How To Analyze Stocks Like A Hedge Fund
The key to reading 10Ks
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If you invest in stocks, fundamental analysis is a huge part of the process. 10Ks tell you everything that you need to know about the company.
In this newsletter, I will show you simple steps that you can take to read and understand any 10K annual report in the most simplest yet productive manner.
It is mandatory that investors on any level know how to read a 10K annual report because it is the only way to truly understand the business.
At first glance, it will seem that reading the annual report is very time consuming due to the length of each report.
However, I do not believe that reading the entire annual report is the best use of your time. (I also thought this about my college textbooks, sorry mom.)
I will discuss the most important sections in a 10-K annual report that require reading and will cover what I'm looking for in each.
NOTE: When you invest in a stock, you are investing in a business. You need to understand the business.
How To Find The Annual Report
The most simplest way to find a 10K is by just doing a google search. For example, just google “Apple 10K 2021 Report” and it will pop up.
You can go to Apple’s website, go to the investor relations section, and search for the 10K there.
You can also use the SEC's website itself to search for company filings.
After you've selected the right company, select "10-K (annual reports) and 10-Q (quarterly reports)," then click on "View all 10-Ks and 10-Qs." There, you can find the 10-K filing for the year you want to analyze.
This is the best section to start with.
This includes basically everything that you need to know about the business.
You should be looking for a few different things when you read through this section.
What does the business do?
How the business makes money? Do they sell products? Are they a software company? Do they sell
How does the business spend their money? Why do they spend it on these things?
What is their marketing strategy?
Who are their competitors? Are they a better business? Should you research the competitors instead?
What is their distribution process?
If you do not understand the business summary page, you should choose a different business to research.
Businesses usually change their business model every 10 years, so I would check to see how the past changes have impacted their business model.
You should be asking yourself the same questions that the Sharks ask on Shark Tank.
Start of Apple Business section:
The next section, risk factors, describes all the risks that are associated with making an investment into the company.
This is a very important section to read through and understand because these factors might prevent your company from providing the returns that you want.
Typically, when you make an investment in a company, you have certain goals in mind that you hope they're able to meet, including profitability goals, cash flow goals, customer growth goals, and more.
In Matt Allen terms: Let’s say that you are investing in Apple because you believe that they are going to sell 100 iPhones a day. You need to understand all the risks that Apple deals with when it comes to these goals.
If Apple is only selling 50 iPhones a day, you will be able to understand why this is the case by understanding the risk factors.
You should look for risk factors that are brand new along with any new regulations.
For example, if "Cyber Hack" is a new risk factor that means there was a recent data breach.
Write down the risk factors that bother you most and monitor them closely.
It is very important to understanding all the risks of a company, however, you have to remember that these sections are written by lawyers. Sometimes, they are more concerned with avoiding lawsuits than giving good information to investors. Keep this in mind, when you read the risk section. For example, “Our stock price is subject to volatility” is listed as a risk but does nothing for us.
Management's Discussion and Analysis (MD&A)
This section is very important. This section provides investors with information on what drove the success and failures of the business.
It also compares this year to previous years and the future plans for future success/failure of the company.
This is the section that you should spend a majority of your time reading about. If I were to consider investing in a company long-term, I would read this section for every year, going back 10 years, so I can completely understand how management has changed their strategy over time.
I also want to see if they have been successful or not with their previous strategies.
Warren Buffett reads Coca-Cola annual reports between 1919-2021.
You should look for management explain on:
What is their revenue growth? (If going down, why?)
Do they have Expansion plans?
Are they planning any new partnerships or do they merger targets?
Does the business have any moats?
Metrics that beat/missed
What are the biggest risks to the business?
What is the future guidance?
Is there a change in governance?
This is the most important part of the 10K because it shows you the money.
These are the 3 financial statements that you should focus on:
Cash Flow Statement
Pro Tip: Check the footnotes for juicy data
For the simplicity of this newsletter, I am not going to go into depth on these 3 topics.
The balance sheet shows the companies:
Assets: What it owns
Liabilities: What it owes
Shareholders Equity : It’s net worth attributable to its owners
At a fixed point in time.
The “at a point in time” is very important. A balance sheet is a snapshot of a company’s net worth. It is usually measured at the end of a quarter/year. That’s different from an income statement or cash flow statement which are measured over periods of time.
Balance sheets use the same formula: Assets= Liabilities + Shareholders Equity
The income statement is also called a Profit and Loss Statement.
It shows a company's revenue and expenses over a period of time.
The most common periods are:
TTM/ Trailing 12 months
YTD/ Year To Date
Companies show the income statement in the quarterly earnings press release.
Cash Flow Statement
The cash flow statement shows how cash moves in and out of the company.
The three main areas of a cash flow statement:
You want to make sure the CEOs financial incentives are aligned with your long-term goals.
You want to make sure that the CEO isn't choosing to overpay himself while underperforming for the company.
Here are the common metrics that execs make their money on:
Earnings Per Share
You want high stock ownership from insiders (Board, C-Suite) this means that they are aligned with shareholder goals.
If insiders are buying the stock this is a huge plus.
"Insiders might sell their stocks for plenty of reasons, but they only buy their stock for one reason: they think it will go up." - Peter Lynch
I hope everyone has a great rest of the week!
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