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Saturday, July 18, 2015

5 More Reasons to Read Annual Reports - Vishal Khandelwal

July 17, 2015 by Vishal Khandelwal

Here’s an old joke. A policeman sees a drunk man searching for something under a streetlight and asks what the drunk has lost. He says he lost his keys and they both look under the streetlight together.

After a few minutes, the policeman asks if he is sure he lost them here, and the drunk replies, no, and that he lost them in the park.

The policeman asks why he is searching here, and the drunk replies, “This is where the light is.”

Behavioural scientists call this the “streetlight effect”, which is a type of observational bias where people only look for whatever they are searching by looking where it is easiest.

When it comes to investing, most people suffer from the streetlight effect and search for keys (stock ideas) where it looks the easiest (stock market and stock prices). But the reality is that the stock market is rarely the place where you can find the best ideas for long term investment.

Rather, the best ideas are found by looking at businesses, studying them, and identifying which ones are doing well, which ones may continue to do well, and which ones may be going downhill.

And how do you know that?

Well, one of the most authentic resources to study a business is its Annual Report – that boring, often in black and white, document a company releases at the end of every financial year to share what it did in the year gone by.

Anyways, I am not writing today to stress upon the importance of reading annual reports, or how to read annual reports, but just to share about five new disclosures I see in the FY15 annual reports of Indian companies.

Most of these disclosures won’t help you understand much about the business quality, but give a perspective on how the top managers reward themselves.

Here are five new pieces of information that you will find interesting, if you think that annual reports are completely boring.

1. Salaries Drawn by Managers & Directors

While the companies were mandated even earlier to share the break-up of the salaries for their directors including their MD, CEO and other key personnel, they are required to disclose far more FY15 onwards, like –
Ratio of remuneration of each whole-time director to the median remuneration of all employees of the company
Increase in pay for top employees over the previous year vs increase in median remuneration
Increase in top management pay relative to the company’s performance.

What you can assess from tiny bits of information is whether the top managers and directors are paying themselves in or out of line with other employees, and with the company’s performance. A useful analysis can also be done with the company’s competitors.

For instance, Vishal Sikka of Infosys draws 116 times the median pay of his company, versus 89 times that Wipro’s Azim Premji earns. ICICI Bank’s CEO earned 97 times that of the median employee in FY15, while Axis Bank’s CEO earned 74 times.

Well, the negative side of availability of this data point may be that it will give the CEO whose pay is lower as compared to his/her peer’s pay – or in relation to median pay or as percentage of net profits – one more reason to ask for a pay hike next year.

2. Actions of Top Shareholders

As per new disclosure norms, companies are required to provide details of what their directors and key managers did with their shareholding in the company in the past year. Details of what the top ten shareholders did during the year is also available now.
The disclosures about what directors and managers did with their shareholding is especially important here as these will suggest whether these insiders buying more into, or selling out of the company.

The details on what the top ten non-promoter shareholders did can be even more interesting. Exide’s annual report, for instance, tells me that LIC, its biggest non-promoter shareholder, brought its stake down from 7.35% at the start of FY15 to 4.85% by the end of the year. On the other hand, Amansa Holdings, one of the very few investment funds I admire, bought 1.09% of the stock during the year. Another respectable fund, Nalanda, held on to its stake in the company at 3.56%.

Now, the negative side of such a disclosure is that it may lead the mind into a sort of Authority Bias. For instance, if I like Amansa’s or Nalanda’s investment philosophies (which I do), the fact that they are buying or holding onto Exide will create a positive bias in my mind towards the business. So another devil to take care of here!

3. Indebtedness of the Business

The third key disclosure that I see in FY15 annual reports is with respect to the company’s indebtedness. Unlike the past, when one had to search through the notes and schedules to gauge the company’s debt situation, the new disclosures lay it clearly in a tabular form, details like –
Amount of principal due
Amount of interest due
New borrowing or repayment during the year

Overall, another nice disclosure to have that cuts down on the hard work to identify the true indebtedness of a business.

