Few years back I read a masterpiece from Shai Simonson on How to Read Mathematics. In order to read mathematics effectively he tells that we should follow a reading protocol, which is a set of strategies that a reader must use in order to benefit completely from the text. I would highly recommend you to read Shai’s article. It’s time very well spent. In this article he writes
Poetry calls for a different set of strategies than fiction, and fiction a different set than non-fiction. It would be ridiculous to read fiction and ask oneself what is the author’s source for the assertion that the hero is blond and tanned; it would be wrong to read non-fiction and not ask such a question. This reading protocol extends to a viewing or listening protocol in art and music. Indeed, much of the introductory course material in literature, music and art is spent teaching these protocols. Mathematics has a reading protocol all its own, and just as we learn to read literature, we should learn to read mathematics. Students need to learn how to read mathematics, in the same way they learn how to read a novel or a poem, listen to music, or view a painting. Reading Mathematics is not at all a linear experience. Understanding the text requires cross references, scanning, pausing and revisiting.
Shai Simonson’s article came to my mind while I was reading the annual report of Amazon. I stopped immediately and asked myself if there is a protocol for reading an annual report. I believe there is one and this post is about it. I am not an original thinker and this post is just a collation of ideas on this topic from some of the best value investing minds like Warren Buffett, Charlie Munger, Mohnish Pabrai, Sanjay Bakshi, and Chetan Parikh. If you like this post it’s because of them. If not it’s because of me.
1. Learn the language of business
All new learning requires a foundation of prior knowledge. In order to learn trigonometry you need to know algebra and geometry. Similarly to read an annual report you need to know accounting as it is the language of business. You need to understand the basics of income statement, balance sheet, and cash flow statement. Also you need to understand their connections. If you are a beginner I would recommend the following book.
2. Quick 10 minute test
There are 50,000+ publicly traded businesses globally. If you read one annual report a day then you need 136 years to read the report of 50,000 business. This is not possible and we need a better way. Reading an annual report takes time and we should make sure that the time spent on reading is worth the effort. We need a simple checklist to filter out all the bad businesses. Given below is that list.
Do you understand the business of the company? If yes then move to step 2. If no then are you passionate and willing to put time and effort to learn about the business? If no then move on to the next company. To be a successful investor you need to buy a business worth $1 for 50 cents. To know what is the worth of something you need to value it and for that you need to understand it.
Does the business produce above average returns on invested capital? If no then move on to the next company. If yes then move to step 3 as the business might have some moat.
Is the management able and honest? If you know for sure that the management is a crook and has political clout then you avoid it like plague. Never do business with a man you do not trust and he who steals for you will also steal from you. Close your eyes and move on to the next company. If the management is good then move to step 4.
Does the company have a lot of debt? If yes then move on to the next company as high leverage can destroy a company in several ways. If no then you have a potential candidate for further research.
If you are a beginner then I would recommend you to look at those companies which are bought by the experts. Do not blindly copy but instead rediscover the reasons behind their purchase. This technique is called as cloning.
3. Do not theorize before you have data
After identifying the potential candidate for further research do not look at the stock price. Why is that? Imagine that you picked up Google and it’s quoting at $450. Also you came to know that it’s 52 week high was $600. What would you do? Under the influence of System 1 you will conclude that the stock is cheap as it is selling for 25% below its peak. You get anchored to $600 and your further research will be influenced by this and you will twist facts to suit the anchor. Never do that. Every investor should have Sherlock Holmes as a role model and Peter Bevelin’s book on Holmes is a must read.
We approached the case… with an absolutely blank mind, which is always an advantage. We had formed no theories. We were there simply to observe and to draw inferences from our observations… I have not all my facts yet, but I do not think there are any insuperable difficulties. Still, it is an error to argue in front of your data. You find yourself insensibly twisting them round to fit your theories… It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts.
4. Business Model Generation
Download the latest annual report of the company you are trying to research and start reading. Amazon’s 2013 annual report has 86 pages. Should I read every page? No. You need to focus on reading the following sections (1) Business (2) Management Discussion and Analysis (3) Consolidated Statement of Balance sheet, Income statement, and Cash flows. You need to read them by asking questions. Charlie Munger tells that we learn learn better if we array knowledge on a bunch of models that are basically answers to the question why, why, why.
What questions should I ask while reading these sections? You need to get answers for nine questions. I got these questions from the book Business Model Generation and every investor should read this book. Sometimes you will not find all the answers in the current annual report. In that case you need to find it by visiting the company’s website and also by reading the management interviews. Do not stop until you get all the answers.
