In his 2006 lecture to Columbia Business School students, Li Lu (Trades, Portfolio) said the following wise words:
"Sound, complete and accurate information combined with the conscious, subconscious and psychological factors. This is what drives me and what is so exciting about that business. You have to learn everything. "
Of all Li's teaching, the one that has helped me the most is to seek complete and accurate information. In investing, both the quantity and quality of information matter enormously. Looking back, most, if not all, my mistakes have resulted from incomplete or inaccurate information, or both. It is thus imperative for me to think about how to seek complete and accurate information, and how to evaluate the required level of margin of safety based on the assessment of information quality.
Needless to say, it is not easy to gather complete and accurate information on a certain public company. After years of making mistakes and learning from them, I have learned the hard way that only accurate and half-complete information is not enough. What separates the best investors from the average investors is the drive to seek both complete and accurate information, with more focus on complete information. I also realized that seeking complete and accurate information is a skill, which can be learned by utilizing a methodological approach.
Generally speaking, public information such as information contained in public filings is accurate. This is why reading annual reports and 10-Ks is very important. For some industries, such as utilities and banks, you can get both accurate and modestly complete information from the public filings.
For instance, in an interview with CNBC's Becky Quick earlier this year, Warren Buffett (Trades, Portfolio) said that he noticed through reading the 10-Ks of the banks that some "had large amounts of transfer from AFS securities to HTM securities, which were carried on the balance sheet at cost. However, the market value of these securities is well below cost." Buffett also noticed, again through reading the 10-Ks, that some banks had "big commercial real estate property exposures that may not be properly valued on the balance sheet." Therefore, he sold a number of banks, some of which Berkshire (BRK.A, Financial) (BRK.B, Financial) had held for more than 25 years.
After watching the interview, I read US Bancorp's (USB, Financial) annual report, which indeed disclosed an unusually large amount of transfer from available-for-sale securities to held-to-maturity securities. It said, “Investment securities totaled $161.7 billion at December 31, 2022, compared with $174.8 billion at Dec. 31, 2021. During 2022, the Company transferred $45.1 billion amortized cost ($40.7 billion fair value) of available-for-sale investment securities to the held-to-maturity category to reflect its new intent for these securities. Average investment securities were $169.4 billion in 2022, compared with $154.7 billion in 2021. As a result of the transfer, approximately 55% of the investment securities are classified as HTM at the end of 2022, compared to only 24% at the end of 2021.”
This is exactly what Buffett talked about in his CNBC interview. In this case, reading US Bancorp's annual report is all you need to understand Buffett's decision.
Similarly, famous short seller Jim Chanos (Trades, Portfolio) noticed the same risk with Silicon Valley Bank long before its collapse. Again, there is accurate and near-complete information in the annual filings of banks.
For many other industries, we can still get accurate information from the 10-Ks. However, we will not be able to get complete information from public filings. In some cases, we get far-from-complete information from reading the public filings. A good example here is the semiconductor industry. While there is plenty of industry data in the annual filings, it is impossible to know the level of excess inventory in the distribution channel from just reading the 10-Ks. While the channel inventory level is a very important indicator of the health of the industry, to find out about the level of inventory, investors will have to do scuttlebutt research, which could be laborious.
In practice, knowing whether we possess complete and accurate information is both science and art. The hard part is to assess how much important information is missing. But the good news is, it will get easier with the accumulation of business knowledge. Buffett did tons of scuttlebutt research when he was young. As he became more experienced, he could make faster and better decisions based on public filings only. I suggest non-professional investors follow Buffett's lead, starting with reading hundreds of annual reports of companies across different industries.
I want to end this discussion by emphasizing that it is perfectly acceptable to use only public information and acknowledge that we do not have complete information. In this case, we can compensate for this lack of complete information by requiring a larger margin of safety. The peril is not knowing what key information is missing or inaccurate and act on the assumption that the information is complete and accurate.
