Warren Buffett (Trades, Portfolio) has a reputation for due diligence. Even though he also has a reputation for doing deals with nothing more than a handshake and one-page contract, he spends hundreds of hours before making these deals researching opportunities and considering the market position of the company compared to its competitors.
When considering his investment in Coca-Cola several decades ago, for example, it is rumored that he read the company's annual reports going back for a century, spending what must have been hundreds of hours trying to understand the business, where it was, where it had come from and where it was going to.
Annual report information
Annual reports can give you a great deal of information about a company, possibly more than the forms the Securities and Exchange Commission mandate, as these generally contain financial data on businesses, and they lack general nonfinancial details about companies. This is something Buffett has said in the past that he looks for when reading through an annual report.
Rather than just concentrating on the figures, he is looking for background on the business as well as the way the company presents its information to shareholders. Indeed, if he believes that the business is trying to withhold or camouflage information from investors, he has said that this can change his opinion of the company.
When picking up an annual report, Buffett wants to be able to see that management is being clear and transparent with shareholders, giving them as much information as possible, in the purest form without trying to mislead and take information out of context by using colorful graphics or an odd layout.
He spoke about this at the 2008 annual meeting of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) shareholders. "We see from that report whether the management is telling us about the things that we would want to know about if we owned a 100% of a company," the Oracle of Omaha stated when describing his process for reading an annual report.
"When we find a manager that does tell us about those things," he went on to add, "that is candid in the same way that a manager of a subsidiary would be candid with us, and talks in a language that we can understand, it definitely improves our feeling about investing in such a business and the reverse turns us off to some extent."
Buffett said that he wants to "understand the business better" when he's finished reading an annual report than he did when he picked it up, "and that is not difficult for a management to do if they wanted to do it."
The quality of management
This is yet another fascinating insight into Buffett's investment process. When it comes to interpreting a company's financials, Buffett's mind is second to none, but he also knows that no matter how successful a company is, its management is what really matters.
Determining the quality of management is vital for investment success, but this isn't easy. You can provide a limited assessment of the quality of a management team using qualitative factors. Instead, Buffett looks for markers that indicate the quality of management, considering everything, from their quality of correspondence to shareholders to actions and words (i.e., do they do what they say they are going to do?).
You could argue that this is probably his most exceptional skill: being able to interpret the quality of management by reviewing their correspondence with shareholders. It is certainly something that has contributed substantially to Berkshire's performance over the long term, and it is also something we can certainly incorporate into our own investment processes.
Reading annual reports might not be an attractive pastime for many people, but these documents can be hugely informative when it comes to assessing the quality of a management and how it corresponds with shareholders — something to consider before you make your next investment.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:Â
Warren Buffett: The Art of Asking Questions to Become a Good InvestorÂ
Warren Buffett: There Will Always Be Opportunities for Value InvestorsÂ
Finding Value the Jean-Marie Eveillard WayÂ
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