IFB172: How to Read An Annual Report – The Secret to Buffett’s Success

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Dave (00:33):

Welcome to Investing for Beginners podcast. This is episode 172 tonight. Andrew and I are going to answer a great listener question. We got from the United Kingdom. So we’ve got a great one from England. This is from Alex. Hi Andrew. I’m a big fan of the podcast over here in the UK. I dip my toe into value investing earlier in the year after reading Warren Buffett’s snowball and then proceeding to read the intelligent investor and security analysis by Ben Graham, and then found your podcast. So I guess I’ve done this thing a bit back to front compared to most of your investors. One thing I’m struggling with is understanding what I should be getting from reading the annual reports of companies I’m interested in buying so far. I’ve read five reports and only invested in one due to some warning flags and other issues that I didn’t like in the remaining four.

Dave (01:22):

It took me several weeks to read a report because I get bogged down in reading every single word and nuance. I guess my question is, is there an easy way to read the annual reports? Is there any specific information I should be focusing on to influence my decision of whether or not to buy a company? I should point out that prior to reading the APS, I stock must already meet my strict evaluation metrics. Therefore I don’t focus on a numbers and the reports as I’ve already interrogated these in detail prior to picking up the report. I hope all this makes sense that; thanks for all you do; kind regards Alex. All right, Andrew, what are your thoughts on Alex’s great question.

Andrew (02:04):

And, yeah, it’s a great question for sure. I think to give some background information for those of you who haven’t read those books, you know, when Warren buffet talks about why he’s so successful in investing, he mentioned that he reads something like sick five, five or six hours of his day when he’s working every day is spent reading, and he reads mostly annual reports, and he also reads newspapers.

Andrew (02:34):

You know, other company filings, like quarterly reports and things and transcripts, but he mainly focuses on the annual reports. And so Alex is, is on the right path here and trying to educate himself about what these businesses are, you know, what’s the business underneath the stock. And how are you going to learn about that as a business owner? And like Buffet says, it’s

Andrew (03:00):

The way you get there is by reading an annual report. And you hope that management wrote it in a way that passes that information down to you so that you can make investments like a business owner who’s owning for the long term. So I guess the problem and the disconnect with many investors, a lot of average investors, and particularly with beginners too, is if you pull up an annual report, you’re looking at something that can be a hundred to 150 pages. And so I think if you’re first starting, I would not recommend trying, trying to read it. And then entirely whatsoever. I know, I came into investing without a background in finance, actually had an engineering background, and that’s what I went to school for. And so for me, getting exposure to the annual report was first through the numbers.

Andrew (03:58):

And then I kind of branched out and grew my circle of competence as time went on. And so when it comes to a beginner, who’s starting, you know, I think it’s very important to know. You want to know what the business is that you want to invest in. Suppose you’re going to be picking these socks and, you know, the annual report annual reports, a great place to start at the same time. I don’t think somebody needs to become as studied as a corporate lawyer and learn every minute detail inside the annual report and either to, also to figure out what a business is about. Because I think in my mind, you know, when you look at an annual report, what you want to get out of it is what does the business do? How does the business make money?

Andrew (04:51):

How do they intend to make money in the future? And whether what have they been doing lately to try to make more money in the future? I think that’s really what it boils down to. And Dave, I’m curious your thoughts maybe before we talk about in our reports in general, just how would you let’s say you’re somebody who’s just starting in investing, right? How would you even approach the idea of an annual report and then to maybe if somebody more further along and maybe more on the path like Alex is, you know, what kind of a recommendation would you make in dipping your toe into the annual report? Because I think it’s, it’s a process. I don’t think it’s a; it’s a onetime thing.

Dave (05:30):

Not a onetime thing. It’s a process, and I can’t speak for you, but I know that I feel like I am still going through the process and learning the best way to work through these reports. I don’t want to kid anybody and say that these are easy reports to read. They’re not; they are not always easy to read. Some are far more complicated than others, but I think a great place to, I guess, start if you’re a beginner is to, for me, is to look at what the business does at the beginning of every annual report. They’ll have a section that says just business; it’s usually ethics section one. And in that section, most companies will outline some in more detail than others. Exactly what it is the business does to make money. And I think that’s probably the best place to start because a lot of times we think we may know how a company makes money.

