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Holon Global Investments - Active Fund Manager
Holon Global Investments - Active Fund Manager

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Part 3: The Annual Report – Get excited about this vastly underrated opportunity

Published 06 Apr 2022

We all know the annual report, and they’re not often described as ‘exciting’, are they?

Many will be familiar with it as a detailed document outlining the operations of a company for the financial year. It discloses a range of information about the company including but not limited to the management team, acquisitions and partnerships, key operational risks, and finances. There is a myriad of information which is presented in an annual report, both qualitative and quantitative.

Of course, an annual report is also a public relations document. There can be language used and information presented with the intention to inflate the value of the business – more on this in a moment.

Annual reports can easily be found on a company’s investor relations page or, if the company is in the United States, on the SEC website.

Given all of this, why do so many investors not read these documents? Is it fear of the unknown? An aversion to dry, impersonal text? It doesn’t have to be this way.

Think in terms of essentially only two forms of information being presented – chock full of opportunities: qualitative and quantitative. Let’s break these down, and get excited about the annual report.

1. Qualitative

Investors will tell you that the true indicator of a company’s health lies in its financial data. However, relying only on financials can remove context from a company’s operations and line items. It’s all context – and there are non-numerical areas in an annual statement which we would recommend reading first.

a) Business overview

The annual report often starts with a detailed overview of the company. Highlighting the service or product offering that generates revenue and locations where the business operates. What’s useful to you is that here’s where you can start developing an idea of how sustainable revenue streams will be in the coming year. Depending on the source of revenue, this section can also give investors an indicator of upcoming increases in expenses, e.g., expansion of service offerings into international markets.

b) Management team

Forget the impressive corporate portraits – this section should give you a more personalised view of the company’s direction, motivation, and vision. It’s crucial to understand the background of the management team, examining whether their experience aligns with their current position(s). Also identifying whether the company is represented by a single member of management, a la Tesla’s Elon Musk. The presence of a strong founding CEO can be positive – however there may be inherent risks in having so much responsibility allocated to one person (Theranos, looking at you).

c) Risk factors

An annual report will list a number of risks which range in severity. It is your job to quickly identify which risks pose a unique threat to the company’s operations. Although the company may not say it explicitly, annual reports can often reveal inherent risks such as having a single source of revenue or having a large dependency on suppliers. These ‘unspoken’ risks should also be considered.

2. Quantitative

Now that we have an overview of how the company generates revenue, who makes the important decisions, and the major risks involved, it is time to delve into the finances.
There are three financial statements which give a snapshot of the current financial health of a company. These three statements have inputs which feed and flow into each other – therefore, it is important to read all three together.

a) Balance Sheet

The balance sheet provides a snapshot of the company’s assets, liabilities, and equity. It helps investors understand the financial position relative to prior periods. Analysing the balance sheet can also inform you of the type of firm you’re researching. For example, high levels of property and equipment may indicate that the company develops physical products and has large levels of infrastructure. Not a red flag, but should be noted.

b) Statement of Income

This statement informs investors how much net income has been generated across the financial year. Pro tip: it is important to check any line items in the statement which are unclear or are abnormally large.

c) Statement of Cash Flows

We now have the company’s net income which forms the first line of the cash flow statement. From there adjustments are made to reconcile net income to net cash provided by operating activities, investing activities, and financing activities. At its most basic it’s how a company brings in cash and for what costs the cash goes back out the door.

For too long, annual reports have gone mostly unread, landing in far reaching corners of dense corporate websites, underused and underappreciated. Although they may not be the most entertaining online option, for the reasons above they are clearly valuable tools in any investor’s quest for knowledge and context before making any decisions, and not just in volatile times, but any time. The opportunities that can be uncovered by even a most basic breakdown can uncover gems, or provide stern warnings. Exciting indeed.

 

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