My father-in-law owns a used car dealership and he alway say’s “I don’t make money when I sell a car, I make it when I buy a car”. To earn a decent profit on the car he has to ensure:
- Car is of a popular make & model
- He is buying it cheap
- Car won’t need a lot of repair work. His cost will increase if it does.
Because of his 35+ years of experience in the business he can answer the first two questions but to answer the third question he has to look under the hood of the car, check the exterior for any major damage, check the tires, check the interiors – power windows are working etc. For us Amateur investors, we can learn a lot from his approach to buying a car. Before we decide to invest in a business, we have to look under the hood and there is no better place to start than a company’s annual report. Following things can be learned from reading the annual report:
- What does the Chairman & CEO think of the business
- Did the business perform up-to company’s expectations
- How does the company make money? What is the business model
- What does the company think of its competitors
- What is the business strategy & future plans
- Financial performance
For those of you who have never read an annual report, it might be overwhelming when you first open it. It’s a big document, over a 100 pages and consists a lot of legal language. Fear not, I will try to walk you through some of the sections that I think are the most important. Let’s take a look at Macy’s 2016 annual report. I will highlight the sections here, I HIGHLY recommend you open the actual document to read these sections:
Letter to the Shareholders
In this section the CEO will explain how the business performed over the past year, what challenges they are facing, will talk about the bright spots & will share his/her vision for the future. This is great place to start, it will provide a high level overview of the business.
Item 1 Business
Under this section you will learn how the company operates, what is the business model, what different segments does it operate in, does it operate under different brand names, and what subsidiaries does the company own. In Macy’s case, I learned that they own Bloomingdale’s & BlueMercury. I didn’t know that. Macy’s generates 38% of its revenue through Women’s Accessories, Intimate Apparel, Shoes, Cosmetics and Fragrances.
Item 2 Property
Since Macy’s is a retailer, it’s important to understand how they manage their physical locations. Do they own them? Are they leased? What kind of lease commitments do they have?
Item 6 Select Financial Data
Look for revenue & profit trends in this sections. Is it going up or down? I will write another post to explain financials in more detail. At a high level financials should reflect what the management said in the Letter to the Shareholder’s section.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Here you will further learn about the business, the revenue model and the future strategy. Look for commentary on key business metrics. These metrics are generally industry specific, for example, performance of retailers is measured by same store sales.
2016 Overview
Under this section management is further discussing 2016 performance. They expand on some of the things that you have already read in the previous sections. What worked in 2016 & what did not etc.
To start with, this might sound like a lot of work but trust me with a little bit of practice it will get a lot easier. To make sound investing decisions you have to understand the business. If you invest without that understanding you are leaving yourself exposed to market ups & downs. Your emotions need the shield of business knowledge. Remember what Warren Buffett said about how we should behave “Be fearful when others are greedy and greedy when others are fearful”. You will not be able to behave like this without the business knowledge.
Selecting a business to invest in should be a rejection process & not a selection process. You will reject more businesses than you will accept. After reading the majority of the annual reports you will & you should get a feeling that it doesn’t make sense to invest in this business. Don’t let that feeling fool you, that is the right feeling. Read on and you will find your diamond. Happy Investing!
Disclaimer: These are my personal views and are for educational purposes only. I am not a financial advisor.
