Annual Reports: Profiting from the Nitty-Gritty
So far in our series on earnings, we’ve focused on evaluating evidence that provides the most recent possible perspective on a firm’s financial health. Profiting on earnings announcements at the “speed of the market” requires reacting quickly to new evidence (ideally with the help of good historical data). But the tools we use to react quickly, like quarterly reports and earnings press releases, aren’t always satisfactory tools for in-depth research.
For conducting a truly thorough investigation of a stock, there’s no substitute for analyzing the annual reporting document, or 10-K. This document doesn’t just go into more detail than shorter reports. It tends to approach another task entirely: providing logical explanations for shifts in financial outcomes rather than just reporting them with a cursory explanation. Whether we “buy” these explanations after evaluating all the evidence is a different story.
The annual report offers so much detail that it can be a bit overwhelming. This post focuses on finding some fundamental information in order to extract profitable insights from this dense document without spending days researching a single stock.
First, a point of clarification. Many investors refer to the “10-K” and the “Annual Report” interchangeably, but many companies issue each of these things as separate documents. When they do, the annual report is a brief, marketing-oriented piece, with the vital information contained in the formal 10-K. Unless you’re looking for cool graphics, the 10-K is what you’re after: it contains the nitty gritty information needed to evaluate a stock in-depth.
The 10-K is sorted into various substantive “items,” and you don’t necessarily want to read it front to back. Item 1, Business, is simply a description of a firm’s core operations and business model. Start here if you’re using the 10-K to research a firm from the ground up. But this section can be safely skipped if you’re well acquainted with a firm and seeking some more specific information. In Item 1A of this section, the firm will report on potential risks. This section can be quite broad, discussing nebulous macroeconomic threats that could affect virtually any firm. But it’s a great way to see how executives view their firm’s relationship to the broader economy.
Item 3, Legal Proceedings provides a place for firm’s to report on major legal proceedings. Some amount of litigation is normal in business, so there’s no reason to panic simply because a firm has some legal entanglements. Keep an eye out for the dollar value of any major claims, and evaluate whether the risk is purely financial or constitutes a fundamental risk to the company’s business model.
Item 6, Selected Financial Data focuses on selected financial information for the firm over the last 5 years. More voluminous reporting of this data can be found in Item 8, but this section is the best place to start evaluating financials. To compare quantitative evidence with causal analysis, this section is often best read alongside Item 7, which provides “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Item 7, often referred to simply as the MD&A, is the most intensely scrutinized part of the annual report. Here, management tries to provide a narrative to explain the results reported in the rest of the report. They’ll discuss mitigation strategies for the risks presented in 1A, major accounting decisions that have shaped the report, plans for the future, and more. Indeed, this section is so vital that it deserves it’s own blog post—which we’ll deliver tomorrow.
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