Friday, June 26, 2009

The joy of annual reports

You would think reading about what your money has been doing in the past year would be jolly interesting, yes? Not when the explanation arrives via most annual reports of companies or funds, though.

Although the financial statement is the heart of an annual report, for most shareholders that is a little too esoteric. The one part of the report likely to be read is the letter from the CEO, usually at the beginning of the book. Nine of 10 of them seem to have been generated by a computer program, like the software that you can use to write your will. I expect the first question AnnualReportMaker 5.6 asks the CEO (more likely the head of shareholder relations) is, "Did your company stock go up or down last year?"

The template for "no" is usually the more impressive as an exercise in distraction, like the stage magician who keeps your attention occupied elsewhere while he performs the mechanics of the trick.

AnnualReportMaker's basic format for the letter from the hapless CEO of the company whose stock has sunk goes like this:

Dear Investor,

This has been a challenging year for all of us. As you know, these are difficult times in the market. Our team of dedicated employees has worked diligently to meet our customers' needs and gain market share. I am pleased to report that production of acetylformaquinine has risen from 48 gl/MGt to 66 gl/MGt, throughput grew at a rate of 4% year over year, and our cost per rgb has been reduced to $7.30, partially as the result of our acquisition of Treadsoftly Laboratories for $88 billion in cash and securities last March.

It was our misfortune that Charles Undergroth, our chief financial officer, left that same month to pursue other opportunities, followed a day later by Polly Morphus, head of accounting. We wish them the best in their new ventures.

[etc., etc.]

Faced with these unprecedented difficulties, the company experienced a slack year in revenue growth. Common stock was off by 70 percent on December 31 compared with the previous year, a situation we are certain is temporary. We appreciate your patience …

Occasionally, though, you run across an annual report that appears to be the work of human beings, able to write good English and speak candidly about what they did right and what they did wrong with the money people invested in the company. I was pleased to discover such a report written by Ian Cumming, chairman, and Joseph Steinberg, president, of Leucadia National Corporation.

Leucadia is a holding company that specializes in distressed businesses that it believes are selling for much less than they are potentially worth. According to Amit Wadhwany, portfolio manager of the Third Avenue International Value Fund (which owns Leucadia stock), Leucadia "carries one of the country's most impressive long-term investing track records. … Since its founding in the late 1970s, Leucadia has been run by Ian Cumming and Joe Steinberg, who are responsible for having compounded the net asset value of the company's portfolio by slightly less than 20% per annum, over the last 29 years."

A few samples from the letter from the chairman and president in the 2008 annual report:
In 2008, Leucadia reported a loss of $2,535,425,000 after tax, which is $11.00 per share fully diluted. In 1992, following a fire in Windsor Castle and marital problems for most of her children, the Queen of England in a speech marking the 40th anniversary of her Accession referred to the past year as “annus horribilis.” 2008 was just such a year.
They go on to explain the accounting line items that represent losses for 2008.
• “All Other, Net” is a dog’s breakfast of income and losses that resulted in a net $22.1 million loss.
• “Consolidated Business Results” is the net result of all operating companies that we control. To a man, the operating companies also had an annus horribilis. More on this later.
• “Corporate Interest Expense” is the interest we pay on our corporate debts.
• “Mark Down of Investment Securities and Associated Company Losses” include the mark to market losses of companies in which we own securities but do not exercise control. Several of these companies represent substantial investments by Leucadia which we believe are likely to have greater value in the future than today’s market price.
The market price of the securities of these companies has been savaged by the current financial crisis, along with Leucadia’s stock price which as of this writing has fallen 72% from its high. We will discuss each of our major investments later in our letter.
They proceed to describe each of the businesses Leucadia owns an interest in, what the business does, what's working and what isn't, and what the prospects are. They make these explanations as understandable as possible, quite a feat considering some are by their nature complex enough to make you dizzy.

Some choice quotes:
Jefferies, listed on the NYSE (symbol: JEF), is a full-service global investment bank and institutional securities firm. Jefferies offers its customers capital markets, merger and acquisition, restructuring and other financial advisory services. …

Jefferies is not in trouble, not a ward of the U.S. Government, not burdened by toxic assets and not overleveraged. Its employees own a substantial interest in the firm and their pay expectations are being managed with the best interests of the firm in mind. Jefferies has successfully hired talented individuals from troubled or failing firms and recently acquired a muni trading and underwriting business. Trading volumes have been good, their restructuring business busy, but their capital markets and mergers and acquisition businesses remain lethargic. This will inevitably improve, but timing is uncertain.

