Become Your Own Expert

Perhaps the greatest challenge in making investment decisions is not the decision itself, but the question of choosing from among many, many indicators. The truly wise investor has strong beliefs about the validity of the limited number of indicators that are important to follow and use to make decisions.

The difficulty, then, is narrowing down your field of analysis. You would find decisions impossible if you were to consider and compare every possible form of fundamental analysis. At some point, you need to determine what ratios and formulas give you useful information. The rest may be interesting, but it must be rejected. You need to define and set priorities. Otherwise, you may find yourself spending all of your time analyzing. By the time you identify the right decision, opportunity has come and gone.

This is the problem for all investors, even those preferring technical indicators. Once an opportunity has been identified, a decision must be made. Markets move and change quickly, and successful investors must also be quick decision makers. A first step in this goal is to become informed about financial statements, comfortable with analyzing them, and proficient at narrowing the range of study so that you can quickly determine the current status of that company.

An informed view about financial statements comes about not from having accounting expertise. On the contrary, too much analytical and financial expertise may get in the way of investment sensibility. Accountants think about the numbers and spend a lot of energy with forecast about future numbers. Investors use the numbers to think about investment value and future investment value. These are vastly different points of view.

Financial statements, viewed by themselves, can marginalize the fundamental information you need and want. If part of an annual report, you should not ignore the accompanying materials. The three big sections of the annual report worth studying are:

1.    Management's discussion of operations. Here you can learn a lot about how management defines its role. How does it discuss the past, especially if the prior year was disappointing? What kinds of forecasts are made by management? Most important of all, were management's forecasts from past annual reports accurate?

2.    Auditor's report. Read the auditor's report thoroughly and carefully. Be sure you comprehend what is being said. Look for the fourth paragraph where any exceptions will be noted. Unless the auditor's report is clearly unqualified, you should investigate the significance of the qualification and determine how that affects the dependability of the published financial statements.

3.    Notes. Many observers believe the most important information is found in the notes. While fundamental analysts believe in the worth of the numbers, the notes might tell you whether or not the numbers tell the whole story. At the very least, the notes are good indicators about what special circumstances should be kept in mind when developing opinions based on those financial statements.