How to read an Annual Report

It is that time of the year when Annual Reports start hitting the mailboxes of investors. There are three things you can do with the Annual Reports you receive:

1. Toss it into the recycling pile with the old newspapers and beer bottles without even opening the envelope

2. Check the Profit & Loss statement and the dividend amount before tossing it into the recycling pile

3. Actually take the trouble of going through the Annual Report in detail to find out whether the company whose stocks you are holding is growing, stagnating or flying kites.

In the wild west days in the USA, there used to be a saying: The only good Indian is a dead Indian. Of course they didn’t mean people from India (though Columbus thought he had reached the East Indies – the islands of South East Asia - when he landed up on the shores of the Bahamas).

If you believe that the only good Annual Report is the one lying ‘dead’ in the recycling pile, then this post isn’t for you. If you think otherwise, please read on.

First, go to the Cash Flow Statement to find out if the company is generating enough cash from its business to finance part or most of its expenditure for growth. If you don’t know how to read a Cash Flow Statement, please read my posts of  Mar 22 2011, Mar 24 2011, Mar 29 2011 and Apr 5 2011.

Next, check out the Profit & Loss statement and the Balance Sheet. Of particular interest should be inventory and accounts receivable (if percentage increases are more than the sales percentage increase, they are warning signs); increase in equity capital and loans (not a good sign if these increase frequently); cash in hand/banks should tally with the figure in the Cash Flow Statement (so that a Satyam-like situation doesn’t recur).

Next comes the Directors’ Report and Management Discussion and Analysis. Read through these even though there will be hardly any negative feedback in them. They will give an idea about the industry and the company’s growth plans and (rosy) prospects.

Last, but not the least, are the Notes on Accounts. However boring these notes may seem – particularly to non-accountants like me – they contain a wealth of information that usually have adverse implications on profits. If a company suddenly announces a surprising turnaround or spectacular recovery in results, chance are that they have ‘cooked their books’ (a Punj Lloyd speciality). Look for changes in depreciation calculation and inventory valuation, which can significantly alter profits without an actual improvement in performance.

Also look at the court cases – usually with various tax authorities regarding disputed demands. Prudent managements will make at least part provisions against likely future liabilities. For companies that provide stock options to their employees, use the diluted EPS to calculate P/E ratios. For companies that have several subsidiaries – listed or otherwise – use the consolidated results for analysis.

There are many other things to look for in an Annual Report – but these are the broad areas for a first-cut analysis to ensure that business and growth are on track.

(Note: Thanks to reader Jalal for suggesting this topic.)

How small investors can widen their Circle of Competence

Warren Buffett is a strong believer of the Circle of Competence concept. If a company or business doesn’t fall within his Circle of Competence, he won’t touch it. He famously avoided buying into any high-tech company in the 1990s – when every one and his brother-in-law were investing in dot.com companies. He didn’t understand how high-tech companies were making money, and whether they had sustainable businesses. He missed the boom – and the inevitable bust that followed.

Warren Buffett is one of a kind. You and I will never be able to match his skill and wisdom in investing. That doesn’t mean we shouldn’t follow some of his money-making principles. What if our Circle of Competence is too limited? Is there a way to widen the Circle?

Let me give you the bad news first. You can’t widen your Circle of Competence in a hurry. It is a process that will take a lot of time and effort. The good news is that the process is not difficult or complicated. It takes patience, perseverance, and a plan.

First make a short-list of all the knowledgeable people you know. The list isn’t likely to be a long one if you are looking for people with real knowledge. Not some one who knows how many hundreds Tendulkar scored before the age of 25, or the exact locations of the seven wonders of the world. But some one who knows about the economy, business and industry.

Next, figure out how you can meet such people without imposing too much on their time and patience. May be he is a friend’s father or your wife’s uncle. If you inform them in advance that you want to meet them, and the reasons for the meeting, knowledgeable people will be more than happy to share some of their experiences.

Don’t know anyone knowledgeable enough? Join discussion forums and investment groups. There are many in cyberspace. Each group or forum will have a few knowledgeable members. Try and pick their brains.

Going to a family wedding or a party? Don’t just waste your time eating and drinking and being merry. Introduce yourself to people you don’t know, and find out about what they do. If you show genuine interest in their activities, they will give you a lot of information that you won’t find in TV channels or pink papers.

