Book Review #44: Investing Between the Lines: Author: L J Rittenhouse

I have so far reviewed 43 books in my series on 50 Finance Books. The books reviewed so far falls into different genres like Personal Finance, History of Finance, Wisdom and Investing Fundamentals. The

book 'Investing Between the Lines - How to make smarter decisions by decoding CEO Communications' written by L J Rittenhouse falls into the genre of CEO Communication. This may be the only book of this genre in this series.

Why does CEO Communication matter?

The goal of Rittenhouse Approach is to create a gold standard for CEO Communication, by culling examples from thousands of such communications. The way CEO communicates is very important due to the following reasons.

• It reveals the character of the CEO. Authentic leaders write trustworthy letters
  
• Warren Buffet uses it to identify the integrity of senior management, which is one of his main investment criteria. He reviews past CEO communications to see if the commitments and plans made in the past has been followed up in later years.
  
• It instills confidence in the shareholder's that their company is managed prudently. It assures that the the mission, vision and core values guide the management in their decision making.  
• It provides transparency on the running of the company 
• It helps investors anticipate serious problems at their inception before them become 'news'
• It helps align investor and management expectations
• Transparent CEO communication has a direct and positive correlation with investor returns
  

About the author.

Laura J Rittenhouse is a financial expert.  She is named as one of the top 100 US thought leaders in trustworthy behaviour.  She is the founder of Rittenhouse Rankings Inc, which helps its customers increase their valuation by providing trust building corporate communications. In addition to the above book, she has written two more, Buffet's Bites and 'Do business with people you can trust'

About the book

The goal of every CEO should be to create sustainable businesses. By analyzing how CEO communicates, an investor can know if the CEO is progressing towards that goal. A successful CEO communicates with candor and specificity. She links the present decisions to the culture and values generated over time and is candid about the mistakes made and lessons learned from them. Most importantly she appreciates the contribution of the three groups of stakeholders - Employees, Suppliers and Customers - to the success of the company.

Her communication can be looked upon as an evolving story. Investor can easily connect the dots.

CEO makes decisions that involve making judgements between multiple options. Corporate culture and values act as a bedrock in making these judgements. The culture can be transparent or opaque. Since the CEO can strengthen or modify the culture and values of the company, the CEO communication points to the direction of the company. A transparent CEO informs and educates. She explains how the revenues were generated, specific plans for the present and the future, the challenges faced and how they were addressed and expected risks and how they will be addressed. She is consistent over the years and communicates progress on the goals announced in the previous years.

How will an investor analyze the CEO Communication? What are the parameters to look for? What are the clues or signs under each parameters that informs them if the CEO is competent? How can they identify the potential pitfalls? 

To answer these questions, the investor needs a mental model, an approach or a framework. This is where Rittenhouse Approach comes in.

The Rittenhouse Approach

This book provides a structured approach to analyzing CEO Communications. The focus is entirely on the text of CEO's annual letters to shareholders. The goal is to analyze the CEO communication to develop a model of sustainable business To come up with the criteria, the company analyzed over 1000 CEO communications. Based on this they came out with 130 topics. These topics are divided into seven parameters as shown below.

Rittenhouse Rankings Approach

The book provides a set of four or five clues that investor can use to evaluate each parameter. Scores are given for the performance on each of the clues. It also provides relevant examples from CEO communications to illustrate the points. Communication supported with numbers gets higher scores. There are negative scores as well. Finally, the approach comes up with one score to rate the CEO communication. 

While the score itself is important, the components are far more important. For example a higher overall scores with high scores on Capital Stewardship and Candor is better. 

The analysis could be as simple as counting the number of times a specific word is used in a letter. One of the criteria in the parameters Capital Stewardship is to count the number of times the word 'Cash' is used in a letter. They also look for FOG, the number of times platitudes ("We are going to be the best version of ourselves") is used in the letter. Needless to say more the number of the word 'CASH' it is good, more the proportion of FOG in the letter, that is a cause of concern.

The summary of the approach is given in the diagram below.

As an example of  Parameter and their evaluation criteria, let us look at the parameter 'Capital Stewardship'. It is measured by the following criteria (the book calls them Clues)

1. Cash and Cash flow
2. Operating and Financial Goals
3. Capital Discipline
4. Balance Sheet Measures
5. Risk Awareness. 

A Cash Flow Statement consists of three groups. Cash Flow from Operating Activities (also known as Operating Cash Flow), Cash Flow from Investing Activities and Cash Flow from Financing Activities. There are two different terms that CEO uses about Cash and Cash flow. Free Cash Flow (FCF), which is the net cash available after providing for Capital Expenditure. This the cash that accrues to the investors and which they use for valuing a business. A good CEO focuses on FCF. However if the management focuses on 'Operating Cash Flow' then it a red flag. It is possible that there are negative flows related to Investing and Financing that impact the investors. An investor should know why the CEO is focusing on OCF and not on FCF.

