Broaden your knowledge by reading a lot.
That’s what you’re told.
And that’s the secret that Buffett tells anybody willing to listen and take up the challenge.
But let’s be honest. Reading the annual report is boring.
It’s filled with useless words like “innovative” and “industry leader.” In the S&P500 alone, there are 500 innovative industry leaders.
Maybe my math is bad, but that doesn’t add up.
The point is that annual reports are boring, unless you are Warren Buffett.
You invest in order to earn a rate of return and reading annual reports may not give you a huge edge, but it will help you make educated decisions about a company.
Seasoned investors know the gravity of reading SEC filings but even veterans may not know what beneficial information to look for because it is so disorganized.
So let’s take a look at four qualitative factors from the annual report you should look at.
Tip #1: Beware Fancy Charts in the Annual ReportsPhotographs and charts are great. It helps to visualize the data but some companies use it all wrong and sometimes in a purposefully sneaky way.
The problem with charts is not the data, but the way it is presented.
Look at this example below.
The Verna model is killing it with 56,486 units sold.
The problem is that the yellow explosion isn’t as big as it seems.
In fact, it’s really just 31.4% but the graph make it look like 40% or so. The intention of such charts is to make you think, “Wow the Verna is the most popular car. That should be my next car.”
Compare the above chart to a fair and balanced version below.
That looks much better. The big difference is that instead of making a statement of “the Verna model rocks!”, the message is now, “the Verna is doing much better than other models.”
A big difference in the message, no?
Next time you come across a chart in an annual report that is all full of bling, 3D and explosions of colors, ask yourself what the chart is trying to tell you.
Management wants to lead you into a particular line of thought to try and impress investors.
After all, what type of company wants to show that their company is suffering and in serious trouble?
Even the worst companies paint themselves in magnificent pictures.
Tip #2: Use the Letter to Shareholders as a Screen for CEO TrustabilityThe letter to shareholders is a great way to really get to know how the CEO presents his company to shareholders.
If you follow a stock, you know what problems the company has been going through.
Here’s what you want to ask yourself:
- Does the CEO discuss problems openly?
- Is the CEO defensive in his writing?
- Is the CEO too optimistic and making light of bad situations?
- Does the CEO refer to vanity numbers to make the business look better than it really is?
- Did the CEO deliver on what he is talking about?
You should also think about these questions while listening to conference calls.
Here’s an example of open and honest management of LAKE.
We have sold some real estate assets at book value. Jesus Christ, everybody is saying we’re not worth book value, but we can sell our real estate at book value. So if we can sell real estate at book value and you can collect receivables at their stated value, then you have cash. And again, you have people saying, “Well, if you’re a company with $100 million of cash but no EBITDA, you’re still worth nothing.” That’s their attitude. So what can I say? I guess we have to build up some EBITDA, and then they’ll have another reason why they can’t pay at the market price.Is there frustration? Yes.
But it’s coming from honesty and passion.
And that’s what you need to decipher when reading those letters to shareholders and conference calls.
Tip #3: Do Not Trust AuditorsAnother tip from Quality of Earnings is not to trust the statement from auditors.
Auditors are a double-edged sword.
You need them to sign off on the numbers, but the whole signing off process isn’t trustworthy.
When was the last time an auditor came out and blew the whistle on a company that was paying them millions?
I haven’t come across a single example.
In all cases where financial fraud was detected, the auditor signed off on it and then resigned when it blew up in their face.
Classic example is Enron. Their auditor was in on the action.
Tip #4: Check Consistency of FootnotesReading footnotes is important, but it’s a pain.
Footnotes are valuable and filled with information but the key is to look for consistency.
Important information is buried among 100 pages of tiny text and it is going to be a nightmare to try and keep up to date with past filings manually.
A tutorial to quickly detect changes in the footnotes has been written, but here’s a quick primer.
- Open up two consecutive years of annual reports on the SEC website.
- Copy and paste the html annual report into a word processing document.
- Save the two documents.
- Use the compare feature to open up both of the documents you just created.
- You get a final document with any changes that have been made highlighted.