When asked what he and Charlie Munger (Trades, Portfolio) look for in annual reports, Berkshire Hathaway's (BRK.A, Financial) (BRK.B, Financial) Warren Buffett (Trades, Portfolio) explained:
“We’ve read a lot of reports (...). We start by looking at the reports of companies that we think we can understand (...), and then we see from that report whether the management is telling us about the things that we would want to know about if we owned 100% of the company (...). When we find management that does tell us about those things and that is candid in the same way that a manager of a subsidiary would be candid with us and talks in language that we can understand, it definitely improves our feeling about investing in such a business(...).”
So why does the Oracle of Omaha place such importance on reading annual reports?
Understanding annual reports
An annual report is a document that public companies are required to file with the Securities and Exchange Commission every year. It provides shareholders and potential investors with a comprehensive overview of the company’s financial performance, business strategy, risks and corporate governance.
The key sections of an annual report typically include:
- An introductory letter from the chief executive officer summarizing the company’s performance and strategy. This provides insights into management’s thinking.
- Audited financial statements like the income statement, balance sheet and cash flow statement. These offer a quantitative look at the company’s financial health.
- Management discussion and analysis, where management provides context for the financial statements by analyzing the drivers behind the numbers.
- Various required disclosures related to executive compensation, risks, internal controls, auditors, etc.
In essence, the annual report provides a comprehensive overview of the company’s operations, financials, leadership and governance. While quarterly filings offer updates, the annual report is the primary source of information on a company.
The importance of reading annual reports
So why does Buffett religiously read annual reports? There are some key reasons why annual reports are important for investors.
First, the audited financial statements provide invaluable quantitative insights into the company’s financial health. Investors can analyze key ratios related to growth, profitability, efficiency, liquidity, leverage and valuation to determine the company’s financial standing. Comparing these metrics historically and relative to peers helps ascertain the quality of the business.
Second, the CEO letter offers qualitative insights into management’s strategic thought process – where they plan to take the business and how they plan to get there. The management discussion and analysis section also analyzes the factors driving the company’s performance, whether positive or negative. This helps investors determine if the company has a sound strategy.
Further, management’s candor, communication style and priorities, as reflected in the annual report, reveal a great deal about their quality. Evaluating management is critical for investors, as great managers create enormous value over time. The annual report provides invaluable insights here.
The disclosures related to risks, controls, compensation and so on shed light on the quality of governance. The risks highlighted by management indicate their ability to identify threats. Clear communication and transparency demonstrate good governance.
Finally, reading reports of key competitors helps ascertain how well the company fares relative to peers. Comparing financial metrics, strategies, risks and governance structures provides perspective on the company’s competitive positioning.
The annual report allows investors to conduct a 360-degree qualitative and quantitative assessment of the company to determine its investment potential. As Buffett says, “What you want is the information to enable you to make an intelligent judgment, at least as intelligent as mine.”
Reading annual reports like Buffett
When it comes to reading annual reports, nobody does it better than Buffett. Over his illustrious career, he has mastered the art.
Buffett’s first step is to read the CEO letter, as it provides an overview of the company’s performance, strategy and outlook in the management’s own words. The tone and topics emphasized indicate their priorities and orientation.
Next, he dives into the numbers, focusing on key ratios related to profitability, growth, efficiency, debt levels and valuation. The guru looks for improving trends and early warning signals. The quality of revenues and sustainability of profits matter more than sheer size to Buffett.
In the management discussion section, Buffett looks for candid insights into the challenges faced and the road ahead. He wants to gauge management’s command over operations. Analysis of business segments helps him determine the value drivers, while discussion of risks provides clues to the unknowns.
Buffett then evaluates the balance of power between management, the board and shareholders. Factors like insider ownership, executive compensation and auditor relationships provide perspective on alignment with shareholders.
Another key aspect Buffett analyzes is whether the company possesses durable competitive advantages or "economic moats" that allow it to fend off competition. These moats may include brand, scale, regulation, patents, network effects or cost advantages. Their sustainability determines investment potential.
Finally, Buffett compares the company’s financial ratios, growth rates, margins, risks, strategies and market share to peers to ascertain relative standing. He combines insights from the report with his understanding of industry dynamics to estimate the upside.
While exhausting, following Buffett’s meticulous approach helps investors make judicious investment decisions based on the wealth of information in annual reports. No wonder he said: “I don’t know a better way to get a fix on the company than by reading annual reports.”
Investment tips for beginners
For investing novices wishing to emulate Buffett’s success, some practical tips include reading extensively. Knowledge is power, so building a broad and deep understanding across businesses, industries and sectors will help develop sound investment judgment. Make reading a lifelong habit.
It is also a good idea to start small. Practice investing early with small amounts to get first-hand experience converting theory into practice. Focus on building skills. Do not risk more than you can afford to lose.
Next, only invest in businesses you thoroughly understand. Stick to your circle of competence where you can estimate value. Do not venture outside it.
Further, give your investments time to perform by holding long term rather than trading in and out. For compounding to work, decades are more useful than months or years.
Learn from experience by keeping track of your investment decisions, both good and bad. Analyze your mistakes dispassionately to continuously improve your process.
The best way to learn to invest is by practicing it diligently yourself over long periods. Reading annual reports will build knowledge. Gaining experience will develop wisdom. Following Buffett’s mantra of lifelong learning while avoiding major mistakes lays the foundation for successful value investing.
Unlocking your investment potential
For Buffett, the annual report is a treasure trove containing valuable nuggets of information for the discerning investor. It encapsulates in one place everything an investor needs to know about the business – its financials, strategies, leadership strengths and risks.
Digging through annual reports has enabled the famed investor to spot undervalued gems that go on to deliver outsized returns. Any investor wishing to achieve enduring success would do well to follow Buffett and make reading annual reports a habit.