The Rittenhouse approach reviews CEO communication to look for words like Goal, Objective, Target and Aim, all of which suggests a focus on goals. They divide the goals into three types. Motherhood goals are generic statements of intention like 'we want to be the best in our industry'. Serious goals combine intentions with measurable outcomes like 'we want to increase sales by 20% next year'. Superior goals wraps a context around the goal. They generally contain a performance matric (increase RoI by 2%), a performance benchmark (compared to industry standards), and specific set of actions to be taken to achieve this goal.

Capital Discipline of the company can be evaluated in two ways. One, how often CEO talks about ROI (Return on Investment), ROIC (Return on Invested Capital) and ROA (Return on Assets). The second way is to see if the CEO focuses on Book Value, which is more predictable and dependable, or on market value, which is more at the mercy of external factors. A good CEO will focus on Book Value, leaving the investors to take care of the market value. 

An analysis of the Balance Sheet will show its liquidity position as well as the Debt to Equity ratio, two key parameters from an investor's perspective. Despite its importance, most of the CEOs do not discuss it much. Any company, whose CEO communicates the status of the Balance Sheet and actions taken to strengthen it, should get a higher investment rating. 

Risks are inherent to any business. It is the duty of the CEO to communicate potential risks and mitigation plans to the investors. For many companies, like insurance and banks for example, Risk management can be a significant competitive advantage. Recognizing the importance of risk. Rittenhouse approach looks for references to the word Risk in CEO communication, with more references displaying competent leadership

Similar detailed analysis is done for all ten parameters mentioned above. 

The strength of this approach is its detail and its consistency over the years. Analysing the CEO communications for the same company year on year can demonstrate the integrity of the management, whether they act on their promises or keep shifting goal posts. In addition, this approach could also focus on changing managerial styles as the company replaces CEOs and helps the investors analyze what works and what doesn't.

How will this book help?

This is a book for all retail investors. The approach is intuitive, easy to understand and easy to put into action. The 'CEO Speak', with surfeit of jargon and numbers can be intimidating to a lay investor. By following the simple but detailed approach mentioned in this book, a lay investor can take informed investment decisions. 

This book is different from all the other books I have reviewed so far in my 50 books in finance series in that this has almost zero math. Numbers if any, add intuitive context to the points mentioned. Any layman can read the book and almost immediately start reading CEO communications with a new and enlightened eye. 

If only for that, I will give this book a 5/5 rating.

Waiting for Mastershare Dividends. Our family tradition....

UTI has declared a dividend of 27% on UTI Mastershare 86 Scheme. Record date is 1st November.

 

Our family has an emotional connection to Mastershare.

 

One of the best investment decisions my father made back in 1986 was to invest a couple of lakhs of rupees in UTI Mastershare when the scheme was launched.

 

I often wondered what prompted him to make that investment. He was not very investment savvy then. I think his auditor must have been instrumental in that decision. There must have been some tax benefits.

 

Though not investment savvy, my dad was a smart investor. He had clear financial goals for this investment. He was about to retire and he wanted the proceeds from this investment to fund the education of his two youngest sons.

 

We are four brothers. My and my next younger bro had completed our graduation by 86 and my next two brothers were about to enter the graduation. Investment in Mastershare was to fund their graduation and higher education.

 

Just to be fair all his sons, he also purchased 1440 units each in the name of me and my younger brother.

 

The scheme has withstood the vicissitudes of time and market cycles. It saw Harshad Mehta, crash and burn of Mastergain 92, demise of UTI Unit Scheme 64, 1998 bull run, 2003 collapse, 2008 collapse and is witnessing the current bull market. Despite all this turmoil, the scheme has stood like a rock, never disappointing the investor, never failing to declare a dividend.....

 

Starting 1986 the scheme has paid dividends every year without any break. In addition in the late eighties and early 90s, the scheme declared bonus and rights issues as well.

 

My dad bought the rights too. He was a conscientious investor.

 

His initial investment increased ten fold by 2000 and the dividends received paid back the initial investment by that year. Effectively he was getting free dividends from 2000.

 

My father also influenced his younger brother, whom we call Dora Chithappa (Chithappa means 'Younger Father', meaning Father's younger brother), to invest in Mastershare. I don't know how many units he held.

 

Mastershare usually pays one dividend every year around Diwali time. Waiting for UTI to announce the dividend was my family tradition over all these years.

 

Every year, around this time, I used to get two calls. One was from Dora Chithappa and the other from my mother. Both asked the same question.

