The other day, someone I talk stocks with on Skype asked how I normally go about starting my initial research into a stock. What documents do I gather?
Here’s what I said:
“Basically, I start by finding the longest series of financial data I can (GuruFocus, Morningstar, whatever) and then look at that along with reading the newest 10-K and the oldest 10-K in detail. So, 10-year+ financial data summary, 20 year old 10-K (or whatever), this year's 10-K, and then the investor presentation if they have one, and the going public/spin-off documents if that's online. Also, I read the latest proxy statement and the latest 10-Q as needed for info on management, share ownership, the balance sheet etc.”
I also check the very long-term performance of the stock. So, I will chart the stock – at someplace like Google Finance – against the market over a period of 20, 30, or 40 years.
So, here’s a full list of my usual sources:
1. Check long-term stock performance (what is the compound annual return in the stock over 20, 30, or 40 years?)
2. Find the longest series of historical financial data possible (search for a Value Line sheet, a GuruFocus page, or go to Morningstar or QuickFS.net to see the long-term financial results)
3. Read, highlight, and take notes on the latest 10-K (so 2016)
4. Read, highlight, and take notes on the oldest 10-K (On EDGAR, this is usually around the year 1995)
5. Read, highlight, and take notes on the company’s own investor presentation
6. Read, highlight, and take notes on the IPO or spin-off documents (On EDGAR, this will be something like an S-1 or 424B1)
7. Read, highlight, and take notes on the latest proxy statement (On EDGAR, this will be something like a DEF14A)
8. Read, highlight, and take notes on the latest 10-Q.
Why Check the Long-Term Stock Performance?
This is something a lot of value investors wouldn’t think of. But, I find it very useful. Any time you are looking at a stock’s performance your choice of start date and end date are important. The good news is that your start date will be fairly arbitrary if you just look as far back as possible. So, if the stock has 27 years of history as a public company – and you look back 27 years – you probably aren’t picking a price near an unusual low point in the stock’s history. In fact, you’re probably picking the IPO price, which will rarely have seemed a “value” price at the time. The other good news is that – as a value investor – you’re probably attracted to stocks that seem cheap now. They trade at low or at least reasonable multiples of earnings, EBITDA, sales, tangible book value, etc. This means that any stock you are looking at as a possible purchase is unlikely to be benefiting right now from a particularly good choice of an end point.
Here’s an example.
If we go to Google Finance, we can see that Fossil (FOSL) has a stock price performance from 1994 through 2017 (so about 23 years) that’s a bit better than the S&P 500. You can use the data in Google Finance and combine that with a compound annual growth calculator to find the stock’s annual return was about 9% a year over the last 23 years. Does that mean Fossil created value over 23 years? Did it compound its intrinsic value faster than the average stock? That would be hard to tell if Fossil had started the period trading at a low price and now traded at a high price. However, the stock now trades at an EV/Sales ratio of 0.3. Historically, it traded around 1.5 times sales. It’s rare for a company in this kind of business to trade much below sales. So, if Fossil survives its current crisis and investors eventually warm to the stock’s future prospects – you’d expect the share price to jump at least 3 to 5 times. The stock’s $12 now. But, you’d expect it to be in the $35 to $60 range the moment investors felt sales had stopped plunging. That sounds like a big prediction to the upside – but this stock once traded at $120 a share. So, that’s still only a slight recovery of what Fossil’s market value had been.
Now, if Fossil stock was at a price 3-5 times higher than it is now, the 23 year return wouldn’t be 9% a year it’d be in the 14% a year to 17% a year range over more than 20 years. That’s a lot of value creation. In fact, if the end point had been the start of 2015 (when Fossil’s current problems hadn’t yet devastated its sales and earnings) instead of the middle of 2017, Fossil would have returned about 22% a year over more than 20 years.
