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Annual Report: Owners Manual!

Jul 7, 2004

What are the primary sources of information for retail investors before taking an investment decision in a stock or in a stock market?

  1. Business newspapers and magazines

  2. TV channels

  3. Financial websites

  4. Brokers

  5. Research houses
Are we forgetting that there is something called the Annual Report, the most authentic source of information on a company? In this article, we try and evaluate how an investor could use the annual report to his advantage and make informed investment decision. We will focus more from a qualitative aspect as opposed to going into analyzing numbers.

What is the purpose of the Annual Report?

Like a Finance Minister presents a year's performance and his outlook for the economy in his Union Budget speech, it is the duty of the management of the company to present its view on the company's previous year's performance and its future outlook to its shareholders. After all, the shareholders have funded the management's long-term objective. Through the annual report, the management conveys its views on the economy, on the sector that it represents, the performance relative to the industry and the future growth prospects. Every shareholder is supposed to receive a copy of the annual report. Even if one is not a shareholder of a company, the latest annual reports, quarterly statements and other information filed by a company are available at www.sebiedifar.nic.in

What aspects could one look for?

  1. Target Vs achievement: One factor that could enable investors to understand the management of the company is to try and match what the management expected at the start of the year and whether it materialized (of course, extraordinary events are beyond anybody's control).

    If a company X expected its revenues to grow by 40% in a year and landed up with a 20% growth at the end of the year, it is important to understand what is the reason for the same? Was the management aggressive for the sake of it or is it a matter failing to look at reality in proper perspective? If the management's explanation is that of slower demand growth, as a matter of conservatism, it should have been ideally conservative in its stand at the start of the year.

  2. Consistency factor: It is not only important to look at what the management is saying in one year but over a period of 2 to 3 years in the past. More than anything else, for long-term investors, it is pertinent to have a confidence in the management before investing in that stock. A two to three year reading of the management statement will enable investor to firm a view on whether the management is directing the company towards its long-term vision and how.

    Also, it could be useful to look at whether the company is making adequate effort to explain its stand to investors. Some companies prepare a detailed report (Infosys comes to mind first) whereas there are companies, which prepare annual report for the sake of it.

  3. Peer comparison: If you are planning to invest/stay invested in say, Tata Motors and you have got the annual report, it will also be useful to understand what Ashok Leyland (the competitor) is saying about industry performance and future prospects.

  4. History in perspective: Most of the companies also highlight the financial performance of the company over a five to ten year period (including the recent year). Though it is important to understand the factors behind these numbers, one could understand from the same, the volatility in numbers (if any), the overall direction in terms of profitability, dividend history and shareholder return ratios.

  5. Auditor report: It is important to read the auditors report of the company and understand whether auditors have qualified the financial statements. By qualified, we mean whether the auditors found the information disclosed by the company adequate to prepare the accounts and whether the accounting policies are appropriate. There are companies wherein the auditors have failed to qualify the financial statement. At the end of the day, an investor has to be sure that the financial statements reflect the true picture.

If an investor makes an effort to understand these aspects, it is possible to arrive at a holistic view of the company's standing in the industry, the management's ability to steer the company through ups and downs and finally, whether it is shareholder return focused or not.

At the same time, some points that could be borne in mind are:

  1. The management of a company is always positive/bullish about its growth prospects and that's why it is the business in the first place. While some companies are conservative by nature, there are companies that have gone overboard at times and later, failed to match expectations. So, it is good to be able to distinguish wheat from the chaff.

  2. Since managers usually take a long-term view of events, shareholders also need to have long-term perspective. Otherwise, there is a mismatch. In this context, one should be realistic in expectations.

If an investor wishes to make an informed investment decision, it is pertinent to read the recent annual reports. From this exercise, atleast it will be clear what business one is buying into and whether it is a competitive industry to be invested for the long-term. Remember, it is after all "buyers beware!"

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