Dave (06:28):

For example, Disney. Everybody thinks they know exactly how they make money, but maybe we don’t know all the details involved in how Disney makes money. So I, I, I think for me, I know that’s always the first place I go, especially if I’m trying to broaden my horizons maybe and learn a little bit more about an industry that I’m not as familiar with, I will go first to that part of the, of the report and try to read and learn what it is the company does. And if I can understand that, then I feel like I can continue down the path of looking at different sections of the annual report. And I think that it is probably the easiest and best way to start with those for me. I know that there have been times where I’ve read through annual reports, and I didn’t understand what the business did.

Dave (07:21):

It was too complicated for me, and I know that it just didn’t make sense as I started to work through the rest of the report. So it was a bunch of gobbly goop, and it was, I should have put it in the too-hard pile and moved on, but I didn’t, I tried to grind through it, and it was it sent me back for a while to diving into the annual reports because I I’ve thought honestly, that if they’re all this hard, wow, what am I doing here? But I kept at it, and I found out ones that I understood right away. And that helped make it a lot easier. Picking companies that you feel like you have a pretty, a grasp on as far as what the business does, like a Starbucks or McDonald’s or a Microsoft or an Apple having at least some basic foundation of what you think, you know, the company does and working through, starting to look through that those types of sections, I think is a great way to kind of dip your toe into the water.

Dave (08:18):

If you pick up something super complicated, like a bank or an insurance company from the outset, I think it’s going to be a tough slog because those can be complicated. There’s lots of jargon, and there are lots of nuances as Alex said that you have to understand. And I think those, I would probably try to steer away from. I also want to give Alex A. Little kudos for reading through those three books that he mentioned. Those are, those are not easy white reading books for beginners. That’s very impressive for him to have been able to work through those, especially security analysis. That’s a nine-page textbook, and that’s not an easy read, so kudos to him for getting through that. So I think for me, for beginners, I think that’s kind of where I would start. What are your thoughts? I agree.

Andrew (09:05):

Yeah. I would recommend; I think if anybody’s interested in reading an annual report, I will pick up apples. That’s one that I read recently, and it’s just very easy to read because they’re very straightforward, and they’re not very wordy or articulate articulates, not the right word. They’re, they’re just not, you know, they don’t go on and on and on about it, very concise. And everybody kind of knows what, what they do. You know, they have the iPhone, they’ve got the Apple watch and, you know, a bunch of other things and you can kind of see the breakdown and it’s, it’s presented very, it’s presented very I don’t know, I can’t talk today. I guess, Insightly concise. It’s, it’s very presented very easily to, to pull up and to be able to understand what’s going on.

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Dave (10:09):

Yeah., another great one that I read through recently was Walmart. I think that one’s a fairly simple one to start with as well. And it gives you a brief overview of the business, and I think most people understand what Walmart does to make money. And it’s not super complicated. They don’t have lots of segments and lots of different divisions, and it’s a pretty straightforward type of report to read through. And I think that’s a, a great place to start now, if that’s, if you’re feeling comfortable with that, I think then branching into working through different sections of the company. And I find that a thing that works well is to have some questions that I want to have answered by reading through this report among those they don’t have to be super complicated.

Dave (11:02):

They could be, how does the company make money? Is the company making money? Are they growing the revenues? Do they have plans to grow, and how are they going to grow? Another question, what kind of risks are involved in the company? There are different sections in the annual reports that they’ll weigh some of that information out. What kind of debt does the company have that may be getting a little more technical, but even just looking at those few questions that I mentioned, another great one is investigating a little bit about the management. How long is the manager’s been in place? How long have they been in their position, particularly, and how long have they been with the company? So having some of those questions and I find that I used to write those down at first. I had them, I had them typed up in a little spreadsheet, and I would go through the list and try to just search through the 10 Ks to find that information first, before I kind of proceeding.

Dave (12:04):

And the reason you want to do some of those things is that it helps give you a foundation of what’s going on with the company. You want to know that the business is doing well, that they’re making money, and they’ve been growing their revenues or profits over time because each tank K will cover more than just the current annual year. It’ll generally cover up to three years on the income statement at two years on the balance sheets, for example. And so some will break it down to give you even longer periods, snapshots, not all of them do, but some will. And so those are great places to kind of get some, a good overview of what’s going on with the company. I want to look at the management because if you have a great company and have a CEO with a company, he’s like the company’s head coach.

