By early March, most public companies have to file their 10-Ks. (For those who are unfamiliar with the term, a 10-K is an annual report required by the U.S. Securities and Exchange Commission (SEC) that gives a comprehensive summary of a company’s financial performance.) Investors who want to gain a deeper understanding of a company’s business and how it is performing, how management allocates capital and what the risks of the business may be should spend time reviewing the 10-K. Surprisingly, not all professional investors and analysts read the 10-K. Some get their information second-hand from a service provider such as Bloomberg or Reuters. Traders who base their decisions on price movements and reviewing charts also do not read 10-Ks, as their process does not require a fundamental understanding of a company’s business.
The following represent some of the key sections of the 10-K that we review:
Management Discussion And Analysis
This section provides insights into what management views as the key drivers of the company’s business in terms of both revenues and expenses. It is also important to assess whether or not these drivers are sustainable. Management’s tone should also be assessed: How open is their communication? Do they discuss what went wrong, or only what worked well? Is there a discussion of both challenges and opportunities? A strong management team should be constantly assessing threats to the business. They should also be open to learning from their mistakes.
Risk Factors
Much of this section is more or less boiler plate language. In general, the more specific a risk factor is, the more likely it is to be relevant. It is also relevant to look for changes in risk factors from one year to the next. This will help identify what may have recently become a concern for the company.
Financial Statement Footnotes
The footnotes are the meat of the financial statements. They include some of the following elements: critical accounting policies, contractual obligations and commitments (many of these are not on the balance sheet), details about merger and acquisition activity, intangible assets, pensions and stock-based compensation. These notes can also be a source of new information. If anything in a company’s 10-K is going to move the share price, it is likely that it will be found in the footnotes.
Summary
At BWFA, reviewing company 10-Ks (as well as 10-Qs – quarterly statements filed with the SEC that contain less detail than the 10-K), is an integral part of the research process. Reviewing 10-Ks helps us to better understand the businesses of the equities held in client portfolios, particularly the competitive landscape, the future outlook, whether accounting policies are conservative or aggressive, and the effectiveness of management’s capital allocation policy. It is also important to review a company’s progress over time to help confirm that the investment thesis still applies and that the qualities that originally led to investment are still present. Comparing the text in 10-Ks from different years can also help identify potential areas of concern. In our view, fundamental analysis is not complete unless it includes a review of a company’s 10-K.