 

"Kanna, what is the date of Mastershare Dividends?"

 

As soon as I get the calls, I will scramble around, go to UTI Website and search. More often than not they would not have declared dividends on that day. Till UTI declared dividend, I was on razor's edge.

 

What if I miss the update?

 

My mom especially looked forward to the dividends. My dad had allowed her to use the dividends as she wished. That was her money. The total dividends came to about 1.8 lakhs every year.

 

Two years ago, my brother sold off the units. He told that 'This scheme has Value Research rating of 3 stars. There are better investment opportunities out there'. He didn't much care for the emotional connect of this scheme to my mother.

 

My brother is practical and pragmatic.

 

Even UTI has forgotten about this scheme. If you call the UTI helpline to ask about the scheme, you will be answered with 'Excuse me?'

 

My dad passed away in 2015, Dora Chithappa followed him last year.

 

I don't get the annual calls anymore. That makes me sad.

 

I still have the 1440 units that my dad gifted me. It will give me 3500 rupees as dividend this year.

 

That is my Diwali gift to my mom. I am sure she will cherish it.

Book Review #43: The Zurich Axioms: Author: Max Gunther

 This is the review of the book 'The Zurich Axioms' written by Max Gunther, who also wrote the book 'How to get lucky'. You can read my review HERE (I have not published the post yet, I will update this link, once I do that). 

Swiss are famous for their prudent and successful money management. It is not for nothing that they have earned the moniker 'The Bankers to the World'. They have a legendary ability to take on and manage risk. At USD 83000, the nation of a couple of million people has the second highest per capita income in the world. 

They must be doing something right with money that we can learn from. 

What are their thought processes? What are the principles that they follow when it comes to money? What are the lessons that we could learn from them?

Book Review #42: The Psychology of Money: Author: Morgan Housel

Most people approach money based on scientific principles. There are many formulae and theorems on how to invest and grow money. After the stock market crash of 2008, Morgan Housel, author of the book ‘Psychology of Money’,  observed that handling money is more of an art than science and the success in handling money depends on how one handles the emotions and stress associated with money.
 

Unlike hard sciences like Physics, money is not dependent on some universal rules, it has behavioral connotations. In 2008 Mr.Housel wrote a report titled ‘Psychology of Money’ that contained 20 behavioral aspects relating to Money. The book 'The Psychology of Money - Timeless Lessons on Wealth, Greed and Happiness' is an elaboration of the ideas that were briefly discussed in the 2008 report.
 

The book is structured across Introduction, 20 chapters followed by a postscript on the evolution of the American investor over the last century.  18 chapters discusses the behavioral aspects of money, the penultimate chapter is a summary of the principles discussed in the earlier chapters. Chapter 20 discusses how he invests his money.
 

How do spinoffs create value?

Value investing is the process of buying securities that are trading at prices well below their intrinsic value and then waiting for the market to discover the value and raise the price in line with the value. As per the legendary value investor Seth Klarman, securities market can throw up many opportunities for the savvy investor to buy securities at significant discount to the intrinsic value.

Management actions like spinoffs present two benefits. One, they help the market close the gap between the price and the value by giving shares directly to the investors. Two, they send a clear message that management is shareholder friendly. 

Market regularly throws Value Investing opportunities

One such opportunity arises when company decides to spinoff its subsidiary into a new company. In the chapter 10 of the book Margin of Safety Mr.Klarman discusses the value investing opportunities provided by spinoffs.

Spinoff is the distribution of shares of a subsidiary company to the shareholders of the parent company. Spinoffs help parent company to divest businesses that no longer fits strategic objective. The goal of spinoff is to create parts with a combined market value greater than the present whole.

They present attractive opportunity since immediately after Spinoff, the shares of the spun-off companies are bound to trade at low prices as markets discover their value. Many shareholders of the Spinoffs sell their shares quickly since they follow the decisions of the management of the parent company. Sometimes the shareholders sell the spun-off company because they know nothing about the new company. Large institutional investors will sell spinoffs since they may be too small for them. Index funds will sell spinoffs since they are not a part of the index they are tracking.

In case of spinoffs, as the shareholders dump the shares immediately after the spinoff, the share prices get significantly depressed. Unlike other securities, the selling is not because the sellers know something more than the buyers, in many cases, the selling happens because the sellers know nothing. 

Wall street do not follow spinoffs. The analysts following parent company may not follow spinoffs that are in different industry. Sometimes management wants to keep the share prices down. Another reason spinoffs are valuable in the initial stages is because there is an information lag. Sometime opportunities exist in the parent company shares and not in spinoffs.

In summary, Spinoffs present a great value investing opportunity due to the following reasons.

