Here's how you can make your own covenants with the management teams of the companies you're invested in!

Wednesday: The Independent Investor FROM THE DESK OF MILES EVERSON: Hello, everyone! How are you doing? We hope you’re having a great week so far. Every Wednesday, we talk about various tips, insights, and coaching comments about investing, the stock market, the economy, and companies you might be planning to invest in. Our aim is to help you improve your financial decision-making and achieve financial stability in the long run. Today, we’d like to discuss with you the importance of LISTENING. Keep reading to know why such “verbal” agreements are as important as the written ones. CEO, MBO Partners Chairman of the Advisory Board, The I Institute

Here's how you can make your own covenants with the management teams of the companies you're invested in! Did you know that the concept of debt is far older than the concept of money? Basically, “debt” is just another term for “obligation.” According to Professor Joel Litman, Chairman and CEO of Valens Research and Chief Investment Strategist of Altimetry Financial Research, a lot of lenders have been introducing more stringent covenants back into debt agreements. That’s a great example of a non-monetary obligation. Covenant. BIG word. 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. According to Professor Litman, 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. So, 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 we would like to discuss today. The thing is, verbal covenants don’t have the same legal backing as a written document… but that doesn’t mean they’re not important, especially in the investing world. Investors ought to treat verbal covenants the way a bank treats written ones. These people should hold the same importance when deciding where to invest and keep their money. The Covenant Between Investors and Management Teams Investors also have covenants with companies’ management teams… and that starts with the earnings call, which is a critical tool to make sure management’s words match the numbers. At one of Professor Litman’s recent courses on valuation, he asked his audience a simple question: “Who here has ever bought a company's stock without listening to the earnings call first?” Unfortunately, most of his listeners raised their hands… and that’s not a good sign. Think of it this way: If your best friend asked you to invest USD 10,000 in his business, would you simply ask him to send the financials and then write the check? We hope not. Even with your best friend, you still need to have a conversation. Listen to his plans and strategy first before committing any of your hard-earned money. Sadly, many people write far bigger checks for stock investments every day without ever listening to earnings calls… and since they don’t listen to the pledges and promises, they have no way to follow up and hold management accountable later on. Professor Litman and his team use the Earnings Call Forensics (ECF) to not only analyze what management says in these calls but also how they say those things. It's one of the ways to tell how likely management is to ACTUALLY do what it says it will do. Allow us to share with you 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 U.S. Over the next two years, the company’s stock fell more than 60%. This could have brought the company down had management not 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 business one of the safest in its industry. In line with that, the company implemented a new system of food-safety interventions and supplier requirements. Chipotle hired food-safety gurus Jim Marsden and Dale Dexter to manage the programs. The 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. In such a scenario, it would have been easy for Chipotle to do all the wrong things—try to minimize the problem and fix things behind closed doors. However, the company kept communication open. By making pledges and living up to them, Chipotle regained the public’s trust. That led the brand’s stock to rise almost 700% from its lows. As you can see, Chipotle’s situation was a lesson for all management teams AND investors. Ells publicly stated his commitment to improved food-safety practices and had an OBLIGATION to investors to make these changes. So, that’s what he did. Meanwhile, investors who listened to management’s plan and saw that it was following through reaped the benefits when the company’s stock rebounded. In the end, both parties were able to benefit from the brand’s appropriate actions. Not only has Chipotle recovered, its investors were also happy with the outcome. The key takeaway here? Always listen to earnings calls for any companies you’re invested in! Keep in mind that these are the ONLY touchpoints you get. As an investor, 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 the team doesn’t deliver, it could be a signal that something worse is coming. Hope you’ve found this week’s insights interesting and helpful.     You can analyze a company to death, understand everything about it, and still lose money… if you don’t take into account how other players in the stock market think. Learn more about the importance of being a contrarian investor in next week’s article!