Why We Should Read The Annual Report?

Why we should read the Annual Report?

Every investor will have three kinds of advantages.

1. Information Advantage

2. Analytical Advantage

3. Behavioural  Advantage

This chapter will deal with the Information Advantage and the other two will be covered in later chapters.

Information Advantage: 

Every investor should make use of information available in the public domain that he can access. Various sources where you can collect information are:

a. Annual Report

b. Quarterly Report

c. Magazines, Industry journals, newspapers

d. Company Website

e. Ministry of corporate affairs, etc, etc.

There is a great amount of valuable information available that everyone should be aware of. Much of this information is free and readily accessible on the internet.

Annual Report:

You will find broadly three themes in the annual report :

1. Regulatory Requirements

2. Public Relations

3. Explanation of traditions and culture

Many companies include information in their annual report that is neither required nor useful. Like for example, if you look at the public relations aspect,

* The annual report includes all photographs and presentations that convey, the company’s public image, its reputation as a good corporate citizen, and product promotion.

All of these reports have photographs of people whose health has been improved or whose lives were saved, of beautiful construction projects that the company has completed, or of the technologically advanced products that the company has provided.

These are announcements to:

A. Public:

Science, Engineering, and helping people provide a positive image.

B. The Company’s Employees:

Their company is at the forefront as a ‘knowledge’ company. This emphasizes their value to the company (despite hundreds and thousands who were recently laid off).

C. Security Analysts:

Science companies are very attractive to investors. Research and development are much more attractive to the investing world than manufacturing. Security analyst likes a high-margin, fast-growth company with recession-resistant special products (these days we can see investors like for specialty chemicals, over commodity chemicals).

*** Many companies merely repeat such themes as science, fast growth, helping people, and similar cliches.

I don’t mean to say that helping needy is bad, but when almost every company is spending money on corporate social responsibility and conducting training programs and recreation events for their employees, reading 100 pages regarding such matters, often will not be useful to an investor.

Other than Investors, who else will read the annual report?


Competitors: 
In their annual reports, these companies will reveal some of their future expectations and describe specific ongoing projects and strategic alliances, which can be helpful to their competitors.

Suppliers: In their reports, these companies may reveal their perception of future sales. Your company is one of their customers(otherwise they wouldn’t waste their time reading your annual report). So they are in fact identifying what they think you will buy, in terms of quantities, technologies, and perhaps geography. For example, Construction and Infrastructure companies (even Government) forecast on infrastructure spending can become a guideline for steel, cement, and paint companies sales.

Lenders & Bankers: For obvious reasons, they would like to know, whether you will be in a position, to pay interest and repay their debt in the future.

So, everyone above, who is reading the annual report has their own specific reasons.

Since, I assume you as an investor (I don’t think suppliers are interested in reading my blog),


Why we should read the Annual Report?

If you don’t try to know, why we should read the annual report? then you will not be able to read it efficiently.

By reading the annual report, or better 4-5 years of reports, you would know much more than other investors out there.

So, if you read 5 years’ reports, then it’s like reading almost¬†1000 pages. If you don’t know why you are reading, then you will not benefit from merely reading.

We should read the annual report, to collect information. But information regarding what?

Company History and it’s Business?

We should read the annual report to know, what business they are in?

Without knowing what products or services they are selling, we should never invest in a stock. It is very important to know their company’s history. We should know, whether it’s a new company or a well-established company? We should know, Is it a family run business or professionally managed company?

Growth?

We should read the annual report to know, how fast has the company grown, what are the sources of its growth, and how sustainable is that grown likely to be?

It’s critical to investigate the sources of a company’s growth and assess the quality of the growth. High-quality growth that comes from selling more goods and entering new markets is more sustainable than low-quality growth that’s generated by cost-cutting and accounting tricks.

The goal is simply to know, how a company is growing?

Profitability?

We should read the annual report to know, what kind of a return does the company generates on the capital it invests?

How much profit does the company is generating relative to the amount of money invested in the business? This is the real key to separating great companies from average ones because the job of any company is to take money from outside investors and invest it to generate a return. The higher that return, the more attractive the business.

The goal is simply to know, How efficiently they are using shareholders’ money?

Financial Health?

When a company increases its debt, it increases its fixed costs as a percentage of total costs. In years when business is good, a company with high fixed costs can be extremely profitable because once those costs are covered, any additional sales the company makes fall straight to the bottom line. When business is bad, however, the fixed costs of debt push earnings even lower.

The goal is simply to know, How solid is the firm’s financial footing?

Competitive Advantage (Moat)?

We should read the annual report to know, Has the firm been able to generate a solid return on its assets and on shareholder’s equity? If no, then it has got no moat, But if “yes”, then

You should try to know why is the company able to keep competitors at bay? What keeps competitors from stealing their profits? And how firms in this industry compete with each other?  Is it an attractive industry with many profitable companies or a highly-competitive one in which participants struggle just to stay afloat?

Risks & Threats?

We should read the annual report to know, What are the potential negatives, from the most obvious to the least obvious? What could go wrong with your investment thesis? Why might someone prefer to be a seller of the stock then a buyer?

The goal is simply to know, What are the risks to your investment case?

Management?

We should read the annual report to know, First and most important, How much does management pay itself? Were executives given loans that were subsequently forgiven? Do executives get perks paid for by the company that they should be really be paying for themselves? Do management use stock options excessively?

***Most importantly, Do executives have some skin in the game?

The goal is simply to know, Who’s running the show? Are they running the company for the benefits of shareholders or themselves?

Financial Shenanigans?

We should read the annual report to know, whether the ‘Chief Financial Officer or Auditors’ leave the company? Whether the bills aren’t getting paid? Are there any changes in accounting policies? Whether they take frequent one-time charges and write-downs?

The goal is simply to know, whether there is any financial fakery?

Now that you know, why we should read the annual report, I hope you will be able to read it efficiently.