The More You Listen, the More You Make

The concept of debt is far older than the concept of money...

Generally speaking, "debt" is just another term for "obligation."

I wrote just a few weeks ago that a lot of lenders have been introducing more stringent covenants back into debt agreements. That's a great example of a non-monetary obligation.

When companies borrow money from banks, the loan documents often have covenants. The borrowers are obliged to act – or not act – in certain ways defined by the loan officers and the bank.

For example, banks can add what are called "positive covenants" to a credit agreement. They can stipulate that the company needs to provide certain levels of financial reporting, like a monthly financial statement or a report on the status of its assets.

These types of covenants help steer the company in the right direction. If the bank sees any reason to be worried about the loan, it can quickly decide what to do next.

In essence, covenants are pledges. They can be written, as in loan covenant requirements in promissory notes. However, covenants can also be verbal... and that's what I want to discuss today.

Verbal covenants don't have the same legal backing as a written document. That doesn't mean they're not important.

As I'll explain, for investors, you ought to treat verbal covenants the way a bank treats written ones. They should hold the same importance when deciding where to invest and keep your money.

Investors have their own covenants with management teams... 

And it starts with the earnings call. It's a critical tool to make sure management's words match the numbers.

When management makes a statement about the business, strategy, or the team's intentions, it's creating a covenant with all of us as investors.

Sure, it's not a legally binding covenant, as in a loan document. However, it's still a covenant – a pledge – in the truest sense of the word.

At one of my recent courses on valuation, I asked the audience a simple question...

Who here has ever bought a company's stock without listening to the earnings call first?

Unfortunately, most of the audience raised their hands.

Think of it this way. If your best friend asked for a $10,000 investment in his business, I hope you wouldn't simply ask him to send the financials... and then write the check.

Even with your best friend, you'd still have a conversation. You'd listen to his plans and his strategy before committing any of your hard-earned money.

Yet people write far bigger checks for stock investments every day... without ever listening to the earnings calls. And because they didn't listen to the pledges and promises, they have no way to follow up and hold management accountable later.

I've written many times about Earnings Call Forensics ("ECF"). My team doesn't only analyze what management says in these calls. We also analyze how it says those things. It's one of the ways we can tell how likely management is to actually do what it says it will do.

You only get a few 'touch points' per year with management...

So you have to make them count.

Here's an example... Back in 2015, fast-casual food chain Chipotle Mexican Grill's (CMG) reputation was on the line. Its restaurants were dealing with a string of E. coli outbreaks across the country.

The stock fell more than 60% over the next two years. It very well could have brought the company down... if management hadn't taken responsibility for keeping shareholders in the loop.

Chipotle acted quickly and publicly to combat the outbreaks. Then-CEO Steve Ells committed to making the franchise one of the safest in its industry.

The company implemented a new system of food-safety interventions and supplier requirements. It hired food-safety gurus Jim Marsden and Dale Dexter to manage the programs.

The new safety team investigated each component and procedure used by the chain's suppliers. The public was the first to hear about each new finding and the subsequent changes.

It would have been far too easy for Chipotle to do all the wrong things in this scenario – to try to minimize the problem and fix things behind closed doors.

Chipotle kept communication open. It made pledges and lived up to them. It regained the public's trust. Today, the stock is up almost 700% from its lows.

Chipotle's situation was a lesson for all management teams... and investors.

Ells publicly stated his commitment to improved food-safety practices. He then had an obligation to investors to make these changes. That's what he did.

And the investors who listened to management's plan and saw that it was following through reaped the benefits when the stock rebounded.

This is your reminder to always listen to quarterly earnings calls for any companies you're invested in.

Again, these are the only touchpoints you get. Most everyday investors can't schedule a one-on-one meeting with the management team. So it's your job to hold management accountable for any obligations it extends during these calls.

If the team makes any promises about sharing business updates, hold those promises like a contract or a covenant. If management doesn't deliver, it could be a signal that something worse is coming.

Wishing you love, joy, and peace,

Joel
July 21, 2023