What is the annual report?

The annual report is a document prepared by a company’s management to the shareholders explaining what happened in the business for the year. There are no real rules for what an annual report contains. Some companies don’t even prepare one.

How is the annual report different from the 10K? Do I need to read both?

If the 10K is regular Coca-Cola, the annual report is Diet Coke. It is a softer, more accessible, easier-to-understand version of the company’s finances, business, and management philosophy. The 10K is often hundreds of pages of text, financial statements, and legal disclosures. The annual report, on the other hand, is sort of a PR document with lots of pictures, colorful graphs, and images of smiling employees.

Some companies don’t prepare an annual report at all, instead releasing everything in the 10K. Others combine a short annual report with the 10K. Still others have a very, very lengthy annual report and their 10K statement consists of nothing but the saying, “incorporated by reference from the company’s annual report.”

The bottom line is that you need to read both the 10K and annual report to get a full understanding of a company. You wouldn’t buy a car without knowing the background of the company that made the automobile and due to the power of compounding, there is much more at stake when you choose a stock to buy.

How do I get a copy of a company’s annual report?

Most companies post their annual report on their website as a free download. If not, you can call or email the investor relations department and request mailed copies be sent to you. These are always free.

For example, you would want to see some of the following relationships:

• A higher growth rate in earnings than the “stock” of the index.
• Lower price-to-earnings ratio than the “stock” of the index.
• A higher dividend yield than the “stock” of the index.
• A much higher return on equity and invested capital than the “stock” of the index.
• If, on average, you can construct a portfolio with these characteristics, over long periods of time your results and compound annual growth rate should, judging by past history, beat the market.

Need a Little Help?
All of that statistical work can be extraordinarily difficult, time consuming, and costly. Thankfully, Morningstar, the market leader in mutual fund research and a major player in the equity markets, as well, has created a tool called X-Ray. For only $14.95 per month (the cost of a premium subscription to the company’s website), you can enter your portfolio one investment at a time. When you’re done, it will prepare a detailed report comparing your assets with the broader market. It will save you all of the time and effort and arm you with the data you need.

Commissions and Fees

The most frequent frictional expense is brokerage commissions and fees. Thankfully, with the advent of the discount broker, the cost of buying and selling securities has been dramatically reduced over the past few decades. At Commerce Bancorp, for example, an investor that places a $2,500 or less trade of no more than 1,000 shares of stock will pay a commission of $29.95 if he places the order online. If, on the other hand, he opts to call the bank and have a broker execute the trade, he will pay $31 plus 1.50% of the principal value of the investment for a total of $68.50. If you had an established dollar cost averaging plan on a monthly basis, that additional commission expense of $38.55 would add up to more than $462.60 per year. Assuming the historical rate of long-term appreciation on equities remains twelve percent, over the course of forty years that would amount to $354,856 in foregone wealth!

Asset management fees can be an even greater impediment to long-term wealth building. Many firms focusing on high net-worth clients will charge fees of 1.5% of assets. A family with a $10 million net worth, under this type of arrangement, would pay $150,000 per year in fees even if they lost money on their investments. This sort of arrangement hardly seems fair. In certain situations, such as estate planning, trusts, and foundation management, however, the fee is justified by the services provided.
Spreads

When buying or selling an investment, a percentage of the investor’s principal is reallocated to the market maker. This reallocation is the spread (i.e., difference) between the bid price (what the buying is willing to pay) and the ask price (what the seller is willing to accept). Like the compounded future value of brokerage commissions, this can amount to significant foregone wealth.

Capital Gains Tax

The unique thing about the capital gains tax is that the investor is free to decide when the tax bill will come due by selling his appreciated securities. Each year that goes by without selling, the value of these deferred taxes becomes greater. To illustrate: assume Adam Smith owns 1,000 shares of Green Gables Industries which he purchased at $35 per share four years ago. Today, the stock is trading at $50 per share. The total value of his holdings is $35,000, of which $15,000 is a capital gain ($50 selling price – $35 cost = $15 per share capital gain x 1,000 shares = $15,000 capital gain). If he were to sell the stock, in addition to the money paid out as brokerage commissions and the spread taken by the market maker, he would have to pay $3,000 in capital gains tax.

This means that he now has $3,000 less in assets working for him, accruing to his benefit. Hence, it would only be intelligent to change investments if Adam believed that 1.) Green Gables Industries was overpriced, or 2.) he found a more attractive investment offering a higher rate of return. For this reason, Benjamin Graham recommended investors only change positions when they are fairly certain the alternative investment has a twenty or thirty percent advantage over their current holding. This rule, although necessarily arbitrary, should help ensure that frictional expenses are covered and the investor’s net worth increases enough to justify the time and effort required to discover the investment and to make the change.