4. Dealings with Related Parties

Another welcome disclosure is that on how the business dealt with related parties (like top managers, promoters, directors or parent or associate firms) during the year. Now, a company entering into related party transactions is normal, but it’s the extent and complexity of such transactions that determines whether the dealings are comfortable or smell of something fishy (like DLF selling a large part of its properties to its subsidiary DLF Assets, and calling it as ‘sales’).

A related party transaction can be an easy way for the promoter to take cash out of the business and into his/her small, unlisted firm. So, the new requirements that all related party transactions are at market rates and at an arm’s length basis is a welcome disclosure.

What is more, if the transactions are not at market rates, the directors have to justify why the transaction was entered into in the first place.

Anyways, while not all, some related party statements can throw up nice insights on the business. Take, for instance, the related party table of housing finance major HDFC, which reveals this…

5. Key Business Details

This new section in the annual report – titled “Form No. MGT-9 Extract of Annual Return” is what gives you a quick snapshot of the business, which is helpful in case you are looking at the business for the first time. Here, you can find details like –

Date of incorporation of the company and its address
Key activities that contribute more than 10% of the revenue
Details of holding, subsidiary, and associate companies
Shareholding pattern and actions by key shareholders during the year
Indebtedness of the firm
Remuneration paid to directors and key managers

In short, this section will help you with all the basic and initial information you may need before you deep-dive into understanding the company’s business and numbers.

For instance, this is what the section on key activities looks like in Hindustan Unilever’s annual report, and which quickly reveals which segments I must really focus on while analyzing the business…

Bring Out the Annual Reports

In an article in Fortune magazine entitled “Best Advice I ever got”, legendary commodities investor Jim Rogers talked about how you can get an edge on the vast majority of people in the stock market if you simply read everything you can on a prospective investment. He said –

The best advice I ever got was on an airplane. It was in my early days on Wall Street. I was flying to Chicago, and I sat next to an older guy. Anyway, I remember him as being an old guy, which means he may have been 40. He told me to read everything.

If you get interested in a company and you read the annual report, he said, you will have done more than 98% of the people on Wall Street. And if you read the footnotes in the annual report you will have done more than 100% of the people on Wall Street.

I realized right away that if I just literally read a company’s annual report and the notes — or better yet, two or three years of reports — that I would know much more than others. Professional investors used to sort of be dazzled. Everyone seemed to think I was smart. I later realized that I had to do more than just that. I learned that I had to read the annual reports of those I am investing in and their competitors’ annual reports, the trade journals, and everything that I could get my hands on. But I realized that most people don’t bother even doing the basic homework. And if I did even more, I’d be so far ahead that I’d probably be able to find successful investments.

So, rather than ruing why you missed that latest multi-bagger stock and how you never seem to find good businesses, pick up an annual report and start reading it. You may start from the annual reports of companies you already own. And if you realize that you are not understanding a bit of what you are reading, ask yourself what that company is doing in your portfolio. Maybe you should sell that stock, simply because you do not understand the underlying business.

On the other hand, if an annual report reveals some new insights and you realize that you never looked at the business that way and that this insight was a positive one for the business’s future, maybe it’s time to buy more of that stock (in case it’s still available at reasonable valuations).

But you will never identify such issues – negative or positive – till you read annual reports.

By the way, if you need to get your hands to hard copies of more annual reports than the companies you own, here is what you can do…write a letter, like I’ve written, to the residents of your housing society…

Dear Residents,

This is to request you to kindly share the Annual Reports of companies that you may have received and are looking to discard.

I am a reader of annual reports, and am thus collecting the ones from the latest financial year 2014-15.

So, if you wish to share them, kindly leave them at the Entry Gate. I will collect from there.

Thanking you in anticipation!

With respect,
[Your Name]
[Your House No.]

…and the response I’ve received, in terms of people giving me their untouched annual reports, has been pretty good.

Unlike what you may believe, annual reports are interesting documents…and many times you can see the story of the business evolving if you are willing to look through the eyes of an annual report.

Just give it a chance.


Statutory Warning: This is NOT an investment advice to buy or sell shares. Please make your own decision, as blindly acting on anyone else’s research and opinions can be injurious to your wealth. I do not own any stock mentioned above. I am a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014 (Registration No. INH000000578).

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