How to Get the Most from an Annual Report

Someone who reads my articles asked me this question:


I've been having trouble analyzing companies. Whenever I read annual reports, I feel as if I am drinking from a firehouse and there is just so much going on, it is hard for me to discern what I need to be focusing on, or what should be telling me that I am learning about a good company.


When I first started investing, I was very checklist oriented — especially the Ben Graham Enterprising and Defensive Investor checklists — because those two lists gave me a rundown of what a suitable company was. However, I feel as if just purchasing a company that passes all of Graham's Enterprising Investor points is too easy. When doing that activity, there really is no analysis of a living/changing company.


Whenever I read other investors' stock write-ups, I am always impressed/jealous of how they were able to pick apart what mattered the most and what it means in terms of the company's prospects and valuation range. I know reading another value investing book isn't going to help me. So I was wondering, after plowing through as many annual reports as possible, does one eventually get a grasp of how to analyze a company? I've been reading about value investing since September/October 2008 and I feel as if I've been running in place over the last year.


Thank you very much,


Will


That’s a terrific question. First of all, you don’t have to give up checklists. If you read Phil Fisher’s "Common Stocks and Uncommon Profits” there is a good example of a checklist – 15 points – that is far from easy to answer quantitatively. It could take you a very long time to learn about a company and answer Fisher’s 15 points. But it gives you something to focus on.


Warren Buffett’s Checklist


Likewise, Warren Buffett’s entire investment philosophy can be boiled down into this checklist:


1. Simple Business


2. Favorable Long-Term Prospects


3. Able and Honest Management


4. Consistent Earnings


5. Good Return on Equity


6. Little Debt


7. Very Attractive Price


You could certainly sit down with that checklist and try to answer all seven questions for every company you analyze. You can keep a file with your notes on each point.


Value Line


This is an expensive education for most people. A subscription to Value Line is over $500 a year – and you can find all the data for yourself online. So how can I suggest subscribing to Value Line for a while?


Because of the way the data is presented. Once you’ve paid that kind of money for some crinkly paper stuffed in your mailbox every week – you’re committed to reading it.


Value Line presents about 130 companies a week. They go through a full cycle every quarter. It’s a very good way to see the historical development of a lot of different companies you’d never look at. I highly recommend it to anyone who feels overwhelmed reading annual reports.


Historical data – truly long-term historical data – is a great way to learn about businesses. You see similarities in what makes a good business and what makes a bad business. Often you see similarities between companies you thought had nothing in common. Their industries couldn’t be more different. But, in both cases, you see how important on time delivery is to the customer. How they aren’t so worried about price as long as they get the right part at the right moment.


That’s a simple example. But it’s the kind of common thread you’ll find running through a lot of success stories. When you read Value Line and see a company you expect to earn consistent, high returns on capital – and it doesn’t – investigate why the business reality isn’t as good as you imagined. And vice versa. Especially look for great companies in industries you thought were awful.


If you can’t understand how some distributor can earn those kinds of returns on equity year after year – investigate it. But come with that specific question. How can a distributor make this kind of money?


Don’t just read the annual report without an avenue of investigation in mind.


Next, go to Sequoia’s website. Read their annual reports. And especially read their investor day transcripts. They don’t own very many stocks. And they hold them for a long time. So, whenever they mention a stock, that’s something to consider reading about. But start with their take on the company. Then go to the company’s annual report and see if you can see anything in that report that paints the same picture Sequoia is seeing.


Business Books


Next, buy these books:


Hidden Champions of the 21^st Century


Common Stocks and Uncommon Profits


Built to Last


Good to Great


How the Mighty Fall


Great by Choice


Put them on your shelf. Read them each a couple times. Most investors aren’t reading these books. They are very helpful. There are a few key insights you’ll get from these books. Write them down. Apply them.


Warren Buffett’s Reasons


Next, look at some of Warren Buffett’s investments. Focus on the one or two reasons that explain each purchase:


Coke (KO)


1. Rising per capita Coke consumption in foreign countries


Buffalo Evening News


1. High penetration rate


2. Duopoly about to become monopoly


See’s Candy


1. Pricing power


GEICO


1. Low cost operator


2. Market big enough to allow for decades of fast growth


Next, if you read my articles – you’ll notice I mention the same stocks over and over again. There’s a reason for this. I only mention stocks I know a bit about. And I only know a bit about a stock because there was something interesting about it. A low price alone is usually not enough to interest me. So, when I mention companies like:


· Dun & Bradstreet (DNB)


· CEC Entertainment (CEC)


· Village Supermarket (VLGEA, Financial)


· Bio-Reference Labs (BRLI, Financial)


· DreamWorks (DWA, Financial)


Read these reports. Look for something that might have interested me. Why would Geoff look at DNB, Chuck E. Cheese, etc.? What got him interested in the stock? Do I see the same thing?


