Reading & Writing Annual Reports (Part 2)

In January 2021 I scratched out a quick blog post on Reading & Writing Annual Reports. I was compelled to write again on the subject and figured that a “Part 2” title was creative enough for the two or three nerds that might read both of my posts.

I write reports to our investments partners. I also read reports from company CEO’s, both public and private companies, and control and non-control positions for us. On top of this I read books like “Investing Between the Lines” by LJ Rittenhouse, “Dear Shareholder” by Lawrence Cunningham. I also read how-to writing books like “Writing to Learn” by William Zinsser. I have an English degree and adequate accounting courses to hold my own. None of this makes me an expert author of annual reports, yet. However, I am coming to believe Warren Buffett’s repeated comments (and I’ll paraphrase), that ‘most everything you need to know to make an investment decision can be found by reading annual reports.’

I wrapped up reading Laura Rittenhouse’s 2013 book on deciphering annual reports after writing my January 2021 post and was encouraged enough to write again on the subject this January 2022. The stand out reason? She documents how candor and fact-obfuscating generalities (FOG) scores can forecast stock performance 2-3 years in advance. Now, to be fair, she doesn’t say this as plainly as I just wrote. But, from reading between the lines of her book I can say without hesitation that it makes perfect sense.

That is a lot of lead time. What gives?

From my experience, the leadership of a company has a huge influence on what gets accomplished day-to-day. This matters. Did you get 8 jobs today or 3 jobs today? When stacked together over 2-3 years the result is huge.

Then, there are the softer elements of vision and culture. If the company leader has a vision –even if fuzzy– and they deliver it with frankness and clarity it likely perpetuates a culture of action and achievement. Over the course of several years the business will beat competitors who lack persistence and clarity.

So what about stock price forecasts?

The price follows the business. In the short term it’s a voting machine… a popularity contest. But, in the longer term (I think 3-5 years) it becomes a weighing machine. How heavy is the business? Does it have substance? Can it be displaced easily? Vaporize easily? How strong is it?

And the strength of a business comes down to the people. Are they coherent? Do they do what they say they will do? Is their logic sensible? These elements show up in the annual report, written by the leader far earlier than the financial reports. In many cases the absolute best investments occur when the writing is clear and the financial reports are bad. This is a sign things are changing for the better. (now to be clear –a completely ruined balance sheet could still be cause to maintain a safe distance.)

I write to clarify my thinking. What exactly are we trying to accomplish? Who are our customers? What do they value? Can we deliver something to them at a lower price than the value they derive? Can we assemble that value at less cost than we charge? Can we repeat this experience for a large enough group of customer to attract future teammates? What prevents it from compounding? How is it ruined? Is there a better way? How do we improve?

In 2021 I began tracking my reading-writing combination as a key performance indicator for our marketable security business unit within Little Engine Ventures. The more annual reports I read, the more I wrote about the companies. The more I wrote about the companies the greater my conviction regarding an appropriate price to pay for ownership in the company. After a cursory measure of my notes versus trades (lots more notes versus trades) over the last five years I could see some things jump out. Where I had more writing, I had read more. Where I had more writing, my actions were sized appropriately and conducted in timely manner. This coincided with the companies where I had conviction, regardless of whether we owned them prior to the decision or going into the decision. And, the actions (purchase or sale) ultimately worked in a super majority of situations. Where I didn’t have adequate reading and writing, I made smaller investments and they usually performed worse (I have gotten lucky more than once.)

For 2021 I established a a brute force effort. I would pick an industry of great interest and just power through annual reports, one-by-one, reading at least one by every company. If it wasn’t crap, I would read additional years of reports. If I “fell in love” I’d read back even further. Result? I got about 60% through all companies in a single industry in one year. As of this publication I’m approaching 70%. I fell in love with two companies… neither of which I bought stock in yet. One of the two I was broadly aware of, but not intimately aware of. The second one I had never heard of, and would guess 99% of financial professionals have never heard of it… as it’s small and controlled by a single family. Anyways, I didn’t set out to find these two companies. I was just interested in the industry and wanted to learn. I read. And I wrote my notes as I went along. Patterns emerged… and many of those patterns are sickening fact-obfuscating generalities. The really sharp leaders have clear writing that punches hard.

I encourage serious investors to join me in reading more. De-emphasize the numerical screens. Elevate your thinking. Write to learn.

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