In previous chapters of “Book of Value: The Fine Art of Investing Wisely,” Anurag Sharma provided tools that allow investors to test their investment cases (or "theses," as the author puts it). Testing is part of the process of trying to negate or refute our pre-existing ideas about a stock.
In chapter 16, he explained how we can use a company’s literature as we further try to refute an investment case. If a case is refuted, then we place less confidence in it; if we cannot refute it, then our confidence in it will be heightened.
The single most important piece of literature, according to Sharma, is the annual report, the 10-K. In addition, there are also quarterly reports (10-Q), current reports (8-K) and proxy filings (DEF 14A). For example, here is a link to the Walmart 10-K (WMT, Financial) for the fiscal year that ended Jan. 31, 2018, and its masthead:
While many investors focus on the financial statements, for good reason, I also find it helpful to read and consider the management discussion and analysis section. For those of us who are not mathematically inclined, it provides information in words and ideas.
Between financial statements and other materials in the annual reports, there is an ocean of information. How do you cope with it all? Sharma recommended that you be clear about what you’re looking for and go directly to the specific information you need (those specifics are listed in following chapters).
To that, I would add the use of the find function of your browser. For example, if I want to know about the international side of Walmart’s business, I would simply do a quick search for that term in the 10-K. Depending on how much information you want, you can use search terms with fewer or more words.
And why are we doing all this? Sharma wrote, “The objective of the qualitative analysis is to try to cast doubt on the defining narratives of the company. We will try to do so on three broad fronts.” Those three broad fronts are the three topics discussed in chapter 15. They are the yield, the stability of the company and its financial strength.
Sharma took on financial strength in chapter 17, telling us that we want to look for problems that are not immediately obvious, but could undermine a company’s financial strength. To find them, he starts with the balance sheet and five important factors:
- Operating leases.
- Pension and post-retirement obligations.
- Litigation and lawsuits.
- Off-balance sheet liabilities.
- Quality of assets.
Operating leases: Often used as an alternative to buying property or assets, leases are contractual obligations like interest payments on debt. The danger is that companies will try to make their finances look better than they are because leases are not included in debt ratios, nor on the balance sheet. At the time this book was being written, Sharma reported that the rules might change to make operating leases explicit liabilities. It appears that happened in 2016, so investors no longer need to search the footnotes for that information.
Pension and post-retirement obligations: Traditionally, companies used defined benefit plans (DBPs) to handle pensions and benefits. That puts all responsibility on the company and means it assumes liability for all current and future deficits. Investors will look for “projected benefit obligations.” Keep in mind that PBOs are based on actuarial estimates and are thus open to error and manipulation.
Litigation and lawsuits: Many lawsuits faced by companies are considered a cost of doing business and they are settled out of court. However, there are some that become very serious matters. For example, Armstrong World Industries, a 100-year-old blue-chip, filed for bankruptcy in 2000 because of asbestos-related lawsuits, 173,000 of them. It’s difficult to know in advance how many lawsuits are minor and how many might lead to potential bankruptcy. One sign is the size of the reserves the company has set aside.
Off-balance sheet liabilities: Sharma called such liabilities “akin to hidden bombs that can destroy a company and your investment in it.” A classic case of this was Enron, which was built on special purpose entities that allowed it to control assets without recognizing the debt needed to acquire them. Many prominent banks were almost wiped out by similar tactics in the years leading up to 2008. Such legal or illegal maneuvering, if it exists, can be found in the fine print of mandatory filings.
Quality of assets: When accountants put together annual reports, they may aggregate the values of many assets, including plant and property. Sometimes the assets are recorded at their historical costs, making those valuations very subjective and disconnected from actual values. In the financial industry, some instruments also lose their connection with reality. When people invest in banks and financial institutions, they often assume that the quality of loans is uniformly acceptable. However, that may not be true, as we discovered in 2007 and 2008.
Sharma summed up the chapter with this warning: “For investors practicing the fine art of investing wisely, a careful scrutiny of the balance sheet and associated risks is an indispensable part of due diligence.”
Getting back the bigger picture, the goal is to try to refute the case for investing in a specific company. If a company falls short in any of the five areas above, then we would have reduced confidence in the investment thesis. At a certain point, confidence might fall to the point where we would simply reject an investment in its stock altogether.
Conclusion
In chapter 16, Sharma argued that investors should continue their efforts to refute an investment case by studying the company and its financial statements. To ease the information burden in dealing with the statements, search for specific types of information. Examples of such specifics were shown in the financial strength analysis for chapter 17.
It saw the author list five areas where bad news about a company’s financial strength might be out of sight or even hidden. By checking each of these areas on the balance sheet, investors can avoid companies that might be carrying hidden bombs.
Disclaimer: This review is based on “Book of Value: The Fine Art of Investing Wisely” by Anurag Sharma, which was published in 2016 by Columbia Business School Publishing. Unless otherwise noted, all ideas and opinions in this review are those of the author.
Read more here:
- Book of Value: 3 Tests of an Investing Case
- Book of Value: A Better Approach to Discount and Growth Rates
- Book of Value: Flaws in the Academic Approach to Risk and Uncertainty
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