CHAPTER 20
Company Disclosures and Information: Following the Paper Trail in the United States*
Narrative Disclosures in the United States
The Documents and How to Read Them
What the Paper Trail Does for the Outside Investor
What the Paper Trail Doesn’t Do
Narrative disclosures are used in fundamental finance as tools for gaining understanding of a business—its operations, values, problems, potentials, and long-term management direction. Except for occasional forays into risk arbitrage, the investor following a fundamental finance approach does not attempt to predict near-term prices for securities traded in outside passive minority investor (OPMI) markets.
The principal purpose for using narrative disclosures in much of Graham and Dodd, in modern capital theory (MCT), in broker-dealer research departments, and among conventional money managers is as a tool aiding analysts in predicting market prices for common stocks trading in OPMI markets in the period just ahead. Certain of these market participants use narrative disclosures as an aid in understanding a business. The primary objective of these market participants, however, remains to predict OPMI market prices over the near term rather than to understand a business.
Given these differences in purposes, it is not surprising that corporate disclosures are used quite differently in fundamental finance from how they are used elsewhere. In fundamental finance no one type of disclosure is of overriding importance. The entire mix of information counts. The information that is most important varies on a case-by-case basis, so timeliness of disclosures is not a matter of material consequence, although it always is for other disciplines, relative completeness of disclosures is always a matter of material consequence.
NARRATIVE DISCLOSURES IN THE UNITED STATES
In the United States, as nowhere else in the world, written disclosures are comprehensive and reliable. As a matter of fact, the very comprehensiveness and reliability of these disclosures make them essential working tools for all types of creditors and investors, from commercial-bank lending officers to individual common stock investors. The key disclosure documents for creditors of, and investors in, public companies are those issued pursuant to rules and regulations promulgated by the Securities and Exchange Commission.1
These frequently crucial documents disclose information in two forms—financial statements and narratives. Our primary interest in this chapter is in narrative disclosures. As far as mailings and website postings to securities holders and filings with the Securities and Exchange Commission (SEC) are concerned, there are three general types of disclosures that are highly important for investors following a fundamental finance approach.
Freewheeling Disclosures from Which Management Opinions and Management Styles Become Evident
These documents include:
The limits on what can be stated on a freewheeling basis by a management whose comments are reviewed by securities’ counsel, as most of them are, loosely follow the strictures on free speech that are imposed by Regulation 10b-5 of the amended Securities Exchange Act of 1934. The scope of permissible insider disclosures has been expanded by the Safe Harbor Act (under the Private Securities Litigation Reform Act of 1995) so that now, subject to hedge clauses, managements are freer to make forecasts. Regulation 10b-5, however, remains a dominant consideration. The relevant portion of 10b-5 states,
It shall be unlawful for any person . . . to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading . . . in connection with the purchase or sale of any security.
Often, CEO letters in ARSs and quarterly reports allow management to take credit for what goes right while blaming uncontrollable circumstances for what goes wrong.
Stereotypical Filings with the SEC
Principal documents of the paper trail include:2
These disclosures are prepared by attorneys who often follow slavishly the forms embodied in SEC Regulations S-K. A common mind-set in preparing these disclosures is that the quantity and quality of disclosures should be such that lawsuits are avoided.
The use of SEC disclosures is the key to our fundamental finance approach. Indeed, there seems to be an almost symbiotic relationship between SEC-prescribed disclosures and our approach in that the SEC seems to make special efforts to provide the types of information that are most important to us.
The presence or absence of encumbrances is almost always spelled out in SEC documents to those who carefully read financial statements (including footnotes), especially audited financial statements. SEC disclosures also permit insights into management character at least insofar as their relationships with security holders are concerned. Information about these matters is contained either in proxy statements for annual meetings, or when proxies are not solicited, in Part II of Form 10-K, the company’s annual report filed with the SEC. The proxy statement and Part II of the 10-K contain descriptions of management remuneration, certain transactions with insiders, and in proxy statements where shareholder votes are solicited, proposals designed to insulate management in office. Also, financial statements, Form 10-K and Part II of Form 10-Q (the quarterly report filed with the SEC) contain disclosures on litigation. All these items give evidence to analysts about management attitudes and management character.
