Annual reports can be quite lengthy documents. For example, Bank of America's (NYSE:BAC) 2017 annual report is 214 pages long, including about 180 pages of financial discussion and statistical tables. So, it's no surprise that many investors aren't sure what parts are the most important to pay attention to, as analyzing an entire annual report can easily take an entire day.
When asked about the most important things he looks for in an annual report at a couple of shareholder meetings years ago, Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) CEO Warren Buffett's answers focused around two general themes -- and neither one had to do with analyzing the company's financials.
How does management deal with problems?
Annual reports typically begin with a letter from the CEO to shareholders about the company's performance over the past year, and where they see the company heading in the future. This letter, which is often just a few pages long (Bank of America CEO Brian Moynihan's latest letter is just seven pages, including some graphics), is perhaps the most valuable part of the annual report, according to Buffett.
It's tough to overstate the emphasis Buffett places on honest, transparent, and shareholder-focused management. "We see if the management is telling us about the things we'd want to know about if we owned 100% of the company," Buffett said. "I like to know as much as I can about the person that's running it, how they think about the business, and what's really going on in the business."
As Buffett explains further:
I'd like to have a report that would be identical to what if I owned half of a company but was away for a year but had a partner who owned the other half. When I came back, that he would tell me what had taken place during the past year and what he foresaw coming up. If we read a bunch of public relations gobbledygook, and we see lots of pictures and no facts, it has some effect on our attitude toward the business. We want to understand the business better when we get through the annual report than when we picked it up.
Buffett also likes to see managers who are straightforward about a company's problems.
Almost every business has problems ... A lot of companies, for example, have investor relations people, and they're dying to pump out what they think is good news all the time ... we try to stay away from businesses like that.
Berkshire's vice chairman Charlie Munger agreed, and pointed out that such honesty is rare. "What you seldom see in an annual report is a sentence like this: 'This is a very serious problem, and we haven't quite figured out how to handle it,'" Munger said.
A great recent example of this can be seen in the 2017 annual report of major Berkshire Hathaway stock holding Wells Fargo (NYSE:WFC). Instead of glossing over the company's infamous fake-accounts and other scandals and simply focusing on the good parts of the business, CEO Tim Sloan made the company's problems and detailed discussions of the planned and implemented solutions the central focus of his letter. And, Sloan acknowledged that "we still have work to do."
How is the competition doing?
The other theme to Buffett's answers was that he doesn't read only the annual reports of the companies that he's invested in, or that he's considering investing in. Instead, he reads the reports of the competition as well. Buffett said:
If we owned stock in a company, in an industry, and there are eight other companies that are in the same industry ... I want to be on the mailing list for the reports for the other eight because I can't understand how my company is doing unless I understand what the other eight are doing.
This makes perfect sense when you think about it. One of Buffett's key objectives is to find investments that have competitive advantages over their peers, and reading the annual reports of other companies can give Buffett insight as to whether a certain company has such an advantage, is losing its advantage, or is doing generally better or worse than the competition.
As Buffett puts it, "I can't be an intelligent owner of a business unless I know what all the other businesses in that industry are doing."
The key takeaway
Don't spend too much time stressing about all of the numbers and charts in annual reports. Sure, it's a good idea to read the company's financial results in its earnings report, but this is generally a relatively short document. It's rare for even a highly experienced investor to read an entire 200-plus page annual report cover to cover.
An annual report can give you insight into how a company's management is handling the opportunities for growth, as well as the challenges facing the business. So, focus on the management discussions in the annual reports of the stocks you own -- as well as in the reports of their competitors.