Carry on this process for some time, and you will be amazed at how much wider your Circle of Competence can become. Then, have the discipline to stick to your Circle of Competence when choosing stocks to buy. That will prevent you from getting badly stuck in the shares of a company that you really know nothing about. Like Suzlon, or Punj Lloyd, or Bartronics.

Related Post

What is your Circle of Competence?

A Tale of Two Charts – Voltas and Punj Lloyd

Why write about these two charts? They are like chalk and cheese. One a boring stalwart from the house of Tata that doesn’t get a passing glance from small investors. The other a darling of the previous bull market that was hailed as the ‘next L&T’, and found a place in the portfolio of many small investors.

Back on Mar 24 ‘10, I had posted an update on the stock chart pattern of Voltas Ltd. The stock had touched a high of 190 in Jan ‘10, only to correct down to the long-term support zone between 145-150 before moving up to 177. The technical indicators were looking bullish, but valuations were a bit stretched. This is what I had recommended to my readers:

‘Existing holders can place a stop-loss at 150 and remain long. New entrants can use any dips to the 150 level to enter... Those who are stuck in debt-ridden, operating cash flow negative stocks, like Punj Lloyd, can make a switch.’

That last sentence motivated me to compare the two charts, when I decided it was time to write another update on the stock chart pattern of Voltas Ltd. Here are the one year bar chart patterns of Voltas and Punj Lloyd.

Voltas

The closing price of Voltas on Mar 23 ‘10 – marked with the blue arrow – was 177.60. The stock was in the middle of its bull rally. After testing the support from its rising 200 day EMA in May ‘10 – when it dropped to an intra-day low of 157 – the stock continued its bullish pattern of higher tops and higher bottoms. It finally reached a high of 262.50 in Nov ‘10, falling short of its high of 267 touched in Dec ‘07.

The first leg of the correction found support above the rising 100 day EMA. The stock moved up to test its previous high, fell just short at 260 and formed a bearish double top pattern that gave a signal to book profits. The subsequent correction has been exacerbated by the not-so-great Q3 results (profits were lower both on YoY and QoQ basis).

The stock dropped to an intra-day low of 159 on Feb 9 ‘11 – close to its May ‘10 low of 157 - correcting almost 40% from its Nov ‘10 peak. The ‘death cross’ of the 50 day EMA below the 200 day EMA (marked by a blue oval) confirms a bear market. Note that the pullback rally of the past few sessions has found resistance from the falling 20 day EMA.

All four technical indicators are bearish. The stock may fall to its support zone of 145-150. If the support doesn’t hold, a drop to 100 is possible. Voltas remains a good stock fundamentally, and lower levels mentioned could be good entry points.

If any investor had listened to my advice and switched from Punj Lloyd, but failed to book profit in Nov ‘10 or Dec ‘10, today’s (Feb 16 ‘11) closing price of 177.20 means he has still not made a loss. What if some one had hung on to Punj Lloyd or, horror of horrors, bought more thinking that the down side was limited? See for yourself.

Punj Lloyd

The stock’s bull rally had peaked out at 276 in Oct ‘09. Within the space of the next 8 trading sessions, the stock dropped below its 200 day EMA after the bad news of its UK project delays and resulting penalty hit the markets. The stock was already five months into a bear market. Its closing price on Mar 23 ‘10 – marked with the blue arrow – was 177.35, prompting me to recommend the switch to Voltas.

Punj Lloyd continued in its bear market, making lower tops and lower bottoms – except for a brief attempt at revival during Sep and Oct ‘10. The bears snuffed out all bullish hopes before the stock could touch its falling 200 day EMA from below. Disastrous Q3 results (a loss at the net level) caused heavy selling.

The stock has fallen 73% from its Oct ‘09 peak, and can fall much lower. The huge debt burden coupled with severely negative cash flows from operations is a killer cocktail. If you are still invested in this stock, ask yourself: Why?

Bottomline? Comparing the stock chart patterns of Voltas Ltd and Punj Lloyd exemplifies Benjamin Graham’s statement: In the short-term the market acts like a voting machine, but in the long-term it is a weighing machine.