Sunday, March 15, 2015

5 Signs of a Good Annual Report

Annual report season is upon us, which presents an opportunity to better understand our current portfolio holdings and watchlist ideas, as well as management's strategy and outlook.

Here are five signs of a good annual report -- that is, one that is helpful, informative, and could signal that a smart management team is at the helm.

1. They aren't afraid to admit mistakes: If the company had a bad year, was management forthcoming about what went wrong or did they sweep it under the rug? Assuming it's something they can control, do they have a clear strategy for not repeating the mistake? Frank discussions of mistakes also help shareholders gain insight into management's decision-making process. This year's Berkshire Hathaway annual report features a number of discussions about mistakes the company has made over the years.

2. They spend time talking about capital allocation: One of the things that William Thorndike stressed in The Outsiders was that capital allocation is a CEO's most important job, yet it's remarkable how few annual reports provide details on the company's capital allocation strategy. How do they prioritize uses of free cash flow? Does the company have a clear and appropriate buyback and dividend policy? U.K.-based retailer, Next, does a particularly good job outlining its capital allocation philosophy in its annual report, as does U.S. based textile firm, Culp.

3. They focus on returns on capital and economic profit: A recent study by IRRCi found that 75% of companies in the S&P 1500 don't use any balance sheet/capital efficiency metrics like ROIC, ROE, or EVA in determining long-term management incentives. This opens the door to management pursuing growth-for-growth's-sake and destroying shareholder value; therefore, I see it as a positive sign when a management team is held accountable for the cost of the capital that its using to grow the business over the long-term. It's an even better sign when ROIC is ingrained in the corporate culture. Good examples of annual reports that discuss ROIC and economic profit metrics are Constellation Software and Sun Hydraulics.

4. They communicate plainly. In my experience, too many companies assume readers of their annual reports have intimate knowledge of key industry phrases and metrics or they make the business sound more complicated than it really is. I like to see companies that take the time to explain their business in everyday language that can be understood by all stakeholders and readers. Admiral Group's annual report is a good example of this. 

5. They provide helpful data points. Good annual reports should contain enough data points to help investors fully evaluate the company's performance. Obviously all companies are required to disclose financial statements, but I like to see more granular data offered at the segment and product level, too. Costco does a great job of this in its annual report. Companies that don't provide data beyond what's required makes you wonder why the data isn't being shared.

What do you look for in companies' annual reports? Let me know in the comments section below or on Twitter @toddwenning.

Related posts
Please note: Going forward, links to articles I've been reading will be found in a separate post. 

Stay patient, stay focused.

*I own shares of Admiral, Berkshire, Culp and Sun Hydraulics. A list of my equity holdings can always be found here