Dave (12:54):

And if he’s been there for 10, 15 years, chances are he’s going to be there longer, depending on his age, he’s probably going to be there longer. And you want to see if that’s the case, or if you want to see if there has been a recent change in the management. And sometimes that’s not a bad thing, but sometimes it’s not a great thing. So it just depends. But having that information can help you make your decision farther down the road. Looking through some of those points helps me focus on what I’m trying to read instead of reading it like a book. And I’ll admit when I first started trying to read through these; I tried to read them like a book. I love reading books that have been a passion of mine since I was a little kid, and I tried to read these books, which could be hard. And so I think for me, having questions to answer helps me focus my attention and focus what I’m trying to take out of, of the annual reports, as opposed to just reading it from page one to page 182, because that could be a slog. So I guess, what are your thoughts on that?

Andrew (14:01):

That’s super interesting. You know, I guess we’ve never talked about it between the two of us, but I did something similar without even realizing I was doing it. Yeah. Cause I, I would do my thing is I, for whatever reason, I’m on this paper and pen kick. So I have, you know, my little lawyer folders filled with notes of annual reports and I’ll take notes. Cause I, I feel like if I just read it, and then I put it down in five minutes, I’m going to forget everything I just read. But if I make notes on the things that I think are important, then for whatever reason that registers in my head. I was taking notes on a lot of the things when I got serious into this was the CEO. You know, how old is he? How long has he been there?

Andrew (14:47):

Or she, and you know, other like, all right, if they have three, take Apple, for example, if they have a, an iPhone segment if they have a like a services segment. They also have a say a wearable segment, they might have one or two others, but take those as an example, what you would want to know is, is how much do they have for total sales and then how much is coming from the iPhone and how much is coming from services. So, you know, if I remember that, because I read that recently, their iPhone was something like 55% of sales. So I knew if I would seriously consider buying an Apple, figuring out what the iPhone would have to be a huge priority for me because this is making up a huge portion of their revenues. If it were something like 80 or 90%, maybe I wouldn’t even look at the other parts of the business because they’re so small compared to everything else.

Andrew (15:51):

And so I think you, there can be so many details embedded in there. And so you have to, you have to make some intentional, not shortcuts, but intentional decision making on what you’re going to separate between what’s important and what you’re going to focus on because, you know, we all have a limited amount of numbers of hours in the day. We all have limited bandwidth, and we all have limited even, you know, attention span. So I know that once I get around one and a half to two hours, I’m going to start losing my attention span. And so, you know, I’m not expecting to, to necessarily try that grind through that. Do you know what I mean? And so, you know, maybe, trying to figure that out, I’m trying to figure out what’s the leadership, what’s the big picture. And then some other things that you’re wanting to focus on depending on the company and as you move along, having those things that are, that you’re consistently looking out for, I think helps you to skim through and identify those important parts where, Hey, I’m going to tune in here. I’m going to tune in there.

Andrew (17:00):

And then eventually when you get good enough, I, I I’ve, I’ve gotten to a point where I’m pretty confident that I can know when to scam and when not to skim, based on how it applies to what company I’m looking at and what parts of the company I know I’m going to focus on. Another example of that would be take like Intel as an example, I would want to find out what’s going on with their manufacturing and supply chain. So if I’m reading through the things that they’re saying that are big risk factors for them, then I’m on the one that knows about distribution, supply chain manufacturer. I want to know about all of that. A lot of companies will have a lot of the same jargon for certain sections. Everybody, every company has a risk of struggling during a recession or every company has a risk of litigation.

Andrew (17:55):

You know, that’s all like really boring stuff that you can usually skim over, but sometimes embedded in that, that stuff that’s boring to skim over is important gems. Suppose they relate to a part of a business that is very critical for that business. That’s kind of the big picture idea that I would try to have when it comes to attacking these things. And it is in the tack. Like you have to be proactive and, and it’s, it’s not an easy exercise. I don’t know. I don’t know how I would try to explain to myself five years ago to do what I’m doing now. It’s, it’s a bit intense. I don’t know.

Dave (18:36):

It is a bit intense. And I love the idea of taking the pen to paper. I know that I’ve been reading several blogs and articles about learning and the best way to learn and hands down on a person. They all say that that is one of the best ways for people to obtain things. That’s a brilliant insight on your part to do that. That’s something that I’m going to try to start to do as well. I, I have been using my Adobe feature on my computer and saving the PDFs and then marking them up that way. But I find that I don’t always retain everything. So I think that’s, that’s a great idea. And I also want to; I think mentioned that Alex was talking about he’s read five reports and took him a couple of weeks.

