The Annual Report

One of the strangest documents in the stock market has to be the annual report. This is a very expensively produced, often multiple-color report including financial statements and forecasts, a message from the top management, photographs, descriptions of the operations of the company, and other interesting information. Most of it is strictly promotional.

Annual reports are useful for finding out about the industry or industries the company is involved in, and in learning about products or services it manufactures or sells. But you are not likely to read an annual report that has any bad news whatsoever. (Even bad news will be reported in terms that makes it sound very good.) Annual reports usually are produced by a company's public relations department or an outside advertising agency. The message from the president is rarely written by the president, but is instead the best possible spin put on everything the company does. ("The past is a strong indicator, we have had a record year, and the future is very exciting.") The document also presents information with colorful, 3-D graphs and offers the reader a slogan that often sounds good but says little or nothing: "Leading the way to tomorrow" or "On the edge of discovery" or "Leadership that cares about you."

So why do companies go through the exercise? Because the annual report is required by law (the financial—not the promotional— part). Publicly traded companies have to publish financial statements in a prescribed form, containing disclosures of all important information including an auditor's report. As financial statements are published as a part of the annual report, these documents certainly are handy. They can be requested from the corporate headquarters directly, by mail, telephone, over the Internet, or they can be picked up from a brokerage firm. As a convenient way to find the financial statement, annual reports serve a worthwhile purpose. However, you can also glean additional information from the annual report. Don't forget that the primary purpose of the annual report—beyond compliance with the law—is to recruit new shareholders, impress analysts, and outshine competitors.

A company's management realizes that the majority of investors do not spend a lot of time studying financial statements, even when they recognize their significance. People simply don't like to spend time with numbers. So documents like the prospectus, annual report, and forms filed with the Securities and Exchange Commission rarely are read as carefully as they deserve. Instead, most people prefer to read the sections of the annual report that avoid the numbers and provide the reader with color pictures and promising narratives.

f KEY POINT

Don't forget that a company's annual report is a glossy promotional piece. Read the whole thing carefully, but watch the tone and compare them from year to year to see what is really going on in a company.

What should you look for in this document? First of all, don't make the common mistake of looking only at one result—sales or profits, for example. Identify those indicators that make up your overall fundamental analysis program, and then test them against what is reported in the financial sections of the annual report.

Read the notes completely. The notes to the financial statements may contain important financial information. For example, you may learn of pending lawsuits, labor problems, changes in management, or accounting method changes (more on notes in the next chapter).

Read the auditor's report. Has the independent auditing firm issued an unqualified report? If not, what reasons are provided for qualifying the report? Any qualifying remarks should lead to further questioning and investigation.

Look for extraordinary items. The company's financial results will be distorted if any extraordinary items are included, such as a write-off of a subsidiary loss, large adjustments for international exchange rate losses or gains, or changes in accounting methods. Those items should be discounted when performing any ongoing trend analysis. If extraordinary items show up frequently on the financial statements, you should start to wonder why.