So, the exact start point and end point you pick matters a lot when judging a stock’s past long-term compounding power. But, if you are looking at something that appears to be a value stock now and yet it still had returns of about 10% a year in its share price over 20, 30, 40 years or more – you’re fine. This is a business that didn’t destroy value over time. It compounded its intrinsic value as well or better than the stock market. If the stock’s future is as good as its past – and you’re buying it at a below average price – you’ll do well.
Those are two big ifs.
But, this check of the stock price performance compared with the more usual approach of looking at return on equity, return on capital, etc. over the past few decades will give you a good idea of what kind of quality business you’re dealing with. The stock performance check is especially important with conglomerates, cyclical companies, companies that issue and/or buyback a lot of stock, serial acquirers, and other corporations that are involved in a lot of financial engineering at the corporate level.
I strongly suggest checking the long-term stock performance when you’re looking at companies like: Baker Hughes (BHI) which is cyclical, Omnicom (OMC) which buys back its own stock, Textron (TXT) which is a conglomerate, and UniFirst (UNF) which acquires companies in the uniform industry.
Although it is easy to find the return on equity for these companies in any one year – it can be difficult to know what the return on investment of their various acquisitions, stock buybacks, etc. has been over a full cycle without using the long-term stock price performance as a guide.
It’s still not a perfect guide.
Remember, depending on exactly when in the last 2-3 years you checked Fossil’s stock price, you’d see long-term compound annual returns of anywhere from 9% to 22% in the stock. The important point is that you wouldn’t get a long-term compound annual return figure much below the S&P 500. So, you’d be able to assume Fossil had – historically – been an average or even an above average business. What you’re looking for here is any discrepancies where a company that seems to have an above average return on capital manages to always barely keep pace with – or even lag – the S&P 500 over the decades.
Why Use the Longest Series of Financial Data Possible?
The simplest reason here is that most investors don’t do this – so you should. There are figures that might be useful – like knowing what a company is expected to report in EPS next year, that have their usefulness diminished by the fact everyone else buying and selling the stock knows this figure. There are other numbers that might also be useful – which other investors aren’t looking at. You want to focus on figures that matter but are ignored by most people.
Let’s stick with the Fossil example. Knowing that Fossil’s pre-tax earnings dropped 22% in 1995, 18% in 2001, and 23% in 2005 might be useful when looking at the stock in 2015 because earnings had never declined from 2006-2014. So, at the end of 2014, a lot of investors might have only been looking at Fossil’s results from 2006-2014 (since that gives you the 5-10 years of history that many investors feel they needn’t look past). Investors may have also been looking at analyst estimates and the company’s guidance for the year ahead. I have nothing against you looking at near-term future projections. But, you should know, that probably 99% of investors are looking at projections for next year’s earnings while maybe 1% of investors are looking at historical data from further than 10 years in the past. That means the old historical data is more likely to give you an unorthodox insight into a company. And that’s what you need to be right when others are wrong.
Why Read the Most Recent 10-K?
As a serious value investor you know you’re supposed to do this. Everyone tells you you’re supposed to do this. You read the most recent 10-K to learn about the company as it exists today. I’m not going to waste words pushing this particular practice. If you aren’t reading 10-Ks, you should try it. They’re the most useful documents out there.
Why Read the Oldest 10-K?
Again, part of the reason for doing this is the same reason a lefty can have an advantage playing baseball. In absolute terms, it makes no difference if you’re left handed or right handed. Left handedness doesn’t make you a better baseball player. But, if 90% of the world is naturally right handed – being left handed makes you different. It makes you the opposite of what your opponent (the pitcher or the batter) normally faces. If trying to bat left handed makes you a worse hitter – there’s a point where you shouldn’t invest the effort in learning to do it. Likewise, if it’s a complete waste of your time to read the oldest 10-K, you shouldn’t read it. But, I don’t think it’s a waste of your time. And I know almost no one else does it. So, here’s something you can do that’s both useful and different.
