Form ARS

The Rules

Companies can use less technical language in the ARS letter than in the 10-k. This has potential advantages (the letter tends to be more readable than anything in the 10-k) as well as potential disadvantages (it may be little more than a sales pitch). Some managers seize the opportunity to communicate openly and honestly with stockholders and potential investors; others don’t. “The annual report is one of the only places a firm’s managers talk directly to you,” says Alex Motola, manager of the Thornburg Core Growth fund. “Read what they have to say — and take it with a grain of salt.”

What to Look For

In short, the best annual reports use straightforward prose to tell you about the roses and the thorns. Look for:

Candor. The company shouldn’t just pump up its accomplishments and advantages; it also should describe its shortcomings and how it intends to overcome them. Google begins its annual report with a letter from company founders Sergey Brin and Larry Page. Their 2007 letter included the following passage:

Our advertising system works well, but we still have tremendous opportunities to improve it. For example, I just did a search for natural swimming pool, which returned eight right-hand-side ads, with only the last two of those somewhat relevant.

True, the letter goes on to explain that the results are both good and bad news: While it’s bad that only a quarter of the ad results were relevant, it’s good there were some relevant ads for such an unusual search — and the founders think the company can make a lot more money as it improves its ad-targeting system. But at least they admit some failings.

Other companies are less forthcoming. Take agricultural firm Archer Daniels Midland’s 1998 report, ranked the year’s worst by Chief Executive magazine. The one-page letter from management failed to mention the fact that three top ADM executives had been convicted in a massive price-fixing scheme. Instead, it offered up mush such as “Think of ADM as an extension of the farm” and “The right to be well-fed is a basic human right.”

Readability. The firm’s management should approach the letter as an opportunity to help you understand the company as well as possible, using prose that’s clear and engaging. You want to feel that company execs respect shareholders as partners. A dismissive or patronizing tone is a red flag.

Warren Buffett’s letters to Berkshire Hathaway (BRK-A) shareholders are famously good reads. You can find them here [link to http://www.berkshirehathaway.com/reports.html]. The letters written by National Beverage Corp. Chairman and CEO Nick Caporella are entertaining on another level. Consider this excerpt from the company’s 2005 report (ellipses and italics are original to the letter):

And so…a full-fledged revolt by the sophisticated beverage consumer developed with a fervor…that has forever realigned the consumers’ demands…a new tasteful evolution is underway! Full swing — as they say.