Neither academics, whether economists or finance professors, nor securities traders seem to appreciate just how useful these documents are. This failure can perhaps be explained by the fact that most of the critics have had virtually no experience in preparing the documents required by the SEC. Document preparation has been left largely to investment bankers, practicing lawyers, accountants, and members of corporate managements. Although firsthand experience as a document preparer is not essential to understanding the uses and limitations of the paper trail, an investor (or critic) ought to comprehend how the preparers go about composing the materials that they must file with the SEC or mail to securities holders.
The first thing to remember is that there are few liars among document preparers. Virtually no professional accountant, lawyer, investment banker, or, especially, independent auditor wants even to be suspected of misleading investors, much less of fraud. The professionals whom we know and work with do not wish to risk their livelihoods and reputations for the benefit of third parties, such as managements and large stockholders.3 As a general rule, the information gleaned from the paper trail is truthful and reliable in stating whatever it purports to state.
This is not to say that all these documents are complete and accurate. There is shortcutting, but much of it is inadvertent. It is sometimes difficult for competent and honest document preparers to make appropriate judgments as to what are material disclosures. However, in our experience, important nondisclosures do not occur frequently. Some shortcutting is undoubtedly deliberate, but the outright frauds or possible frauds—Equity Funding, Stirling Homex, National Student Marketing, Westec, Enron, and WorldCom—seem few and far between.
Second, as we have already pointed out, in preparing documents, there are two well-established rules:
These antifraud provisions make it unlawful in connection with the purchase or sale of any security for any person, directly or indirectly, “to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.”4 The typical preparer of documents, therefore, is going to try to disclose, as truthfully as possible, everything he thinks is factually relevant. He will do this to avoid trouble, both from government regulators and from private securities holders whose attorneys may bring class-action suits, either derivatively or directly, to redress their grievances.
Understanding this is a large part of understanding why the paper trail is so useful. In most commercial and economic transactions, any sensible participant has to worry about the truthfulness of the other parties to the transactions. This is rarely a consideration for followers of the paper trail, who rely on written disclosures. It is as if the person contemplating the purchase of a used car could know that the salesman who says “This auto was only driven on Sundays by a little old lady going to church” is telling the truth. Being able to rely on the truthfulness of disclosures about publicly held corporations is of enormous help to any creditor or investor in coming to financial judgments.
Sources of Readily Available and Useful Disclosures in Addition to Freewheeling Disclosures, SEC Filings, and Security Holders’ Mailings or Website Postings
These sources include the following:
THE DOCUMENTS AND HOW TO READ THEM
In order to take full advantage of disclosure, the reader ought to have an understanding of what is contained in principal disclosure documents. The first and most important thing to do is to read them. Almost anyone, after carefully reading, say, five 10-Ks and four merger proxy statements, will have good insight into how their contents can help him in an investment program.
Second, the reader should obtain copies of the forms and the general regulations for the preparation of forms. Reading such materials will give good insight into what preparers go through to produce the various key documents. Investors pursuing an in-depth study of these forms can obtain copies of them as well as general instructions and guides for their preparation from the SEC website.5
There are other SEC filings that are occasionally important, but these are beyond the scope of this brief chapter. These include offering circulars under Regulation A and filings by insiders concerning their shareholdings and changes in holdings (Forms 3 and 4); and Form 144, filed by holders desiring to sell restricted stock under Rule 144. Form 13F, filed quarterly by institutional investment managers exercising discretion over accounts holding more than $100,000,000 of marketable equity securities, describes the securities held in those portfolios.6 Notices of various filings can be found in the SEC News Digest, a daily summary of SEC activities,7 including rules and related matters, announcements, registrations, and filings in connection with tender offers and 5 percent ownership; the SEC Docket, a weekly compilation of the full text of SEC releases; and the Official Summary, a monthly summary of securities transactions and holdings reported by insiders, taken from Forms 3 and 4 as filed.