As of December 31, 2008, we acquired approximately 25% of the outstanding common shares of AmeriCredit Corp., a company listed on the NYSE (symbol: ACF) … . ACF is an independent auto finance company that is in the business of purchasing and servicing automobile sales finance contracts, historically for consumers who are typically unable to obtain financing; this segment of the business is known as subprime.

Years ago we owned a similar business and as a result carefully followed ACF. We observed that their large volume and efficient processing and underwriting abilities made them a fierce competitor. We also observed that when a recession hit ACF went through a period of poor results, but when a recovery began they were able to make very large profits by being able to select more credit worthy customers and to charge more for loans.
Much of the above remains true; however, we began to buy the stock too soon and paid too much. The recession has been much harder and much deeper than we anticipated, though ACF is succeeding in acquiring more credit worthy customers and is able to charge higher rates. The fly in the ointment has been that it has been almost impossible to secure additional funding to make loans. Securitizations, which were the lifeblood of their financing, are in rigor mortis.
The Hard Rock Hotel & Casino in Biloxi, Mississippi has had a hard life! It was scheduled to open to the public on August 31, 2005, two days after Hurricane Katrina hit the Mississippi coast. The wind broke many of the windows and water drenched nearly everything inside. By law, the casino sat on a floating barge in the Gulf of Mexico up against the hotel. The tidal surge set the casino and all of its contents free of its mooring and it sunk into the briny deep. [The previous year they wrote, "The tidal durge from Katrina sent it and all the contents into the briny deep to entertain Neptune."]

The Hard Rock has had a rough time fighting for market share among a crowded Mississippi Gulf Coast market, but has made slow and steady progress and is now getting its fair share of gaming revenues based on available hotel rooms. To fill its gaming tables the Hard Rock needs additional hotel rooms, for which we own the land, but for the time being and in light of the recession expansion plans are on the back burner.

Were we to do it again we wouldn’t! We are struggling ahead with small single digit returns on our investment.
With this kind of honesty in their letter to shareholders, I can believe Messrs. Cumming and Steinberg when they summarize the situation, under the heading "Fortress Leucadia":
“Fortress Leucadia” is a draconian look into the future and a basis for defensive planning. It assumes we will not make any more investments, continue watching our expenses, keep only assets that are promising and slowly turn everything into cash which will be used first to retire or pay down debt, while always maintaining at least $500 million in cash or liquid assets.

That is the theory. The reality is we will continue to look for companies to buy, but only consider companies that earn money, have a bright future and are durable! In these troubled times there are sure to be good opportunities for investment and we will remain on the hunt. We can recognize a good deal when we see one and will strive to execute.
I am considering a small investment in Leucadia — small being all I can afford — but I hesitate. In general, I don't like conglomerates. Even brilliant businesspeople have a hard time understanding many different, unrelated industries. I like very focused companies where they know everything there is to know about one line of work.

Still, Leucadia's record speaks for itself. But my other concern is that I don't see this as a good time for turnarounds, which is essentially what Leucadia manages. We have seen a serious rally in stocks since the March lows, but the economy — related to, but different from, the stock market — seems to me in no significant way better off. The problems are still there, masked somewhat by government intervention and political rhetoric. When and if the economy exhibits genuine healing, Leucadia should be a good bet.

Disclaimer: I have no qualifications as a financial advisor and have often been wrong.



David said...

There's a woman who has a company which analyzes annual reports (specifically, the CEO letter) for their verbal style--she claims excessive ambiguity shows a good correlation with future bad performance. I'll see if I can find something on it.

See business writing, then and now, comparing J P Morgan writing from 1933 with that from 2006. OTOH, Jamie Dimon's for this year is pretty thoughtful.

David said...

Found it...couldn't remember if I'd ever gotten around to posting on this or not.

Rick Darby said...

"If language determines actions and results, then corrupt language will lead to debilitating actions and unsatisfactory results."

Well said. Obscure and evasive language from corporate executives may be partly designed to put the best face on a company's problems. But like a neurological disease, it gradually attacks the brain cells and decreases the executives' ability to analyze the trouble and frame realistic solutions.