Whenever possible, also read the quarterly earnings call transcripts. You can listen to them too. But it’s easier if you read them and listen to them.


Just listening is a bad idea.


Whenever I can get a transcript of anything – even Warren Buffett’s appearance on CNBC – I’ll keep a copy of the transcript even when I have a copy of the video (or audio). You can refer back to a transcript easily. You can highlight. You can take notes.


Taking Notes


Now, you are doing those things when reading an annual report, right?


You never just sit down and read an annual report. You always sit down with a pen, a highlighter, a pad of paper, and a calculator. Use the margins of a 10-K – or your pad of paper – to jot down notes. Ask questions. Do calculations.


If you ever see a 10-K after I’ve read it – it’s not very white anymore. There’s lots of stuff written in the margins. Mostly it’s questions I was asking myself. But it’s also calculations of numbers the company does not provide.


Numbers to Know


So, for example, in a bank’s 10-K I always write down:


· Deposits per share


· Deposits per branch


· Cost of deposits


· Texas Ratio


You can actually look up the Texas Ratio of any bank here. And some banks calculate and report cost of deposits the way I like to think about it. But, it’s not common for banks to report deposits per branch – although small banks will sometimes mention (perhaps in the shareholder letter) what their biggest branch has in deposits. Others may mention how quickly new branches achieved a deposit milestone.


Those are the kinds of numbers I write in the margins of a bank’s 10-K. There will be questions like: “Why is efficiency ratio so low?”, “Why aren’t they reserving more?”, etc. Sometimes, you will get an answer to these questions in the shareholder letter or management’s discussion in the 10-K. Often, you won’t.


But when companies follow unusual practices – holding lots of inventory, keeping expenses very low, focusing on specific kinds of clients, operating stores of unusual size, etc. – they will tend to explain and defend their strategic choice somewhere in the 10-K. This is especially true if there might be criticism of the approach.


Hudson City


For example, a bank might explain why they choose to focus on a certain area – as Hudson City (HCBK, Financial) does here:


“Through our branch offices, we have operations in 10 of the top 50 counties in the United States ranked by median household income. Operating in high median household income counties fits well with our jumbo mortgage loan and consumer deposit business model…The northern New Jersey market represents the greatest concentration of population, deposits and income in New Jersey. The combination of these counties represents more than half of the entire New Jersey population and more than half of New Jersey households. The northern New Jersey market also represents the greatest concentration of Hudson City Savings retail operations – both lending and deposit gathering – and based on its high level of economic activity, we believe that the northern New Jersey market provides significant opportunities for future growth.”


Village Supermarket


Or they could explain why they operate especially large stores as Village Supermarket (VLGEA) does here:


“These larger store sizes enable the Company’s superstores to provide a ‘one-stop’ shopping experience and to feature expanded higher margin specialty departments such as home meal replacement, an on-site bakery, an expanded delicatessen including prepared foods, a variety of natural and organic foods, ethnic and international foods and a fresh seafood section. Superstores also offer an expanded selection of non-food items such as cut flowers, health and beauty aids, greeting cards, small appliances and, in most cases, a pharmacy. Recently remodeled and new superstores emphasize a Power Alley, which features high margin, fresh, convenience offerings such as salad bars, bakery and Bistro Street home meal replacement in an area within the store that provides quick customer entry and exit for those customers shopping for today's lunch or dinner.”


ADDvantage Technologies


Or they could explain why they hold so much inventory as ADDvantage Technologies (AEY, Financial) does here:


“We market ourselves as an “On Hand – On Demand” distributor. We maintain a wide breadth of inventory of new and used cable television products and many times can offer our customers same day shipments. Even though we have been decreasing the amount of inventory we carry, we still carry one of the most diverse inventories of any cable television product reseller in the country, and we have access to inventory via our various supply channels. We believe our investment in on-hand inventory, our product supply channels, our network of regional repair centers and our experienced sales and customer service team create a competitive advantage for us.”


