3 Reasons Why You Should Read Annual Reports

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 replied, “No Sir, I lost them in the park.”

The policeman asks why he is searching here, and the drunk replied, “But this is where the light is.”

This old anecdote is what behavioural scientists call 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 (eg. stock ideas, estimations) where it looks the easiest (eg, analyst’s recommendations, headlines and stock prices). However, the reality is that these places are not really where you can find the best ideas for long term investment.

In my opinion, the best ideas are found by studying businesses and identifying which ones are doing well and which ones may be going downhill.

One of the most authentic resources to study a business is its Annual Report. Yes, this boring, heavy and full of accounting jargons document that a company releases at the end of every financial year to share what it did and sometimes what they are planning to do.

Anyways, to make it more interesting, I will be sharing about three observations that I see in the annual reports of SGX companies which somehow or rather, influenced my decision whether to invest in them.

So here they are;

1 – Remuneration

From the annual report’s “Report on Corporate Govenance” section, we are able to look at the pay the top management is receiving for the year. From this, you can assess whether they are paying themselves in line or out of line with the company’s performance. A useful comparison analysis can also be done when you also look at their competitors.

Let’s take a look at the remuneration of LHN Group (SGX:41O), a company listed on SGX since 2015. I’ve attached the extract from their FY2015 and FY2016 annual reports. You can see that their remuneration has increased more than 100% after their first year of listing! I’m not saying that it is wrong to have a pay raise but doubling it only after a year of listing feels too excessive for me.

Even though they have a really unique business model, I did not invest in them as I felt that management is more interested in rewarding themselves handsomely rather than aligning with shareholders’ interest.

Taken from LHN Annual Report 2015 & 2016

2 – Indebtedness

The second disclosure that I see is the indebtedness of a company. From the annual report, you are able to see clearly the;

  • Amount of principal due
  • Amount of interest
  • New borrowings or repayments

Last year, we saw a company which was once a SGX darling fell from grace when they sought court protection in order to restructure its bloated debt load.

I first read Hyflux’s annual report in 2017 when I was looking for investment ideas. At that time, my colleague was raving about their 6% corporate bonds, saying that it has government backing and there is no way they won’t pay. However, when I looked at their balance sheet, the amount of cash they have against their total debt worried me.

Taken from Hyflux 2016 Annual report

Furthermore, upon reading the excerpt below, the fact that they are facing difficulty with debt refinancing is also a ticking time bomb (Issuing more debt with higher interest to pay off debt is never a good solution).

Taken from Hyflux 2016 Annual report

Lastly, I did a calculation on their interest coverage ratio, which is the Earnings Before Interest & Tax (EBIT) divided by Interest Expense. With a EBIT of $64.1mil and interest expense of $62.3mil, Hyflux’s interest expense is about 1.03x. A low interest coverage ratio means that it has a high chance of the company not being able to service its debt, putting it at bankruptcy risk.

Due to these 3 main reasons, I decided to avoid Hyflux at all cost.

3 – Chairman’s Statement

This is my favorite part of the Annual Report. this section helps me get a rough feel of how the top management sees the company’s business outlook. Sometimes, it reveals how optimistic the Chairman is, like Powermatic Data’s Annual Report. When that happens, focus on it and find out why.

The more you read, the more you will be able to pick up certain hidden messages and sometimes, eveb notice if they specifically did not mention something or emphasizing only one part of the equation (eg, for CNMC Goldmine, the Chairman is very confident on achieving record revenue, but decided not to say anything about profit).

It is also from the AEM’s (SGX:AWX) 2015 annual report where I got the hint that the future is very bright for this company.

Reading the excerpt below,

Looking beyond the financial results of 2015, we are pleased with the foundation that we have laid for our company. In 2015, we saw the initial fruits of over 4 years of engineering investment in our high-density test handlers. Our development program with one of the world’s largest semiconductor companies represents a paradigm shift in how semiconductor chips are tested. This program is important for our company, as it not only represents a multi-year migration for our customer, but it also enables us to apply our intellectual property to assembly and test solutions in other industries. So, we cannot stand still…

In 2016, we plan to increase our engineering resources to support the current and offshoot programs, and will aim to be profitable while doing so. We also expect to strengthen our product marketing team to work with new customers to solve their complex assembly and test handling needs.

Loke Wai San – AEM Non-Executive Chairman

It is really rare to see the chairman saying something like “we cannot stand still..” It definitely caught my attention. Of course, I would be lying if I say that this is convincing enough for me to invest in AEM. I waited for 2 more financial reports before I finally decided that it was the real deal and invested in it. And the rest, they say, is history.

Bring Out The Annual Reports

Rather than complaining about how you missed the latest multi-bagger and how there is nothing good in invest in SGX, why not just pick up an annual report and start reading it.

I would suggest starting from the annual reports of companies you already own. It could reveal insights of the business which you have never looked at before, or even make you realise that you do not understand its underlying business at all (maybe you should just sell it).

One thing’s for sure, you will never identify such issues, both positive or negative, until you have read the annual reports.

Before I invested in Straits Trading, I pored over the last 10 years of annual reports to get a better understanding of their business strategy. Similarly, you will be able to see the story of the business evolving through the eyes of this boring, heavy and full of accounting jargons document that a company releases at the end of every financial year to share what it did and sometimes what they are planning to do.

Cheers

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s