Falling Asleep Over Your 10-K? It's Not Just You

Fascinating research tells us that looking at the language companies use in their 10-K filings can be just as informative as what they say.

Aug 16, 2014 at 8:00AM

Flickr / geezaweezer.

Albert Einstein once admonished that if you can't explain a concept in a way a six-year old would understand it, you probably don't understand it yourself. The idea is that if you have to use jargon or highly complex explanations, you're probably covering something up -- in this case a lack of expertise.

How does this relate to company valuation? It turns out that how a 10-K filing is written is just as informative as what's inside. You'd be wise to pay attention when you're falling asleep: one researcher found a significant correlation between the readability of a 10-K and the stability of earnings in future years. 

Using linguistics to measure earnings 
What exactly makes something readable? One way is to use the Fog index, which looks at a document and takes the number of words with three or more syllables and the number of words per sentence and plugs them into a formula. The resulting score is roughly equivalent to the number of years of education you need to understand something on a first reading. 

The idea is that the more arcane the language and the longer each sentence, the harder it is to process the information.

Making lower earnings look better with complex language
Using the Fog index, Professor Feng Li at the Ross School of Business at the University of Michigan looked at the complexity of 10-K filings to see if there was a relationship between readability and earnings. He found that companies with lower earnings tended to use more complex language in their reports.

While this effect was small in terms of dollars, Li also found that the persistence of earnings was significantly tied to complexity. In other words, profitable firms that had less readable 10-Ks also had less stable profits -- in a way that made a significant economic difference.

Don't all 10-Ks make readers want to cry?
Well, yes. While the Fog index of the average Wall Street Journal editorial is about 15.2, the average score for 10-Ks was 19.2 -- significantly harder to read. 

But, as it happens, they don't need to be quite so complicated. Li finds that reports vary widely in complexity, even within the same document. He notes that "the MD&A section of the report is much easier to read than the document as a whole," and there is an enormous amount of variation among reports from one year to another. From the group of hardest-to-read reports in one year, only 44% remain in that category in the following year.

What on earth is going on?
Perhaps they're hiding something. "I find that, indeed, the positive earnings of firms with 'foggier' or longer annual reports are less persistent," Li said in his paper. In other words, more complexity in a profitable report could mean bad news is on the horizon. The same holds true for the length of the report: Longer reports are associated with less persistent positivity.

Whether this implies deceit or just a correlation between complexity and performance is not answered by Li's research, but it's certainly food for thought. 

So pay attention to how those 10-Ks are written, and if you're falling asleep or completely zoning out, it might not just be a need for coffee. It could be that there's more to this company's 10-K than meets the eye. 

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4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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