Most documents—for example, annual reports, annual meeting proxy statements, prospectuses, and cash tender offers—are publicly distributed. The investor who wants to study any of these can easily find them and download them for free from the Company’s website or from the SEC website: www.sec.gov.
WHAT THE PAPER TRAIL DOES FOR THE OUTSIDE INVESTOR
Once all this information has been gathered, how useful is it? How limited? Though it is not particularly useful for the trader who seeks immediate market performance, we think it is extremely useful for all other investors, whether they be control buyers, distress investors, or passivists, who have a modicum of training in what to look for. The paper trail is especially useful in allowing those using the fundamental finance approach to arrive at very meaningful judgments most of the time.
This does not mean that the paper trail is perfect. Certainly it will not tell the creditor or investor everything he wants to know. Even so, unless the outsider has some special know-how or know-who, we think it is so good that he would do well to restrict his investments to securities covered by the paper trail. In fact, when we advise European clients about U.S. investments, we frequently recommend securities to them, rather than, say, real estate, precisely because the paper trail exists, and the disclosures it provides mean that other things being equal, an investment will involve a lesser element of disclosure risk than one in any non-SEC filing enterprise.
For the followers of the fundamental finance approach, the paper trail is excellent, as we noted above, for pointing to junior tranche securities that because of poor financial position or insider avarice are unattractive at any price. But it is also highly useful in a more positive sense: An investor can obtain quite reliable assurances that a company’s financial position is strong and that insiders are not overreaching, or based on past performance, are likely to overreach in the future.
In effect, much of the entire SEC narrative disclosure process and many of the disclosures of financial accounting are directed toward informing investors about corporate obligations. Stockholder annual reports, 10-Ks, 10-Qs, 8-Ks, and where issued, other documents will give investors strong clues to the encumbrances attached to a business entity. Particularly important in this regard are audited financial statements, including the auditor’s certification and the footnotes to the financials. Descriptions of on-balance-sheet debt and footnote descriptions of encumbrances, including balance sheet items, pension plan obligations, and contingent liabilities, tend to be carefully and accurately done.8 Indeed, it appears to us that the footnotes to audited financial statements provide an excellent road map to analysts seeking to undertake a “due diligence” investigation, where the analyst seeks both public and nonpublic information.
Auditors’ certificates are particularly important as attestations that have become increasingly carefully worded in recent years. Such attestations are either clean—presented without qualification—or subject to certain conditions. Additionally, there are what in effect are nonattestations, namely adverse opinions or disclaimers of opinions. Clean opinions, as distinct from certain but not all subject-to opinions, adverse opinions or disclaimers of opinions, are important in giving comfort to investors following the fundamental finance approach; such investors are unlikely to be interested in a junior security on the basis of an opinion subject to a serious qualification (such as “subject to the ability to continue as a going concern”), or on the basis of an adverse opinion or of a disclaimer of opinion.
The encumbrances that are missed by the paper trail tend to be those that sometimes even the insiders are unaware of. One example is a business that enjoys a strong financial position only because it fails to make needed expenditures to modernize, expand, or replace outdated facilities. In such cases, a strong financial position is deceptive, and the strong balance sheet will tend to be dissipated in future years as the business suffers large operating losses, embarks on massive catch-up capital expenditure programs, or both. (This is precisely what happened in the cement industry in the late 1950s and early 1960s.) Nonetheless, it has been our experience that most of the time, the paper trail does disclose enough, so that the investor’s estimate of what the total encumbrances will prove to be are relatively accurate.
The paper trail is also fairly good in giving clues about insider overreaching. Proxy statements for annual meetings at which directors are elected contain disclosures about management remuneration,9 about borrowings by insiders from the company, and about certain transactions—dealings and participations between the company and its insiders. In addition, the long-term record of management is revealed, and this is helpful to analysts who tend to believe that behavior patterns probably do not change much, if at all.
EXAMPLE
Since the management of Rapid American Corporation forced out minority shareholders of Schenley Industries in 1971 at what we believed, from examining the 1971 proxy material, was a grossly unfair price, we concluded that we would rather not be an outside investor or creditor in any company controlled by the Rapid American management, albeit there was nothing illegal about the Schenley Industries force-out.
