Remember those new year resolutions of 2015 – the ones like “lose ten pounds, learn a foreign language, and travel to distant places?” For the most savvy investors, don’t forget one more: read more annual reports. It’s the perfect time to make good on this commitment. Most companies’ reports are available now except for the smallest public firms. With earnings season for the first quarter only a month away, it’s the perfect time to review a company’s annual report and get a snapshot of what the outlook will be in the year ahead. These reports can easily run hundreds of pages long; rather than get bogged down by the details, here are 5 things to watch for:
1. Venezuela. The country’s battles with inflation and unrest have led to persistent currency devaluations that cause translation headaches and earnings jolts for U.S. multinationals operating in Venezuela. Run a Control-F on “Venezuela” in every annual report to find mentions of the firm’s revenue and net investment exposure to Venezuelan turmoil.
2. The strong U.S. Dollar’s footprints. Another foreign exposure, yet close to home. The value of the greenback rose rapidly in 2014 and expected to strengthen further. While this signals it’s probably a good time for U.S. tourist to finally book that Europe vacation, it gets more complex for U.S. companies. Find the “Statement of Comprehensive Income,” which usually follows the income statement, and look for an item in it called “Currency Translation Adjustment.” If it’s big – for instance, compared to pretax income – and negative, the company was affected negatively by the dollar’s strength in the last part of 2014. Also, take a look at the Management’s Discussion & Analysis (MD&A) section to see if management has any warnings of what to expect in 2015.
3. Contractual payments. One of the handiest 10-K requirements the SEC ever dreamed up, this table lists by year the contractually-required cash obligations of a firm right in the MD&A. Think of it as a company-issued cash budget – at least for the outflows. Compare the near-term outflows to the cash generated by the company’s operations as shown in the cash flow statement – before a company’s shorts get it in a knot, so to speak.
4. Low tax rates. If a firm has been chiseling a little more out its tax rate each year by “indefinitely reinvesting” more untaxed foreign earnings, you’d be right to be somewhat skeptical. After all, all good things come to an end. Check the strength of a firm’s operating earnings; if the company depends on improving its tax rate to improve net earnings, instead of operating earnings, increase your skepticism.
5. Read the “Critical Accounting Policies & Estimates” in the MD&A. This is where management is warning you about the most sensitive areas in the financial statements – the places where they have to come up with the most malleable numbers they report to shareholders. Consider it a gut check or an IQ test – if you don’t have the slightest idea of what they’re telling you, you probably should not be an investor in the company.
Read all of the annual report – but it helps to have a goal when you start. Make these five points your minimum goal and get started. By the time the first quarter is reported, you’ll be finished with the annual reports – and you can start working on those ten pounds.
Jack T. Ciesielski is president of R.G. Associates, Inc., an asset management and research firm in Baltimore that publishes The Analyst’s Accounting Observer, a research service for institutional.