Reading the oldest and newest 10-Ks one right after the other is a shortcut to understanding how the business developed and how the industry developed. You could work on studying the company’s entire history. But, that’s a huge investment of time for a stock you’re not sure you’re interested in yet. By reading the oldest annual report and the newest annual report, you get the quickest overview possible of the truly long-term history of the company. I think it’s sometimes useful. And I know it’s very rare for other investors to do this. So, if you’ve never read the oldest 10-K you can find on a company, try adding this to your regular routine.
Why Read the Company’s Own Investor Presentation?
This one is a bit more of a mixed bag.
There are aspects to reading this report that probably aren’t good for your understanding of the stock. One, everything in the presentation is well known by people buying and selling the stock. Two, this pitch is being made directly by the company’s management and aimed directly at people like you (potential investors).
So, it can be dangerously biased.
Those are the negatives. And they’re big negatives.
The positives are that, frankly, the investor presentation can give you the most background on a company and an industry in the shortest amount of time. If, for example, you have no idea how the frozen potato industry in the U.S. works, reading the Lamb Weston (LW) investor presentation is the quickest way to get an overview of the industry, the company’s rivals, and the company’s customers.
This is especially true for obscure industries – like frozen potatoes – where nobody writes books about the industry, none of the companies in the industry have ever had much cultural impact, and the companies just aren’t that well known by the public.
For example, you really need to read an investor presentation by Grainger (GWW), Fastenal (FAST), or MSC Industrial (MSM) to start your research into the MRO industry – because most people don’t know what the MRO industry is or how it works. It’s an invisible part of the economy.
If you don’t have much time to spend researching a stock before deciding whether or not to cross it off your list – I’d say skim at least 10 years of financial data (at someplace like GuruFocus) and read the investor presentation (on the company’s own website). That’ll take you a matter of minutes, not hours. And it’ll give you the background you need to look for the names of competitors, suppliers, and customers and to know what to look for in the 10-K. So, the investor presentation is often the best place to start your research into a company.
Why Read the IPO or Spin-Off Document?
This is often a very detailed report. It will have a lot of information on the industry. It is probably the single longest document on this list. Take your time. If you can work your way through a 10-K, you can work your way through an S-1, etc. Finding this document on EDGAR can sometimes be inconvenient because the company will often file a bare bones version initially and then keep amending it. Sometimes companies keep their original going public roadshow presentation on their website many years after actually going public. The same is true for spin-offs. For example, I own BWX Technologies (BWXT). Even though it is now 2017, that company keeps a 60 or so page presentation on its website that dates back to the 2015 analyst day which discussed the spin-off. Like a lot of IPO / spin-off presentations, that one takes a longer term view of the company. So, it has some discussion of how Babcock’s nuclear business evolved from the early 1990s through 2015. That’s the kind of historical information that is rarely discussed in quarterly earnings results. You’ll only find it in company presentations. Historical discussions that take a longer term view are especially common when a company goes public or is spun-off. So, an IPO or spin-off document is kind of the opposite of a quarterly earnings call transcript.
Why Read the Proxy Statement?
This will be the DEF14A on EDGAR. I read this just for background information on management, to understand how much control big shareholders have over the company, and to see how management is compensated.
So, I’m looking for: 1) Who the managers are 2) Who the owners are and 3) How the owners choose to compensate the managers. Incentives are part of what I’m looking for here.
For example, Grainger (GWW) has a passage in the latest DEF14A that reads:
“The 2016 Company Management Incentive Program (MIP) payout was calculated at 75% of target for all eligible employees as the Company fell short of the 2016 sales growth goal of 5.5% and the ROIC goal of 26.6%.”
So, we see that Grainger incentivizes management to hit two targets: 1) A sales growth goal and 2) A return on capital goal. The sales growth goal is modest. In a normal year, nominal GDP growth in the U.S. might be in the 4% to 6% range. So, a 5.5% sales growth target is close to a GDP type growth rate. And then the return on capital goal is aggressive. A 26.6% return on capital before taxes translates into about a 17% unleveraged return on equity. A business like Grainger can use some leverage. So, this return on capital target – if achieved – would tend to deliver a 20% or better after-tax return on equity for Grainger shareholders. There are more details about how incentive compensation is paid (in what form and when) as well as if it’s capped at some level. But, what I’ve discussed above is one of the most important parts of the proxy statement. Look for the metrics management is judged on for compensation purposes. And also look at what the specific target levels are for those metrics.