Frictional Expense in the Mutual Funds

Frictional expenses, including management fees and sales loads, are the primary reason actively managed funds as a whole have not outperformed their non-managed counterparts such as index funds over long periods of time. In order for an actively managed fund to merely break even with the market, it would have to earn higher returns by several percentage points to pay the frictional expenses. This is especially true thanks to capital gains taxes which are not applicable to index funds which, because they are a group of non-managed stock assumed to rarely change, do not require the frequent sale of securities.

The owners of the property came back with their counteroffer, but refused to budge much. They had in mind a price that they thought appropriate for the property based upon their own analysis of the comparable sales in the neighborhood. They determined that based upon their own financial needs that they couldn’t afford to sell their asset for the price the market was currently indicating it was worth; indeed, they demanded the same appreciation that had been the rule for the past twenty years, not recognizing the new reality. That’s fine. That’s what I’ve been trying to teach you with the thousands of articles that have been published. Although I trust my own analysis (this is what I do for a living – valuing assets, buying them at attractive levels, and generating profit on those capital commitments), they had arrived at their own estimate of replacement value for the property. They will now either have to continue holding the real estate, wait for an offer that they think is more inline with their estimate of value, or be forced into a sale if they can’t hold out until the market recovers.

Now, here’s where most people make huge errors that cost them years, even decades, of wealth building effort. If they had owned a basket of stocks – say, shares of Wal-Mart, General Electric, Johnson & Johnson, and U.S. Bancorp – and they had experienced a drop of 10% or 20%, let alone the 50% drubbing many equities have taken over the past year, it’s unlikely that these same people would apply a rational disposition to their portfolio like they did their house. They wouldn’t research the valuation of comparable businesses to each of those they owned, estimate what they think their share of those businesses was, and then refuse to sell (or better yet, buy more while it was cheap) until it reflected a conservative estimate of intrinsic value.

Instead, it’s likely that they would be more likely to sell the further prices fell because they trusted their neighbor’s estimate of what their property is worth instead of their own, cold, dispassionate calculation. I wrote you a few weeks ago and told you that if you were selling your 401(k) assets, people like me were out there buying them in the midst of all the fear. In a few years, you would wonder why we had gotten substantially richer.

The bottom line: You must assess all of the assets in your life based on their estimated intrinsic value. There’s nothing more irrational than saying, “My accounts are down $10,000 or $100,000 or $500,000! What do I do?” If you are invested in a broad-based, low-cost index fund, falling prices are good for you in the long run. That’s because the dividend yield on your portfolio will increase, allowing you to purchase more shares with your reinvested earnings. Your regular contributions will also purchase more shares. This is the secret to building equity, which is the surefire way to building wealth.

Understanding Intrinsic Value and Why Different Businesses Deserve Different Valuations

At its core, the basic definition for the intrinsic value of every asset in the world is simple: It is all of the cash flows that will be generated by that asset discounted back to the present moment at an appropriate rate that factors in opportunity cost (typically measured against the risk-free U.S. Treasury) and inflation. Figuring out how to apply that to individual stocks can be extremely difficult depending upon the nature and economics of the particular business. As Benjamin Graham, the father of the security analysis industry, entreated his disciples, however, one need not know the exact weight of a man to know that he is fat or the exact age of a woman to know she is old. By focusing only on those opportunities that are clearly and squarely in your circle of competence and you know to be better than average, you have a much higher likelihood of experiences good, if not great, results over long periods of time.

All businesses are not created equal. An advertising firm that requires nothing more than pencils and desks is inherently a better business than a steel mill that, just to begin operating, requires tens of millions of dollar or more in startup capital investment. All else being equal, an advertising firm rightfully deserves a higher price to earnings multiple because in an inflationary environment, the owners (shareholders) aren’t going to have to keep shelling out cash for capital expenditures to maintain the property, plant, and equipment. This is also why intelligent investors must distinguish between the reported net income figure and true, “economic” profit, or “owner” earnings as Warren Buffett has called it. These figures represent the amount of cash that the owner could take out of the business and reinvest elsewhere or spend on diamonds, houses, planes, charitable donations, or gold-plated fine china.

