Value investors of all stripes need to be fluent in the language of accountancy. The only way to really understand a company is to get under the hood and read through its financial statements.
Warren Buffett (Trades, Portfolio) ascribes much of his early success as an investor to the fact that he would read through the Moody’s manual of listed companies. In a similar vein, I thought it would be useful to talk about the 10-K and how to read it.
What is a 10-K?
A 10-K form is the annual report that publicly traded (and even some private) companies must submit to the U.S. Securities and Exchange Commission (SEC). It discloses all the information that the SEC deems should be made available to investors, including balance sheets, income statements and statements of cash flow, as well as a summary of the business and other details.
They are important because they are usually the most comprehensive look that investors can get at what is happening inside the company, and they are generally more informative than presentations given to investors by management, as there is less room for obfuscation of the facts.
What should you pay attention to?
There is a natural tendency, at least from what I've seen, for investors to jump straight to the income statement when leafing through a 10-K. In my view, you should resist this temptation and instead spend some time reading through the description of the business first to get a feel for what it really does.
In particular, you may want to take note of what the various parts of the business are, how they interact with one another and how they have evolved and changed over time. Understanding how different parts of the business are grouped together, both organisationally and geographically, can give you an insight into what management really thinks about the company.
There are a few things that you need to figure out when reading this first section of a 10-K. Firstly, what is the best part of this company, the one that produces the lion's share of the cash flow? Businesses cannot survive for sustained periods of time without a reliable source of cash. Identify the cash generator and make a note of it for when you move onto the financial statement portion of the 10-K.
Secondly, what are the growth prospects in this business? You may be interested in a business purely from an income standpoint, and that is fine if you want to buy into a mature business that returns most of its cash to shareholders via dividends. But usually, investors are interested in capital gains as well as income, and for that you need growth. Has management highlighted an area where sales have increased over the last few quarters or years? Are they doing much better than other segments? Could this growing segment over time supplant the current core business?
And finally, you want to figure out what the main dangers posed to the company are. Management is required to be upfront with its investors, and what they list as a risk can also tell you a lot about their mindset. Is there a legal liability they are worried about? Supply chain disruption or bottlenecks? Competition? Make a note of all of these things.
Speaking of taking notes, I have found that writing notes as you go along is the best way to learn anything. I strongly recommend writing things out on paper, as I find my mind retains information much better this way than when I use a word processor, but to each their own. It may seem like overkill, but I promise this is better than simply reading a page and trying to memorise everything. This will serve you well when analysing the financial statements, which we will discuss in part two of this article.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Howard Marks: The Problem With Forecasters
- Why Peter Lynch Loves Volatility
- What Activist Investors Do, According to Bill Ackman
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