Bio-Reference Laboratories


Or they could explain why their margins are lower as Bio-Reference Labs (BRLI) does in their letter to shareholders:


“Why do we grow? We pay for growth. Sales and Marketing expense for FY2010 remained over 9% of total revenue and, in fact, it was actually about 50 basis points higher than in recent years. Our margins are not the same as other laboratories. We spend money on service. We spend money on informatics. We spend money on science. Our Sales and Marketing group is specialized. Not all physicians are the same. Not all of our sales representatives are the same. They are all trained for one specific expertise that allows them to succeed and their managers and support staff allow them to remain focused on very specific targets.”


How Companies See Themselves


All of these discussions give some insight into the business. More importantly, this is subjective data you’re getting. Objective industry data does not give you a clear idea of how a company sees itself. Often, in its annual report, a company will reveal as much about its perception of itself as it will about the facts. This is very important because you are looking for situations where a company’s perception and reality coincide.


There are some wonderful companies out there with managers who have no idea why they are so profitable. You have some of the widest moat businesses in the world being run by engineers. That’s fine. But if their competitive advantage has little or nothing to do with engineering – it just required some engineering to create it in the first place – then those managers need to have very good non-engineering insights.


One of the reasons I’m interested in DreamWorks Animation (DWA) is because I think they have the best CEO – Jeffrey Katzenberg – for running a family entertainment company because he understands the intersection of business and story better than anyone else. For a company working on such few (but so huge) projects at any one time, a good storyteller would make a bad CEO. And a good CEO might very well make a bad storyteller.


By the way, I don’t worry as much about a manager’s competence as most people do. I think skills are overrated. And principles are underrated. So, I’m interested in knowing what a company thinks its principles are.


In cases like Google (GOOG) , where I’m uncertain that the company’s principles have anything to do with its profits – I have to knock a lot of value off the number I’d value the stock at based on its cash flows alone. Because you have a culture there that probably is not the one I want allocating my capital.


In general, whether I like and admire the management and the company’s principles usually does not make a difference. There are people who I would not want to get stuck in an elevator with who I’m perfectly happy running a company I own shares in. It depends on the company’s situation. Usually, the most important issue for a CEO is capital allocation. Sometimes a CEO – especially a founder – can be very important in other respects too.


By the way, when I say capital allocation I also mean matters like whether the company sees itself as a “growth company” or not. This is really a capital allocation decision that has been intentionally transformed into a cultural trait.


This illustrates the most important point about reading 10-Ks, shareholder letters, CEO interviews, earnings call transcripts, etc.


Ask Questions


You need to ask questions.


Your job is to focus on a few key factors. Focus on things you think are really important. Ask questions. And try to make them questions you have a chance of answering.


For example, I happened to be looking at Murphy Oil (MUR, Financial) recently. There are a lot of questions you could ask about the company. Some are answered in a few seconds. For example, their financial condition is strong. It takes two seconds to see this. So you just see it and move on.


But there are two tougher questions I focused on right away:


1. How expensive is Murphy – relative to other oil companies – when you compare their reserves to their stock price?


2. How much is Murphy’s U.S. gas station business worth?


Those were the two questions I thought were the best questions to ask.


Why?


For one thing, I can’t tell a great oil company from a not so great oil company. I can’t evaluate the company’s culture, management, etc. There was no way I was ever going to answer questions like that. But I can easily split Murphy’s U.S. retail business from its other operations. And I can compare that part of the company to other public companies like Pantry (PTRY) and Susser (SUSS). I can also – this is much harder – look at Murphy’s reserves and compare them to other oil companies’ reserves. The SEC now requires a standardized way of reporting discounted net cash flows for all oil companies. So, there’s certainly a specific number available for every company. Whether it’s a very good number or not depends on the assumptions the method uses.


Aren’t there a lot of other questions to ask about Murphy Oil?


Absolutely. But they are either things that don’t matter as much or things that matter a great deal but that I don’t think I can answer.


I can answer questions like whether the market is giving Murphy any credit for its U.S. gas stations or not. So I focus on questions like that.


That’s the way to deal with every annual report.


Focus


Focus on questions that:


· Are important


· You can investigate


· And you have some hope of answering definitively one way or another


Of course, most of the time you end up without finding an actionable idea. Maybe the company is slightly undervalued. But it’s only undervalued if your assumptions were justified and you’re not really sure if that’s true.


That’s why it’s easier to study companies in industries you’re already familiar with.


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