True, much past insider overreaching may escape disclosure in the documents of the paper trail. Certainly the documents as they exist today leave few clues concerning such matters as the prevalence of widespread nepotism at levels below parent-company officers and directors. Yet, there appear to be sufficient data, so that the outside investor can make reasonable judgments about the character of the insiders, at least insofar as it affects actual or proposed investments.
An investor may decide that a security meeting the criteria of a fundamental finance approach is attractive because of additional considerations. The paper trail will help him uncover these other attractions, perhaps providing hints that future earnings might increase dramatically; that large cash distributions to stockholders are likely; that a company is a takeover candidate; that it is likely to be liquidated or recapitalized in whole or in part; or that a security is priced inexpensively compared with other companies, based on its history.
The paper trail can provide information that is crucial to assessing each of these factors. The knowledge gained from it about a company’s business and operations provides a reasonable basis for making judgments about future earnings, cash returns, and risk. Information about who owns the company’s stock, who is acquiring it and what resources the company has may tell whether or not it is a likely candidate for a takeover, or for a liquidation or recapitalization.
As we stated before, the paper trail enables an investor using the fundamental finance approach to pinpoint those securities that are unattractive at any price. The statement that everything has a price at which it is a bargain is, as a practical matter, simply not true when it comes to investment. Junior securities—especially those that are pure residuals, such as common stocks and warrants—may be in such a hopeless position that they are likely never to have a value high enough to compensate for the costs of ownership. This may happen in one of two situations. The first is where the financial position of the company is so bad that whether the company is in bankruptcy or not, the entire business has to belong to the creditors.
The second situation in which equity securities should be avoided at any price is that of a going concern with an entrenched management whose prime objective is to milk the company for personal benefits at the expense of the security holders. By far the best way to pinpoint such a situation is to follow the paper trail.
WHAT THE PAPER TRAIL DOESN’T DO
The principal shortcoming of the paper trail stems from the fact that it is designed and used to provide material disclosures of hard information. Soft information, such as company forecasts, company budgets, and valuation appraisals of assets—for example, appraisals of the value of income producing real estate—are not disclosed.10 This is principally because much soft information is a tool for stock market manipulation.
The SEC, however, has expanded the promulgation of soft information through new rules and regulations. A breakthrough in requiring soft information probably occurred in 1976 when the SEC, for the first time, required companies with inventories and gross property, plant, and equipment aggregating more than $100 million and comprising more than 10 percent of total assets to provide supplementary data in the 10-K about estimated replacement costs (Accounting Series Release 190, dated March 23, 1976). In 1978, the SEC proposed guides that permitted and encouraged projections of financial information by companies. These forecasts were to be made voluntarily, and forecasters were to be given a safe harbor, that is, they generally would not be held liable under the federal securities laws for reasonably based projections that did not work out (Exchange Act Releases 15305 and 15306, dated November 7, 1978). Also, in Accounting Series Release 253, dated August 31, 1978, the SEC adopted requirements for supplemental disclosures for fiscal years ending after December 25, 1979, of the valuation (and changes in valuation during the year) of certain companies’ proved oil and gas reserves; this is a method of accounting the SEC calls reserve recognition accounting, or RRA.
Sometimes this soft information may be vital to understanding a business, either as a resource conversion enterprise or as a going concern.
EXAMPLE
In early 1976 Tishman Realty announced liquidation plans. Without knowing the prices at which Tishman’s real properties could be sold, there was no realistic basis for judging the merits of Tishman as an investment; and without real estate appraisals of the individual properties, it was extremely difficult to approximate these prices.
EXAMPLE
Another example is Duplan Corporation, which in early 1976 found itself in serious financial trouble, its very viability threatened unless it could become profitable in six months to a year. Here, management forecasts and budgets were crucial to anyone contemplating becoming an investor in or creditor of Duplan.