In other words, it doesn’t matter what the reported net income is, but rather, how many hamburgers the owner can buy relative to his investment in the business. That’s why capital-intensive enterprises are typically anathema to long-term investors as they realize very little of their reported income will translate into tangible, liquid wealth because of a very, very important basic truth: Over the long-term, the rise in an investor’s net worth is limited to the return on equity generated by the underlying company. Anything else, such as relying on a bull market or that the next person in line will pay more for the company than you (the appropriately dubbed “greater fool” theory) is inherently speculative. I don’t know about you, but I don’t want to be in doubt about my ability to retire comfortably.

The result of this fundamental viewpoint is that two businesses might have identical earnings of $10 million, yet Company ABC may generate only $5 million and the other, Company XYZ, $20 million in “owner earnings”. Therefore, Company XYZ could have a price-to-earnings ratio four times higher than its competitor ABC yet still be trading at the same value.

The Importance of a Margin of Safety

The danger with this approach is that, if taken too far as human psychology is apt to do, is that any basis for rational valuation is quickly thrown out the window. Typically, if you are paying more than 15x earnings for a company, you need to seriously examine the underlying assumptions you have for its future profitable and intrinsic value. With that said, a wholesale rejection of shares over that price is not wise. A year ago, I remember reading a story detailing that in the 1990’s, the cheapest stock in retrospect was Dell Computers at 50x earnings. That’s right – had you bought it at that price, you would have absolutely crushed nearly every other investment because the underlying profits really did live up to Wall Street’s expectations, and then some! However, would you have been comfortable having your entire net worth invested in such a risky business if you didn’t understand the economics of the computer industry, the future drivers of demand, the commodity nature of the PC and the low-cost structure that gives Dell a superior advantage over competitors, and the distinct possibility that one fatal mistake could wipeout a huge portion of your net worth? Probably not.

The Ideal Compromise

The perfect situation is when you get an excellent business that generates copious amounts of cash with little or no capital investment on the part of the owners relative to the profits at a steep discount to intrinsic value, such as American Express during the Salad Oil scandal or Wells Fargo when it traded at 5x earnings during the real estate crash of the late 1980’s and early 1990’s. A nice test you can use is to close your eyes and try to imagine what a business will look like in ten years; do you think it will be bigger and more profitable? What about the profits – how will they be generated? What are the threats to the competitive landscape? An example that might help: Do you think Blockbuster will still be the dominant video rental franchise? Personally, it is my belief that the model of delivering plastic disks is entirely antiquated and as broadband becomes faster and faster, the content will eventually be streamed, rented, or purchased directly from the studios without any need for a middle man at all, allowing the creators of content to keep the entire capital. That would certainly cause me to require a much larger margin of safety before buying into an enterprise that faces such a very real technological obsolesce problem.

Say you are in the grocery store with a friend on a Thursday afternoon and see something you need for your house; a broom for example. Although you get your paycheck the next day, you ask your shopping buddy to borrow a few dollars so you can purchase the broom now, in return for which you will not only pay them back tomorrow, but buy them dinner as well. Your friend, finding these terms acceptable, loans you the money and you purchase the item.

This is, in essence, what happens in the corporate world when a company issues bonds. Generally, as a business grows, it doesn’t generate enough cash internally to pay for the supplies and equipment necessary to keep it growing. Because of this, most businesses have one of two options. They can either 1.) sell a portion of the company to the general public by issuing additional shares of stock, or they can 2.) issue bonds. When a company issues bonds, it is borrowing money from investors in exchange for which it agrees to pay them interest at set intervals for a predetermined amount of time. In essence, it is the same thing as a mortgage only you, the investor, are the bank.

Why Would Anyone Invest in Bonds?

Most everyone knows that over the long-run, nothing beats the stock market. This being the case, why would anyone invest in bonds? Although they pale in comparison to equities in the long run, bonds have several traits that stocks simply can’t match.

First, capital preservation. Unless a company goes bankrupt, a bondholder can be almost completely certain that they will receive the amount they originally invested. Stocks, which are subordinate to bonds, bear the brunt of unfavorable developments.

Secondly, bonds pay interest at set intervals of time, which can provide valuable income for retired couples, individuals, or those who need the cash flow. For instance, if someone owned $100,000 worth of bonds that paid 8% interest annually (that would be $8,000 yearly), a fraction of that interest would be sent to the bondholder either monthly or quarterly, giving them money to live on or invest elsewhere.

Bonds can also have large tax advantage for some people. When a government or municipality issues various types of bonds to raise money to build bridges, roads, etc., the interest that is earned is tax exempt. This can be especially advantageous for those whom are retired or want to minimize their total tax liability.