. I ask them not to distribute the letter without permission, but I’m not sure what they do. I’m not even sure everyone reads every page. It’s in an email with legalese at the bottom that says don’t distribute; and I don’t quiz them on page six, paragraph four. I simply make it available, because it’s what I would want if our roles were reversed. I also try to bear in mind the various attention spans of our individual partners. I want to write it for the partner that cannot sit still for more than a single page (read the first page and move on.) And I want to write it for the analytical type that will read and re-read it several times. I want them to feel like they’ve had a very frank conversation with me… where I didn’t fumble my words or go off on a tangent.

I don’t publish it broadly because I write enough on these goofy blog posts that people can get to know Mikel and I by reading these. If someone calls, it’s pretty easy to tell whether they’ve read anything I’ve written or are just fishing. If you haven’t read anything we have written then it’s going to take us longer to get to know each other. I’m also unlikely to pretend to be something I’m not, or change in any tectonic ways to work with you. Sorry, it’s just not in my DNA.

There is a fine line when writing an annual letter to shareholders. One wants to tell enough that a passive owner can make a decision to stay or to go… but also not give them so much that they become overwhelmed and inadvertently become obsessed and even fearful of something that is less impactful to the more experienced. For example, we don’t give financial statements of every single company –our Advisory Committee reviews these– because each company is undergoing various sorts of changes. Certainly some of them are just pumping out cash flow and everything looks perfect. Those would be no problem to share. Everyone would be thrilled, or even amazed. And, I don’t want to accidentally invite competitors into our domain. However, in some companies we are losing money to a degree that would make people wretch. (what the heck were you thinking?) To the uninitiated these boundaries are somewhat more difficult to contextualize at the aggregate level. Losses are not always losses if they ultimately produce a larger and more valuable company. Simple to write; hard to think when you are staring at financial numbers without any operating context. Ironically, it’s the numbers people that have the most trouble seeing through these R&D and growth initiatives in the early stages. They need to trust the leadership. What better way to get that trust, from a passive owner, than just to tell them the aggregate figures? See, that’s not so bad, right? I sometimes include tables on progress, growth rates, dividends (or lack thereof), it just kind of depends upon the theme from any given year.

We are still in the very early innings of our partnership. I had some big ideas and am grateful for those who have trusted Mikel and I with their cash to go find deals and then tell them what we did after the fact. I write to them as though they are the third party with Mikel and I. What do they need to know? What’s the right resolution given our current circumstance?

In 2020 I learned that the Annual Letter to Shareholders was recently deemed a genre. It deserves its own genre. The format of letter writing is ancient (think books of the Bible old), and the report on the business is unique in its requirements. One must write in a way that delivers something other than the financials. I prefer it emphasize strategy over marketing. Don’t tell me how great you are. Tell me how and what you expect to be great at. What makes your business work? What makes it fail? What are you doing to extend its functionality and avoid its failure?

I’ve read all of Warren Buffett’s annual letters. It’s the pinnacle of clear thinking and right resolution for owners and partners to decide the degree of their continued involvement. However, there are many other good letters. One of my favorites is a little public company, that we own a few percentage points in, and the Chairman writes a two page letter that hits the key initiatives, major surprises and the fundamental history that shapes their actions. Our business (I say “our” on purpose) is a simple one and although I have not met him in person, I “get him” and know he is disciplined about costs even when we lose money. He knows the right sort of customers and doesn’t waste time trying to be something he and the company are not. It’s run for the shareholders and I can see it plainly.

In some annual letters there is a lot of marketing speak that hides the $5M annual compensation for the CEO even when we are losing money. If he is going to pay himself regardless of performance and feels justified in doing so, I’d like to hear why. His answer might be as simple as “I’m the best there is at this and there ain’t no one that can do this as well as me.” If he’d say that, I’d probably be more open minded about owning more, for a longer term. Instead, I’ve got to try and thread the needle on the business and the manager and it sometimes just makes me uncomfortable. I’ll go forward at times but it changes my line of thinking.

There are other managers of public companies, whom I’ve met in person more than once, who do not write letters. Some of them are excellent leaders and I’m happy to be a shareholder. Some of them are pillaging the company despite the shareholders. I’ve owned shares in both types. The excellent managers that don’t write, come across like gems when you meet with them, and realize they are more verbal in their communication. They are probably more social than I and a bit more salesmen in their posture. I’m cool with that, but like to know that they also know how the business works and what it won’t be doing so I can see that we are attempting to achieve this or that, and have a disciplined strategy. If you put them on a conference call or presentation they crush it. A few might have “letters” at the header of a 10-K but they miss the tone of the person. These are not enough but their strong numbers speak for themselves and their industry is often quite plain. It’s all about execution anyways.

For those that don’t write and don’t speak well, I’ve come to realize that they’re often running a dog of a company at an unfair compensation level. I might own some stock in this if it’s super cheap but I’ll sell it on a hiccup of good news. And frankly, I’d prefer to not even have to bother with these companies. Why not just keep Little Engine Ventures on control companies exclusively? I’ll save that for another blog post.

The main reason to read and write letters is to communicate with your partners and co-owners. A well crafted annual report delivers guidance without forecasts. It informs without misleading. It ought to reveal the inner thinking of the human at the helm and provide enough substantive context so that passive owners can decide to stay or make changes. In our office, I use the phrase, “put off the right kind of stink.” –the “stink” ought to repel some and attract others.

In a small business where all shareholders are involved on a daily basis, one can stay abreast of the happenings and decisions through regular dialogue with the team. As the owners become more passive they come to rely on the Chairman and/or CEO for more and more of their insights. In a publicly traded organization the SEC requires certain disclosures but many Chairmen and CEOs avoid writing an annual letter altogether. Why? I’m not sure exactly. My guess is they don’t know what they are doing. Or, why they do what they do. Or, they are afraid of legal pressure, or prefer to run initiatives through their marketing channels. I see very few annual letters to passive shareholders of private companies (family members or the like.) This is unfortunate because many of their dependents rely on the business for sustenance. Why don’t they write? Are they too busy? Are they just trusted to do their best? I think they are trusted in most cases, but sometimes I think it’s more a lack of habit. A two page note would probably help align everyone. But, maybe that’s just me?

Mikel wrote a letter to his staff at Delmar this year; and shared it with me. I think it was really great. I’m guessing he will continue it in the future and look back on these fondly. I’d also wager that his team will be able to make decisions with a bit more confidence thanks to the clarity of thought and leadership he put into it. When new employees join his software development firm they’ll also be able to review the history and come up to speed faster… reaching higher productivity levels more easily.

While no great movement ever transpired without a fanatical leader, it is not sufficient to place your bet on him or her regardless of the cost. You must count the cost. In today’s age Elon Musk and Jeff Bezos have appeal. They are leading horses at the race. What are the odds? In the age before it was Steve Jobs and Bill Gates. In the holy land of value investors it is Warren Buffett and before him Ben Graham. Before these odds makers were John Maynard Keynes, Adam Smith and Ben Franklin. Before Ben was Marcus Aurelius, Nebuchadnezzar, Solomon and Abraham. The bookmaking of business must rest on first principles to endure. The horse must finish the race.

When reading annual reports, ask oneself, ‘What possibility does this enterprise have in coming to an untimely death?’ And, ‘will the leader prevent it?’

Is he or her the type of person you want to be in business with?