• Spinoffs help increase the market value of the group.
• Shareholders are ignorant and tend to dump shares
• Spunoff companies do not fit the strategic objective of the Institutional Investors and hence they dump the shares
• Management wants to keep the share prices low
• Not many analysts track spiinoffs

Spinoff opportunity is the most valuable in the first few weeks of trading.

Book Review #41: Margin of Safety: Author: Seth A. Klarman

This is the review of the book Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor written by Seth A Klarman

In the introduction to the book, Mr.Klarman sets out two goals for writing this book. One is to highlight the investment pitfalls so that the investors could avoid them. Two is to explain why value investing method works and often works spectacularly.

Value investing is the strategy of investing in security trading at an appreciable discount from underlying value. This approach has a long history of delivering excellent returns with limited downside risk. It requires a great deal of hard work, strict discipline and a long-term investment horizon. Few are willing to put that effort.

How do you value a business?

The practice of Value Investing, any investing for that matter, calls for valuing a business. The concept of Margin of Safety for instance, talks of buying a security when there is a significant gap between the price of a security and its intrinsic value.

The question is how do you define value? What are the different methods available to value a business. What are the pros and cons of each method? Which should be the method of choice? 

Chapter 8 of the book 'Margin of Safety' written by Seth Klarman talks of Business Valuation. The reported valuation numbers like book value, earnings and cashflow are best guesses of accountants. Also value is not static. It changes over time with different macro-economic factors. The business value cannot be precisely estimated, but the apparent precision offered by mathematical formulae like NPV and IRR can lull investors forgetting that these are based on assumptions of cash flow far into the future.The other assumptions in valuation could be regarding future, different intended uses of the asset and different discount rates used.

Three valuation methods that author finds useful are Net Present Value (NPV) - valuing the cashflows of a going concern, and its offshoot Private Market Value, the value paid by a sophisticated buyer of the business, Liquidation value - the expected proceeds if the company were to be sold off, an offshoot of which is Breakup value that values each components of the business separately and Stock Market Value - the estimated price at which a company will sell in stock market.

These valuation methods are illustrated in the diagram below.

Two aspects of valuation are Expected Growth in earnings and Discount Rate. If future cashflow is predictable, NPV can be very accurate. However cashflow depends on many factors like market share, the volume growth, pricing power, brand loyalty etc, each of which can be assumptions. 

Growth investors face many challenges One, they show higher confidence in their ability to predict future value than is warranted. Two, even small differences from one's estimate can have catastrophic consequences. Three, since many investors are focused on such companies, the prices may go up lowering the margin of safety. Four, investors tend to oversimplify growth into a single number, while it is based on many factors. Just as an example, earnings growth can come from more units being sold due to increase in population or it may also be due to increased usage by the existing customers. It could also be due to increased market share or due to price increases. While some of these are predictable, others are less so.

Investors by nature are overly optimistic of the future. Since future is unpredictable, value investors have to be conservative in their assumptions of growth as well as discount rates.

The other factor in valuation is the discount rate. The more conservative you are, the higher rate you will use to discount future cash flows. The discount rate should depend on Investor's preference of present consumption over future returns, his risk profile, the risk of investment under consideration and on the returns available from other comparative investments. However, investors often simplify and use 10% as discount rate.

When interest rates are low, investors pay high multiples assuming rates to remain low.

Once future cash flows are forecast conservatively and an appropriate discount rate is chosen, present value can be calculated. In theory, investors might assign different probabilities to numerous cash flow scenarios, then calculate the expected value of an investment, multiplying the probability of each scenario by its respective present value and then summing these numbers.

Given many valuation methodologies, which one should an investor choose? The answer to this question depends on the nature of the company the investor is evaluating.  NPV may be a good approach to value a company with stable cash flows, liquidation method may be used to value a company selling well below its book value, a mutual fund may be valued at stock market price. Sometimes you may used different methods for different units of a conglomerate. Ideally multiple methods should be applied and the lowest value chosen.

A wild card in valuation is the theory of reflexivity propounded by George Soros. It says that stock prices can influence the valuation, rather than the other way round. For example, an under-capitalized bank, trading at high multiple can raise cheap capital in the market based on its price multiple. On the other hand if the stock was trading at low multiples, it would not have been able to raise funds leading to bankruptcy. In this case, the stock multiple acted as the valuation cue for the bank. It could be true for a highly leveraged company with impending redemption. Good market perception can help it raise funds to honor the redemption. Sometimes managers accept the market value as a signal of the business value and may issue additional shares at values lower than market thereby worsening the situations. A bad market can depress prices lowering the liquidation value, thus becoming a self fulfilling prophesy.

The author gives reasons why valuation based on Earnings, Book Value and Dividend Yield are easily manipulated by crooked management. He suggests not to trust such valuations.