There are many other kinds of information besides management forecasts, budgets, and asset appraisals that the paper trail fails to disclose. For example, there are no disclosures of merger and acquisition discussions that never reach a definitive state. There rarely will be information about comparative cost analysis, comparative security prices or comparative market penetrations within an industry. Ordinarily, outsiders do not know what a company ought to spend on plant equipment or inventory in order to remain competitive. The paper trail rarely includes disclosures of detailed special studies in areas such as marketing or engineering. Nor will there be information about long-festering internal disputes among management. Occasionally, even obviously material hard information may be lacking.
EXAMPLE
Companies may provide only consolidated financial statements in situations where such statements would be less informative than consolidating or company-only statements. (In consolidating or company-only statements, information about the parent company and individual subsidiaries is disclosed, whereas such information is not shown separately in consolidated statements.)
There may even be situations that the paper trail misses entirely.
EXAMPLE
An example would be a very small acquisition that does not require a stockholder vote. If such a vote were required, proxy statements would be mailed to shareholders. Without a proxy or 8-K filing, the financial statements and descriptions of the companies being acquired would not be available at all from SEC filings.
It is important to note, of course, that the lack of soft information on the paper trail is a much less serious shortcoming for the long-term investor than it is for the trader. For the trader, a near-term earnings forecast or dividend action may be the only disclosure of interest. The long-term investor, especially the investor whose analysis rests on the fundamental finance approach, is resource conscious; the hard information disclosed by the paper trail is of great importance to him in virtually all his evaluations. Furthermore, for this investor an apparent low price relative to an estimate of the resources in the business can compensate for the risks inherent in knowing less about a company than would be optimal. This safety valve does not exist for the trader who is seeking the best possible near-term market performance.
HOW GOOD IS THE PAPER TRAIL?
The SEC paper trail provides the investor with a stereotyped format. The disadvantage of the stereotyped format, of course, is that following a form frequently results in inadequate descriptions of reality and inadequate weighting of what is important. The principal advantage is that the reader can be assured that the professional preparers are striving to see that the documents do not omit material statements and do not contain material mis-statements. In addition, the investor who uses stereotyped documents becomes a very practiced reader and can obtain vast quantities of information merely by skimming, because he knows what to look for and where to look for it.
On balance, our appraisal is that most of the time the paper trail is excellent. We have reached this conclusion in large part on the basis of our experience in conducting in-depth analyses for companies that retain us. In these situations, the companies provide all the data we want and do studies to generate any necessary data that is otherwise unavailable. Invariably, these in-depth analyses have been materially easier to do and more meaningful for users when we have had SEC documents available as a source of information and as a check against other information received. We are sure this holds true also for virtually all other analysts doing comparable studies. This points up, incidentally, one of the more important social and economic benefits to the United States from the paper trail: It has uplifted the standards of analysis, making it infinitely easier to conduct meaningful analyses for all sorts of appraisers, from commercial-bank lenders to government officials, who may not be interested in securities markets per se or common stock investing at all.
Of course, the paper trail is always going to be more useful for some kinds of companies than for others. For example, for large, stable, dividend-paying companies, such as Graham and Dodd’s theoretical list of the one hundred highest-quality issuers, the paper trail probably imparts more information to outside investors than they care to know. On the other hand, in areas where GAAP are not an overly useful tool—such as in the analysis of extractive industries, real estate development companies, and emerging issuers—the nonaccounting disclosures of the paper trail are not going to be too useful either. For the whole range of companies in between, however, the paper trail is a godsend.
Anyone who follows the paper trail must, of course, appreciate what it cannot do for him. First and foremost, much of the world is unknown and unpredictable. Thus, forecasting will always be an art. Second, the paper trail is probably not of much help in gaining insight into immediate timing and immediate performance in the stock market. Obviously, there is no way the paper trail is going to disclose intimate secrets of activists and their plans, which are frequently formulated no place else but in their minds. Nor does it provide anyone with know-who, even though it does tend to give the background that makes it easier to obtain.
The paper trail does not provide full disclosure, and never can. Like any other analytical tool, it has its limitations. But for the investor who concentrates on our approach, the paper trail is going to be the essential starting point for his analysis almost all of the time. In some instances, the paper trail is all he or she will ever need.
