Letters of Credit

When a company’s annual report arrives in the mail, too many investors skip past a really interesting partu00e2u20ac”the CEO’s letter to his shareholdersu00e2u20ac”to get to the financials in the back. That’s a mistake, in my view. Why? Because a CEO’s letter can tell you a lot about management and what it’s thinking. It’s all there (or should be): the CEO’s level of candor and self-awareness, the quality of his strategic thinking, an indication of his ability to execute, and his commitment to building shareholder value. These are all attributes investors want to be able to observe in management directly, but rarely get an opportunity to do so.

The shareholder letter is their chance. It is a CEO’s “state of the company” address, aimed at his widest possible audience, both externally and internally, and is worth paying attention to.

For instance, if a letter is an obvious bundle of clichu00c3u00a9s, bromides, and industry jargon thrown together by some staffer at the local P.R. firm, that tells you a lot right there. The most competent CEOs are consumed by the idea of building and executing a strategy that will enable their companies to win in the long run. They’re passionate about where their companies are headedu00e2u20ac”and will tell that to anyone who’ll listen. If that passion doesn’t come through in the CEO’s letter, you have a valuable piece of input no line on the company’s P&L can ever provide. Beyond that, the company’s shareholders are, after all, its owners. If the CEO doesn’t see fit to take the time to tell the owners what challenges and opportunities he believes the company faces, you know you have a problem.

As an analyst and a portfolio manager, I’ve known so many bank CEOs for so long now that I can pretty easily gauge which ones are blowing smoke in their letters and which ones have put a lot of thought into their messages. I can also usually tell which ones wrote the letters themselvesu00e2u20ac”more do than you might thinku00e2u20ac”and which ones relied on their staffs. For each letter I read, I have a mental checklist of things to look for. Here are some key items:

Honesty. Not everything goes right all the timeu00e2u20ac”even at the best-run companies. I’m always interested to see how forthright a CEO is in acknowledging any problems that have arisen in the past year (and why they arose), and how realistic he is in assessing the company’s response. It’s easy to minimize bad news or blame bad luck when things don’t go well. It’s also easy to provide a whitewash rather than a real solution. The best shareholder letters candidly discuss the challenges the company faces and how they’ll be addressed. On this score, it’s easy to spot the pabulum.

Vision. I’ll often compare a given company’s shareholder letters from prior years to its latest letter, and am often amazed at the memory lapses and unspoken fudges that occur. In particular, you’d be astonished how often a CEO’s “long-term vision” for his company will change from year to yearu00e2u20ac”without the CEO actually admitting that he’s changed anything. A company’s “7 Goals” become “6 Goals” the next year and “5 Long-Term Goals” the year after that.

It’s not so much that changes in goals and visions are a bad thing; rather, investors will want to know why the changes have occurred. If it’s because the ideas didn’t make sense in the first place, that’s one thing; if it’s because management simply isn’t up to achieving them, that’s another.

Hot buttons. After the letter, I read the section of the report wherein the company says what it does for a living. This can be telling. At mediocre companies, the descriptions often change from year to year, depending on what’s in style. In the late 1990s, for instance, some banks tried to cast themselves as pseudo-Internet companies by highlighting their “alternative delivery channels.” (This year, by contrast, too many banks emphasized the bright outlook for their de novo expansion plansu00e2u20ac”a sure sign, in my view, that the de novo craze is peaking.) I look for companies that know what their purpose is, and stick with it year in and year out.

Which bank CEOs write good letters? Three stand out. Jamie Dimon, who ran Bank One before becoming COO of J.P. Morgan-Chase following the Chase-Bank One merger, was inordinately forthright with Bank One holders as he discussed the company’s massive turnaround. I expect similar candor from Jamie once he becomes Chase’s CEO in 2006. And Wells Fargo’s Dick Kovacevich is a classic straight shooter who doesn’t hesitate to give holders his unvarnished view of Wells’s successes and disappointments. You will never see “vision creep” in a Kovacevich letter. Finally, there’s Bob Wilmers, CEO of M&T Bank Corp., who typically offers levelheaded comments about short-term fads both within and outside the banking industry.

There are others as well. Every CEO letter will tell you something about a CEO, though, whether the CEO means to or not. That’s why shareholder letters, often one of the most-ignored parts of a company’s annual report, should be one of the most scrutinized, instead.