How to Read an Annual Report (if you only have 20 minutes)

Quarterly financial statements and annual company reports are the language of investors and executives. At the end of the day, the results of managerial business and capital allocation decisions get translated through audited financial statements, which, like haikus and box scores, require interpretation and translation. While investors and analysts claim to like transparency, the reality is the reading and interpreting of financial statements requires practice and patience (and interest).

Warren Buffett, for example, has interest. He reads 500 pages per day. He says that, while others may enjoy Playboy, he prefers annual reports and financial statements. (No comment).

Annual reports can yield valuable information, even if you are short on time. Reviewing annual reports can better prepare you for working with customers, suppliers, and your markets. They can yield insights, benchmarking and market intelligence. If you had 20 minutes, where should you focus? I think “L-L-C” to prioritize three things with the goal of understanding how a business makes money, how the managers/leaders think (and who they are), and the overall performance of the firm.

  1. Letter: read the Chairman/CEO letter. While some write this off as “fluff”, it always included business highlights (and lowlights, reasons, and excuses; make sure to know the difference). The letter will include noteworthy investments and efforts, and usually discusses the strategy and the business model.
  2. Leadership: understand who runs the company, including the Board of Directors. Look at the makeup, backgrounds, and skills of those who control the company. This can be especially relevant in smaller firms, and recent changes to the Board can highlight firm priorities.
  3. Cash: confirm how cash is generated and used, including financing. Are the core operations generating cash? How is the company using that cash? How are they financing investments into growing the firm? The ability to review the Statement of Cash Flows can benefit from a brief tutorial, but it is straightforward once your eye knows where to go. At the end of the day, numbers need to match.

If you have more time, read the Business Description to confirm the business model, business segments, key customers and exposures.

The Math of Investing and Our Unease with Rational Thought

Professor Richard Thaler won this year’s Nobel Prize for Economics, in part, for research confirming that we (humans) believe we are smarter and more rational than we actually are. Asked how he plans to spend the $1.1 million prize money, Thaler replied, “I will try to spend it as irrationally as possible.” [Should he call, please let him know I stand ready to help.]

Reading Thaler’s research raises issues relevant to investing. We may believe we have superior insight into the value of an asset or the wisdom of a strategy, and that this belief in our own insight – as opposed to subjecting the insight to a suitable gauntlet of tests – gives license to act and a means to profit. This encourages us to overweight our assessment of values and market plays, while discounting the reality that hundreds or thousands of other (humans) are looking at the same data at the same time and coming to similar conclusions.

When too much capital chases too few assets, it creates its own momentum. And this momentum of the institutional conscious can lead to overvaluing assets. So when we prophylactically ask whether any asset is priced above or below its intrinsic values, we should assume the icy logic and rationality of Dr. Spock and look to the math.

Click here for a longer post that applies this thinking to timberland investments.

Communicating in Public: How to Make Effective Impromptu Comments

At times, you will feel compelled or asked to share your opinion in a meeting, at a business event or during a conference.  For these situations, a bit of advance planning will reduce the pressure and increase the likelihood of making a valuable contribution.

Effective impromptu comments have specific characteristics. First, they are relevant. Second, they are specific. Third, they are brief.  While many of us know and appreciate natural comedians or gifted story tellers who can talk all afternoon and hold their audiences, most of us benefit by being relevant, specific, and brief.

The PREP approach for impromptu comments advocated by Toast Masters International provides one strategy for putting this thinking into action. PREP stands for Point, Reason, Example, Point.  Make your point.  State the reason for the point. Give an example that supports the point. And close by restating your key point. In Loving Trees is Not Enough, I ask readers to consider this response to questions about the value or purpose of annual training at work:

Point: “Professionals at all levels practice basic skills annually.”

Reason: “We practice these skills to keep them sharp.”

Example: “Look at Major League baseball players.  Each year, teams have “spring training” to review and practice the same fundamental skills being learned by the youngest little league players. And Major Leaguers are the best players in the world.”

Point: “We are professionals and we train annually to keep these skills sharp.”

PREP provides a framework for organizing our thoughts in impromptu speaking situations. Think about how this approach could improve meetings.  How often have we listened to people ramble on without making logical sense or contributing useful points?  This framework reduces anxiety and increases effectiveness by removing the need to figure out how to start, organize, and end our comments.

