the 10k and annual
Let’s put the proxy to the side for now, and consider the annual report and the 10k. They’re both once a year reports of a publicly traded company’s performance.
what they have in common
Sometimes, the annual and 10k are just about one and the same document. Some companies complete the 10k, wrap another cover on it, include the chairman’s letter and a picture or two, and call that the annual. It’s not the norm, but it happens. It tells you something about the company that does this, as well: no-nonsense, spartan, don’t think they have much need for marketing, the record speaks for itself.
In most cases, the 10k and annual are separate documents, however. They do have two features in common. Both contain:
–detailed audited financial statements, complete with many pages of footnotes, and
–the auditing firm’s “opinion,” or statement about the conformity of the financial statements to Generally Accepted Accounting Principles.
Understanding the financial statements requires knowledge of financial accounting, which every serious investor must sooner or later acquire. Checking out the auditor’s opinion, however, is relatively straightforward. Look for three items:
–by most far the most important factor is that the opinion be “unqualified,” that is, that the auditor state the accounts are fully in accordance with GAAP. A “qualified” opinion, on the other hand, one that says that in some respect the accounts are not in accordance with GAAP, is a gigantic red flag.
–who the auditor is. Any large company should hire a major accounting firm to do its audit. For a microcap stock, this may not be possible. But one of the more obvious long-term signs of trouble with Bernie Madoff was the fact that his auditor was a small, obscure firm that was radically dependent on Madoff’s business.
–how long the current auditor has held the position. A change of auditor is always worrying. Frequent changes almost always signal trouble.
how they differ
The 10k is the annual filing required by the SEC. It contains a detailed description of the company’s operations, line of business by line of business. It has an assessment of the competitive environment, the positioning of all the firm’s major products and the most important variables influencing earnings. There’s also a comprehensive discussion of the profit performance of the company during the year.
The company analysis can easily run 50 pages or more. A comforting fact for investors (at least, for me): any material misstatement or omission can be a cause for government prosecution of the offending parties, which can result in possible jail time. Therefore, I regard the 10k as completely reliable.
There may well be material information that a company would rather not make well-known. In my experience, such data will never find its way into the annual report. But because it’s material it must be in the 10k. It may not necessarily be easy to find–but it’s got to be there.
The one drawback I find in the 10k is that it is fundamentally backward looking. There won’t be a discussion of new products or changes in strategy or other plans that may affect the company’s profits in the coming year and beyond.
the annual report
The annual report is an information document. But it’s a marketing document, as well. It’s not only aimed at shareholders as its audience. It also wants to build morale among present employees, to help to recruit new talent, and to keep suppliers and customers content to do business with the firm.
The annual is usually shorter in length than the 10k, and contains lots of pictures and upbeat prose. While what the annual says must be true, it need not be as complete and as blunt about miscues as the 10k.
To my mind, the main plus of the annual is that, despite its positive bias, it’s the best place to find out what the company’s plans and ambitions for the next few years are. There is, of course, no certainty that the company will be able to achieve its goals. But this future orientation is, by design, almost completely lacking in the 10k.
The proxy statement contains information on the structure of the company’s board of directors, and the background and compensation of its members. It lists major owners of the company’s stock. It also contains details of any proposals that will come up for a shareholder vote at the annual meeting, along with the company’s recommendation for or against.
For individual investors, the proxy statement might well be best regarded as a cure for insomnia. But there’s a section that’s crucial to read, especially when dealing with smaller companies. It’s called “Related Person Transactions” or something similar. It deals with any business the company may do with other firms in which directors have a financial interest.
Why is this important? It’s to make sure your economic interests and those of the directors/management of the company you’re interested are aligned. For example, suppose Director A is the largest single shareholder of your company, with a 10% interest. Director A owns 100% of another company that either supplies your company or buys its products. You have to consider whether these dealings are arm’s-length transactions, or whether Director A’s 100%-owned firm is getting a better deal than it should. The proxy is the only place this potential conflict of interest will be disclosed.
In short: read the 10k for facts, the narrative part of the annual for aspirations, and the proxy for potential conflicts of interest.
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