SUMMARY
Narrative disclosures are used in fundamental finance as tools for gaining understanding of a business—its operations, values, problems, potentials, and long-term management direction. In the United States, as nowhere else in the world, written disclosures are comprehensive and reliable. The key disclosure documents for creditors of, and investors in, public companies are those issued pursuant to rules and regulations promulgated by the Securities and Exchange Commission (SEC). There are three broad types of disclosures used in due diligence investigations: (1) freewheeling disclosures from which management opinions and management styles become evident; (2) stereotypical filings with the SEC; and (3) other sources of information. We provide a detailed description of the three categories. For the followers of the fundamental finance approach, the paper trail is excellent. In effect, much of the entire SEC narrative disclosure process and many of the disclosures of financial accounting are directed toward informing investors about corporate obligations. The principal shortcoming of the paper trail stems from the fact that it is designed and used to provide material disclosures of hard information, which turns out to not be very useful in analyzing the entities engaged in exploration, discovery, and new inventions. On balance, our appraisal is that most of the time the paper trail is excellent.
* This chapter contains original material and parts of the chapter are based on material contained in Chapter 10 of Value Investing by Martin J. Whitman (© 1999 by Martin J. Whitman), Chapter 6 of The Aggressive Conservative Investor by Martin J. Whitman and Martin Shubik (© 2006 by Martin J. Whitman and Martin Shubik), and ideas contained in the 2006 4Q letter to shareholders. This material is reproduced with permission of John Wiley & Sons, Inc.
1 Although SEC disclosures are crucial for most analyses of public companies, they are far from the only disclosure documents that may be important in a given situation. The others, however, are beyond the scope of a book. Chapters 32, 33 and 34 of Volume II of the Financial Analyst’s Handbook, ed. Sumner N. Levine (Homewood, IL: Dow Jones-Irwin, 1975), 852 are excellent overviews of the types of public non-SEC disclosures that are generally available. Chapter 32, by Dorothy Hennessey Sussman, is entitled “Information Sources—An Overview.” Chapter 33, by Sylvia Mechanic, is entitled “Key Reference Sources.” Chapter 34, “A Guide to Industry Publications,” is a reprint of a brochure originally issued by the New York Society of Security Analysts.
2 For a comprehensive description of each of these forms and the instructions on how fill them see http://www.sec.gov/about/forms/secforms.htm.
3 We are convinced this remains true despite what we consider to be the Supreme Court’s unfortunate language in regard to Section 10b-5 in Ernst and Ernst v. Hochfelder 425 U.S. 185 (1976).The vast majority of financial professionals appear to us to be honest and ethical because they want to be, not because they have to be.
4 10b-5 is part of the Securities Exchange Act of 1934 as amended. Prospectus preparers operate under similar and additional strictures growing out of Section 17 of the Securities Act of 1933 as amended. In addition, there are similar strictures existing under other parts of the Securities Exchange Act of 1934 as amended. But 10b-5 is the catchall of the antifraud regulations, covering situations not otherwise enumerated specifically.
5 www.sec.gov/about/forms/secforms.htm.
6 For a comprehensive list of forms and their descriptions go to: www.sec.gov/about/forms/secforms.htm.
7 www.sec.gov/news/digest.shtml.
8 Though perhaps not part of any glossary, on-balance-sheet items commonly refers to assets or liabilities stated directly on a balance sheet, whereas off-balance-sheet disclosures usually refers to information about assets or liabilities disclosed in footnotes to financial statements.
9 The management remuneration section of a proxy statement (or Part II of a Form 10-K) will contain information not only about salaries, but also about all other types of remuneration, such as stock options, stock-appreciation rights, pension plan benefits, bonuses, profit-sharing plans, and employment contracts. The SEC also requires that information about management perquisites, such as company hunting lodges or the use of company planes for private purposes, be disclosed.
10 This is true under GAAP but not under IFRS used by all non-U.S. companies owning income-producing real estate. Such assets under IFRS are carried at appraisal value unlike GAAP where income-producing real estate is carried at depreciated cost less impairments.