The most scary part of value investing is reading and understanding the Annual Financial report or shareholder’s letter.
I mean how can I make sense out of this ~200 page document. I have never done any finance course didn’t understand a thing about most of the terms used here. Now don’t expect next para to be “When I really started reading a financial report it was really easy”. Of-course it is not so easy to grab at first. You have to spent sometime on reading about the terms (mostly wikipedia is enough). Go through a few blogs or videos about how to skim Annual report. Do not go into lot of detail just a few videos/blogs and you are good to go. Select a company you really like in the field you understand.
For example say you understand IT or Infra anything if nothing suits you just select a known FMCG company. Go through the latest Annual report don’t read everything start from Chairman’s letter read the parts which interests you skip the part which you do not know. Try to go through the boring tables of Balance sheet and Cash flow. It doesn’t matter whether you understand everything or now just go through them.
This exercise will give you some idea about how company is run what kind of challenges the company is facing. What future prospect they have. Are they facing any cash crunch? Is the management able to handle the growth? How much salary management team is drawing? This is correct for any listed company in India you can actually know the exact renumeration a big shot guy/gal is receiving from the company.
After going through some of the terms from balance-sheet and reading through couple of annual reports of companies. I got addicted at least for a week or so and whenever I got any time I was skimming through some annual report.
Let us go into little bit of detail now. What exactly do I read in an Annual report:
- The most interesting and easy part is reading the chairman’s letter this is directed toward investor stating how the company they have invested into is doing. What future goals the company has in mind. This can be just data for some company or may be just filled with high short terms from MBA/finance without making iota of sense.
- Depending upon company or the field the company is working in you may read about Director’s letter, Independent Auditor’s report, Management renumeration(Salary), Advertising effort etc. But all this if it seems interesting to you. You really don’t have to do this. If it interests you you can even read the CSR(=Corporate Social Responsibilities).
- Balance sheet In some other blog post I will cover how to go about it right now I am kind of also learning.
- Cash flow statement. You know cash is really important even to run a small coffee shop. You gotta have milk, coffee beans/powder, equipments etc (the establishment cost, raw materials), you need to pay yourself/employees. There are so many small/large things. I just mean to say that cash is really important so you have to make sure that company has surplus cash to run the business even through bad times right because you never know(actually no one knows). The company which can sustain the bad time are the one who emerges to be leader because at bad times competitors may go for a toll.
- 5 year/10 year performance
Basically there are couple of things which you want to be sure of
- Futuristic thinking: Are they thinking futuristic? sometime they just want to make fast cash or may just have 1-2-3 years in target. If you read that for our factories power was a big expenditure so we installed Solar panel, Windmills thumbs up (That is huge investment in the business may be thinking about long term).
- Capable Management: How good the management is? How capable they are? Can they handle good/bad days? What are the management credentials like degree B.Tech, Masters, BE, MBA (credentials of management team) even if there is no degree then you need to check other hints which will make sure the capability of the management.
These will make you in sync with the actual Vision and mission statements of the company not the one you write in the section of mission statement/Vision but the actual ground reality.
3. Cash: Do the company have surplus cash to take and decisions? Think in long term. Invest in research/future growth. Or is the company cutting it’s expenditure all around is it facing ash crunch?
4. Is current price a bargain? Next is making sure you are not paying a lot for the business. This is just like knowing that a company is really great but at this time the price is not worth buying at. You don’t buy something very pricey when their are other similar things which are really cheap. You also know that there will be Diwali/Christmas sale sometime in future. You don’t know dates though.
This part is somewhat tricky and there can be multiple ways to judge this. Everyone has their own formula to calculate the bargain price. It will depend upon what you feel is comfortable for you. In beginning you are not sure actually what is comfortable as this will come with practice. You can read about P/E ratio, Book value, Debt earning ratio etc. You can make your formula based on what return you are expecting then use company’s earnings (profit) and past couple of years growth, you can weigh on market cap which is nothing but combined value of all shares. You can check on company’s all asset (-liabilities). How much Debt the company has.
But before you start on all this first thing you have to make sure that do you want to invest in this area/company? You should not just take the annual report read it verify all and invest. You need to be comfortable about companies business first. Like you may not be comfortable in investing in a print media company right now (just a thought).