Dave (19:29):

I think that’s a great pace. This is not a race. And if you read one a week, that’s 52 in a year, that’s a lot. And I you’ll get a long, long way if you can read through that many in a year. So don’t get down on yourself and think that you’re, it’s taking too long. They’re not intended to be quick, easy reads. As Andrew mentioned, you will also say this; you will find the more you do this. Like anything else that your knowledge will compound. And by that, I mean that you will learn the different places you can pick and choose where you want to really focus and read every word because it contains information you think is pertinent to a decision that you need to make. At the same time, there will be other sections where they may not be as relevant to what you’re trying to determine at that particular point.

Dave (20:23):

And there’s also nothing wrong with skipping around from different sections of the report and reading through the management discussion and getting a really good idea of that. And then maybe reading through the notes and then looking at the actual financial information. I find that I tend to stay away from the main financial documents until I’ve read through what management thinks about what’s on with the company and some of the risks and other information that is entailed with that. Because I don’t want to jump to conclusions by reading through the income statement or the balance sheet, because sometimes that can Jade my viewpoint of what is going on with the company, and the other thing I wanted to mention too, is as you read through more of annual reports, quarterly reports, any of these kinds of financial documents, once you know what the business does, you don’t need to read through every single word of what Walmart does or what Apple does, because you already know what they do, unless there’s been some change that you need to pay attention to, by. Large, that’s not going to change.

Dave (21:30):

That section will be similar to the quarterly report as it will the annual report, which means that that’s a section you don’t need to focus all your attention on. And so there’s, there are some not shortcuts. That’s not the right word for it, but some changes. You can sometimes move around different sections and not focus all your attention on some of them. For example, the risks sections will contain what I like to call boilerplate language, which we always, for, as Andrew said, every single company is facing a downturn in, in an economic recession. Every single company could struggle if there’s a terrorist attack. I mean, these are all things that we all know if there’s a hurricane, it could affect the business. Yes. We know that they have to put that in there because it’s a legal document, but do you need to read through every single part of that? Not necessarily. There will be times as you work through these, that you’ll find different nuggets of things that will pertain to what you want to learn about the company. And there’ll be other parts of the annual report set that won’t pertain to what it is. You need to know.

Andrew (22:47):

A perfect example that would be like, if you have an insurance company who writes hurricane insurance, is a big part of their revenues, then you would want to read that part extra carefully. Whereas if I’m looking at Apple,

Dave (23:01):

They mentioned hurricanes. I’m probably not going to read it. Yeah, exactly. No, that’s, that’s a perfect illustration. Perfect illustration. So yeah, I think I think Alex is definitely on the right track. And I think some of these suggestions that we’re talking about are great ways to go about reading these things. And again, I love Andrew’s idea of making notes and writing things down. If you can print the documents out, that’s even better because you can Mark them up. You’re on your own. You could use highlighters to write notes in the margins; however, it works. But I think the biggest thing is just trying to find a groove and a routine that works best for you and working with that. But I have found for me having questions to Helps me work through the report. And then once I do that, then I can kind of pick and choose where I want to focus my attention on.

Andrew (23:53):

Yeah. I love that. I like everything you said; those are all great suggestions. And I hope it didn’t blow over with people interested in this because it’s a lot of experience, many nuggets you can gain from, from everything you said, one last thing I will impart. If I can, Buffet also recommends that he says that he doesn’t spend one second on an annual report that he’s on the company’s not interested in. So, you know, if you’re not interested in the company, if you feel that reading this thing, doesn’t help you understand the competition of a company or considering, or company you own, or the company that you’re thinking of, then don’t waste your time. There are too many companies that nobody can keep up with every single one.

Dave (24:37):

So don’t try to, yeah, that’s a great nugget. I would wholeheartedly agree with that. I know that I probably won’t waste a single second reading—a Tesla report.

Andrew (24:48):

Never say never true.

Dave (24:51):

Never say never I’ve taken over the world. Yeah, they are.

Dave (24:56):

All right, folks. Well, that is going to wrap up our discussion for today. I wanted to thank Alex for taking the time to write us that great question. And again, kudos to Alex for the great question, as well as all the great reading, and you’re definitely on the right path. So keep it up. Thanks again for sending us that great question. And we hope we answered it to your satisfaction. So without any further ado, I’m going to go ahead and sign this off. You guys go out there and invest with a margin of safety emphasis on the safety. Have a great week, and we’ll talk to y’all next week.

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