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The importance of annual reports

Stock research is incomplete without going through the annual report. We tell you about some of the important things to look for in these reports

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If you are a cricket enthusiast, you can surely make out the difference between a T20 and a test-match commentary. A T20 match commentary gives a ball-by-ball description of the shots played and the runs scored. On the contrary, a test-match commentary is slightly slow-paced and discusses the strategy of players and the teams, how they played in the last match, their future potential, etc. While a T20 commentary reminds us of quarterly results, test matches are the equivalent of companies' annual reports.

Like T20 matches, quarterly results are more glamorous and attract attention in the market, while the release of annual reports is not celebrated, though they are equally, if not more, important as quarterly results. Going through an annual report should be an inherent part of the investment process and merely relying on quarterly results may lead to missing out on important information.

Annual reports are one of the most reliable sources to gather company-specific information in an exhaustive manner. Ideally, annual reports serve two purposes. First, they help generate ideas and take investment actions and, second, they help identify red flags and early signs of trouble when everything seems to be going well. To summarise, annual reports act like an anchor to your investment decision.

Annual reports act as an anchor
'Other guys read Playboy, I read annual reports,' said Warren Buffett in an interview when asked about how he discovered and got conviction in PetroChina, one of his best investments, which yielded more then 50 per cent over five years.

Warren Buffett has always built his conviction and based his investment decisions on annual reports. He and his team read hundreds of annual reports in a year. Obviously, a retail investor cannot think of reading on such a scale but it is desirable that one should go through the annual reports of the companies in which one has invested or is considering to invest.

We, at Value Research Stock Advisor, have a similar approach to investments. Our proprietary non-negotiables (which act as a filter) and Risk Score (which we prepare for every company under consideration) are derived thoroughly from annual reports. We use the annual report to initiate investment ideas and for us, quarterly results act as a performance tracker.

For instance, take a company that shows 20 per cent growth in earnings for two quarters. This is the performance of the company, which is an outcome of a certain strategy. An annual report will tell you what the company has done to achieve this growth, what its strategy was and whether this performance will sustain for long or not.

Qualitative information in annual reports
Annual reports are a repository of qualitative information which is crucial in making an investment decision. Such information includes the following:

Management discussion and analysis (MD&A) and chairman's speech: These two sections narrate the aspirations of a company and where it wants to be in the future. It describes the core competence of a company and where the company is spending to build capabilities. Not only does MD&A give an idea about the future strategy of a company, it also tells you if the management really walks the talk. Read older reports and you can check if the company has stuck to its plans or strayed away frequently from its path.

For instance, a few years ago, the management of one of our recommended companies stated that it wanted to reduce exposure to a fast-growing segment because it looked risky. Today, without falling for the temptation of fast growth, it has reduced that exposure to this segment from 22 per cent in FY13 to 8 per cent in FY18. The historical context gives the comfort in reading the current statements made by the management.

Management compensation and board members: Management compensation will tell you how greedy managers get when the times are not good. If the management is taking out huge salaries, even in lean periods, it may not have shareholder interest as its top priority. An ideal compensation which sets the management's direction right is one where the fixed component is low and the larger part depends on the profits. Similarly, look for board composition. Do all board members regularly attend company meetings? An ideal composition is where there are several independent directors.

Auditor's report: Companies appoint an external auditor to audit their accounts. The auditor reports whether the company has complied with the rules and regulations in maintaining its books. If there is anything questionable, the auditor can raise a concern. Moreover, looking at the history of auditors can throw light on the company's mala fide intentions. For instance, if auditors have been changed frequently or they have resigned unexpectedly, this is a sign of trouble in making.

Take the case of Educomp. It was found in the company's annual report that that the auditor's address was just next to the company's registered address, that too on the same floor. This smacked of a collusion between the company and the auditor. Such corporate-governance issues severely hit the stock price. Educomp's stock has corrected over 90 per cent from its peak value and is a penny stock now.

Other scattered bits: Annual reports may also have some passing comments on unscrupulous accounting activities, which should not be overlooked. For instance, consider high related-party transactions, wherein a company might be selling or purchasing goods from the promoter's private firm to give it an undue advantage. Such instances should be closely inspected. Other things like serial resignations of the top management or key personnels should also be thoroughly investigated.

Quantitative information in annual reports
While many financial websites provide data on listed companies, annual reports are still important. Here is some crucial quantitative information that you can get from annual reports:

Cash flow statement: Earnings are accounting profits wherein actual cash may or may not have been received for the sale made. The company may manipulate its revenue by showing sales and corresponding debtors in its book. The cash-flow statement shows the actual cash the company has received or spent. This statement is difficult to manipulate. In the Indian context, annual reports are also important because the cash-flow statement is disclosed only in it.

I have a personal anecdote which helped me realise the importance of cash flows. In April 2012, while I was researching on some companies, I wondered if there is any company which had delivered a sequential growth in earnings per share for the past 20 quarters (five years) without any fall. That is when I discovered Amar Remedies and was mesmerised by its performance. Naturally, curiosity set in and I analysed the company deeper. Its income statement was very attractive, but the cash-flow statement revealed the truth. The company was selling on credit and was not realising any cash for the same. I stayed away from this company. Soon enough, the company went in for liquidation in December 2013.

Schedules to the income statement and balance sheet: Though the balance sheet is now mandated to be published half-yearly, due to absence of detailed schedules, it can hide many things. Schedules, which are available only in the annual report, are where crucial details are found. For example, take total debt. Usually, debt is classified as long-term debt and short-term debt but there could be a large component of debt (called 'current maturities of debt') which does not appear under both these categories and is hidden under other current assets. In absence of schedules, one cannot make out the actual total debt of the company.

Similarly, on the asset side, there is an item called loans and advances. It sums up all the advances a company has paid and loans given to any party. Paying an advance for taxes or expenditures is OK but if the advance is made to a related party or the promoter without sufficient interest, then it may be a way to siphon off money. We found this trend in the annual report of Birla Power, a penny stock now. The debt taken for a power project was used to provide money to the group companies.

Contingent liabilities: Contingent liabilities are expenses, charges or any other liabilities which may arise in the future and are dependent on uncertain events. These events include pending cases in the court or warranties given to customers, etc. If a negative outcome can erode a substantial portion of the company's net worth, one should take a note of it.

Detailed financials of subsidiaries: Quarterly results do give consolidated statements but do not give the break-up for subsidiaries. In the annual report, you can get the broad break-up of the financials of subsidiaries and how money is moved through them. There may be cases where the money is poured into a loss-making entity just to benefit the promoters.

Summing it up
In India, where certain reporting is anonymous and done at annual frequency, reading the annual report is a must to build conviction in a stock. Quarterly results are equally important, but they should not be studied in isolation but in conjunction with the annual report.

As a retail investor, the annual report may scare you and look complicated. If you do not understand accounting, one way to start is by reading the message from the management.

What if you do not understand the annual report as it looks very complex and doesn't make sense? Simply drop that company. Probably, the company is too complex and hence better avoided.

As far as the subscribers of Value Research Stock Advisor are concerned, they can rest assured that we are avid readers of annual reports and quarterly results and enjoy reading them.

Vikas Vardhan is Senior Equity Analyst at Value Research Stock Advisor

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