Finally, you also want to look at the ownership structure of the company. For example, the Under Armour (UA) proxy statement – this is the DEF14A – tells you that the CEO, Kevin Plank, is also the company’s founder. It tells you he has a 15% economic interest in the company and a 65% voting interest. It also tells you he’s 44 years old. Founders often make it to a retirement age of 65 or beyond. So, you this tells you that – since he has voting control of the company – Under Armour’s founder might lead the company for another 20 years or more. Minority shareholders have no say in the company, because the CEO has more than 50% of all votes. Also, we know the CEO owns about 15% of the company and UA has a market cap of around $8 billion. So, he has maybe $1.2 billion or so of his net worth in the company’s stock. His total compensation was usually in the $2 million to $4 million range over each of the last 3 years (that kind of information can be found in this same proxy). So, the performance of Under Armour stock is something like 300 times more important to Plank than his own pay. So, the proxy statement has told us: 1) This is a controlled company – your votes don’t matter 2) The company may have another 20 years to go in its founder led era and 3) The CEO’s overriding incentive is getting the best possible growth in the stock price over time.
A lot of people skip the proxy statement. But, the points I just made about Under Armour are huge. You could have another 20 years of the company being run by a founder who is something like 99% compensated as a permanent owner.
And that founder has voting control – so your votes don’t matter. Under Armour has 3 classes of stock. You can buy two of those classes. The two classes you can buy have identical economic rights but one comes with voting power and one comes with no votes. The shares with the “UAA” ticker cost $19.10 and have one vote each. The shares with the “UA” ticker cost $17.86 and have zero votes each. The proxy tells us your vote can’t matter in either case. So, you should buy “UA” shares not “UAA” shares and save yourself more than 6% of the purchase price. See, reading that proxy just made you 6% smarter. That’s why you should always read the proxy statement. You want to know: who the owners are, who the managers are, how everyone is compensated, and which class of stock is the better buy.
Why Read the 10-Q?
The more you know about accounting, the more you’ll get out of the 10-Q. The 10-Q is useful because it has the exact number of shares outstanding on the front of it (and, of course, this figure will be more recent than the 10-K in 3 out of 4 quarters of the year). You will want to study the balance sheet. And you’ll want to read the footnotes to the financial statements. A lot of the value in the 10-K and 10-Q comes from reading about how the company accounts for everything in the financial statements. What is amortization made up of? How quickly are they depreciating various assets? How long have they had certain assets – like land – on the books? Do they lease or own all their property? If you’re more of a Ben Graham type investor than Phil Fisher type investor – you’ll get more out of the 10-Q. Honestly, a long-term growth investor isn’t going to find anything in the last quarter to change his mind about a company. As far as sales and earnings go, it’s not necessary to check in more than once a year with the stocks you own. I’ll look at a 10-Q or even read an earnings call transcript or two if there’s been a big drop in the stock and I want to understand if the reaction from investors is appropriate given some change in the company. For example, Under Armour’s stock dropped a lot after an earnings report. The company’s sales growth has decelerated from more than 20% a year to closer to 10% a year (which is about what management is now guiding for in fiscal 2017). Recently, sales actually dropped about 1% in the U.S. So, you can read the 10-Q for Under Armour along with checking the 10-Qs of competitors like Nike (NKE) and key customers like Dick’s Sporting Goods (DKS) to try to understand exactly why sales and earnings disappointed investors, what the problem is, and whether or not it’s temporary. Other than that kind of analysis of a very recent event – the 10-Q is most useful for giving you an up to date balance sheet.
So, those are the first 8 things I look at when researching a stock. They aren’t necessarily the most important 8 things to look at. But, they are easy enough to find and important enough to give you a good foundation for understanding the business even if you never read anything else.