Avoid Losses with These 4 Simple Techniques When Reading the Annual Report


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Jae Jun

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What you will learn:

  • 4 tips to help you avoid losses
  • Simple techniques and discussions to think critically
  • A favorite book recommendation

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 Reports

Photographs 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.

Bad 3D Pie Chart

Pies are good. Pie charts are bad.

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.

good bar chart

Bars are good and yummy. Bar charts are also tasty.

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.

Now, here’s a example that I’m sure you’ve seen in so many presentations.

TTAC-USA-auto-brand-market-share-chart-August-2014

Even if you have a PHD, it’s difficult to immediately grasp all the stats on this chart.

The data that this image is supposed to depict is

As U.S. auto sales grew 5.5% to more than 1.58 million in August 2014, GM’s market share fell from 18.4% in August 2013 to 17.2% last month.

Beware of Fancy Looking Charts That Try to Dazzle You with Meaningless Information

Many times, 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. That’s one of the reasons why I don’t like believing everything management says.

Ultimately, the numbers will do the talking. If management is able to walk the walk, it will show up in the numbers.

Tip #2: Use the Letter to Shareholders as a Screen for CEO Trustability

The 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?

This is a technique brought up in Quality of Earnings, a must read book for all value investors.

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.

Take a look at Zulily (ZU).

Ever since its IPO, it’s been on a nice and steady downward slope.

They’ve hit issues with soft end of year sales and guidance, questionable uses of cash for a growing company and weak margins.

But the company obviously paints themselves in the best positive light in presentations and conference calls.

2015-03-10_1711

What do the numbers say?

zu-ratios

Zulily (ZU) Numbers Tell a Different Story to the Rosy Presentations

Certainly, nothing inspiring from the story the numbers are telling.

Tip #3: Do Not Trust Auditors

Another tip from Quality of Earnings is to not 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.

But before that, click on the image below to avoid devastating losses by detecting red flags before doing anything else. You’ll also get exclusive content and resources that we don’t publish anywhere else.

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Tip #4: Check Consistency of Footnotes

Reading 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.

I wrote a tutorial to quickly detect changes in the footnotes, but here’s the short version.

  1. Open up two consecutive years of annual reports on the SEC website
  2. Copy and paste the html annual report into a word processing document
  3. Save the two documents
  4. Use the compare feature to open up both of the documents you just created
  5. Save and review the final document which automatically has all the changes in the text highlighted.

The final output looks something like the image below.

footnotes compared

Quickly see changes in the footnotes

Recapping

  1. Beware Fancy Charts in the Annual Reports
  2. Use the Letter to Shareholders as a Screen for CEO Trustability
  3. Do Not Trust Auditors
  4. Check Consistency of Footnotes

In addition to the above, I shared a collection of checklists recently. If you didn’t get it, go check it out.

Has a ton of value in addition to what’s added here.

So finally, tell me what simple methods when going through the annual report.

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2 responses to “Avoid Losses with These 4 Simple Techniques When Reading the Annual Report”

  1. asadilak says:

    great tip and trick = microsoft word. thanks

  2. sure is. Makes that difficult task really easy.

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