We can reduce the PREP approach further. First, state a single, relevant point. Second, give a specific reason or example that supports this point. Third, say “thank you” and sit down.  Impromptu speaking success is simply one relevant, specific, and brief comment away.

When Do We Overvalue Investments?

In 1990, Nobel Prize-winning economist Daniel Kahneman and two colleagues published a study documenting how we can “overvalue” things we already own (D. Kahneman, J. Knetsch and R. Thaler, “Experimental Tests of the Endowment Effect and the Coase Theorem,” The Journal of Political Economy, December 1990). This “endowment effect” applies to investors who may hold on to assets beyond their strategic relevance, failing to account for true opportunity costs, and missing out on opportunities to reallocate that capital to investments that better meet the needs of the portfolio.

Recent reporting in The Economist magazine also highlights the powerful incentives investors have to stand behind the original return assumptions for their investments (“Interest Rates and Investment Returns,” March 2, 2017). Beyond the resistance to accept a potential error, some make the case that low interest rates have reduced borrowing costs for firms, which increase opportunities for outsized returns in the future. In our view, this argument can strain efforts to support return expectations and hurdle rates, and reinforces the importance of firmly making the best investment decisions given our understanding of current values and opportunities.

When we consider investments, we must look forward. This may require us to adjust our thinking for probable nominal returns.

In forestry, for example, we often struggle with “sunk costs.” When evaluating the current value of our timberland investment against new investment opportunities, we must do so with ice in our veins and clear financial analysis on hand. We, first, ignore sunk costs and, second, evaluate forest investments based on their ability to generate income and returns moving forward.  The only time we have complete control over our portfolio is today.

Clear here for key questions to ask as applied to timberland investments.

Common Errors and Potential Approaches for Evaluating Investment Strategies

Understand how to understand and frame the current situation.  [That was not a Rumsfeldian typo.] Executives and investors make, or don’t make, decisions on how to allocate capital and other resources based on their understanding of the current situation.  On average, our team at Forisk supports over $1 billion in capital projects, transactions and plant construction in the timberland and forest products industry each year.  While everything may not look like a forestry situation or timber market, I have learned that few situations are that unique.  For example, common errors and sources of resistance to “scraping the ice off of the windshield” include:

  • Failing to consider the view from the other side of the table. In forestry, when we own something – when we buy land and grow trees – we tend to see things from that point of view.  And yet owning timberland is but one side of a two-sided equation.  What does a mill see?  When a forest products firm thinks about building a mill, what does it look for?  Understanding this helps us assess timberland values and forest management strategies.  Conclusions from this type of analysis and research are relative.  It’s a constant comparison of one market to another, of one region to another, GIVEN an assumption about the economy.  
  • Imposing rigid projections for the economy.  Nobody forecasts the economy well; it’s a hard place to create value. For capital budgeting and investment strategies in forestry, prioritize understanding how THIS local timber market or THAT local wood basket performs relative to every other given an assumption about the economy.  Massive economic growth?  “These timber markets are positioned to outperform those.” Brexit? “Those markets would be affected this way, and those timber markets that way.”  And so it goes.  
  • Forgetting to test opinions and data sources.  When thinking about information and the situation, consider the source.  Who is telling you this and where do they get their information?  Few people I know have a process for testing their own ideas and assumptions, or testing and thinking about the data and information they hear from others. 
  • Creating goals via fiat rather than by analysis. Pushing for stretch targets differs from disregarding the projections from your team and replacing them with a decree of what they should be.  I have heard too many times executives say their direct reports sandbag their budgets and expectations, and that they need to be pushed. Well who made them sandbaggers in the first place? (If that’s even true.)  Padding the numbers is a response to the organizational environment.  In most cases, it’s a culture that punishes missed numbers rather than risk taking.  Just understand what you have, why you have it, and how this lines up relative to what you actually want from your team, career and portfolio.

At the end of the day, we need to systematically aggregate the facts and organize them in ways that bring to the forefront an understanding of how things work. That means part of our responsibility and obligation is to develop a true sense of the current situation. Without that, it becomes difficult, if not impossible, to plan and strategize for the future. We must confirm the facts as best as possible given the time and resources available, get varying points of view on what they mean, think for ourselves what makes sense – is this operable? Doable? Actionable? Viable? – and if we remain unsatisfied with where we are, get back to getting more data and viewpoints.