Customer Segments: Customers comprise the heart of any business model. Without customers, no company can survive for long. You need to find out who are its customers. Are they businesses or consumers? What is the demographics of the customers and how affluent are they?
Value Propositions: What value does the company deliver to its customers? Which customer’s problems does the company solve? Which customer needs are being satisfied? What bundles of products and services does the company offer to each customer segment?
Channels: How does the customer know about the company’s products and services? How does the company deliver its product and services to customers? Is it online or offline? How does the customer contact the company post-purchase?
Customer Relationships: How does the company establish relationship with each customer segments? Can a customer communicate with a real customer representative to get help before and after purchase? Is it self-service and the customers are expected to do it all by themselves?
Revenue Streams: It represents the cash a company generates from each customer segment. If customers comprise the heart of a business model, revenue streams are its arteries. You should ask, For what value are customers really willing to pay? For what do they currently pay? How are they currently paying? How would they prefer to pay? How much does each revenue stream contribute to overall revenues? There are several ways of generating revenue and some of them are (1) By selling goods as Amazon does (2) Based on usage as Hilton does (3) Based on subscription as Netflix does (4) By Advertising as Google does (5) By transaction fee as Visa and Master Card does (6) By renting as Enterprise and Hertz does.
Key Resources: What are the key resources that enable the company to create value, win customers, and generate revenue? The key resources could be (1) Physical assets such as manufacturing facilities, building, and distribution networks. Walmart rely heavily on physical assets (2) Intellectual resources such as brands, proprietary knowledge, patents and copyrights. Nike and Coke rely heavily on its brand (3) Human resources are crucial in knowledge intensive and creative industries. Technology companies like Google and Facebook rely heavily on people (4) Banks and lending companies rely heavily on financial assets.
Key Activities: What are the key activities a company does to generate value? These activities can be categorized as (1) Production; Examples are companies like Ford and Toyota design and manufacture cars (2) Problem Solving; Examples are IBM and McKinsey solves problems for its customers (3) Platform/Network; Examples are companies like Amazon and Apple.
Key Partnerships: A company cannot do everything on its own and it depends on key partnerships. A real estate development company like Ashiana partners with land owners by way of area sharing, profit sharing, or revenue sharing. By partnering it reduces title risk and minimizes investment in land. An insurance company may choose to rely on independent brokers to sell its policies rather than develop its own sales force. Find out who are the key partners of the company.
Cost Structure: It describes all costs incurred by the company to operate the business. The cost structure of a company depends on the type of business. Enterprise companies like Sales Force need to spend a lot of money on sales people. Wholesalers like Costco operates with a razor thin gross margin of 10%. It is profitable because of the membership fees. On the other hand Facebook has an healthy operating margin of 36%. Once the costs for employee salary and running the data centers are covered everything flows to the bottom line. You need to find out the cost structure of the company.
5. Know the Industry
After generating the business model you should have a decent understanding of the company’s business. Now its time to understand the industry in which the company is operating in. Why is that? A company does not exist in a vacuum. It competes with other firms that are operating in the same industry. The profitability of a company to a large extent depends on the dynamics of the industry. Pat Dorsey wrote about this in The Little Book That Builds Wealth
ONE OF THE BEST THINGS about being an intelligent investor is that the world is your oyster. You’re not forced to invest in industry A or industry B, so you’re free to cast a discerning eye over the entire investment universe, ignoring what you don’t like and buying what you do. This freedom is especially important if you are looking to build a portfolio of companies with economic moats, because it’s a lot easier to dig a moat in some industries than in others.
Let me repeat myself, because this is a critically important point: Some industries are brutally competitive and have awful economics, and creating a competitive advantage requires the managerial equivalent of a Nobel Prize. Other industries are much less competitive, and even average companies are able to sustain solid returns on capital. (No one ever said life was fair.) As an investor, you’ll have better odds hunting for ideas in industries where managers only need to hurdle one-foot bars to succeed than you will looking for long-term winners in industries where the barriers to success are much higher.
Nine times out of 10, the competitive dynamics of an industry will have a much greater impact on whether a company has an economic moat than any managerial decision. This is not because most managers are incompetent, but rather because some industries are less competitive than others; the cold, hard truth is that some CEOs just have an easier job maintaining high returns on capital.
In general you are better off avoiding industries with anemic returns on invested capital. What should I do if I do not know anything about an industry? There are several ways to learn about an industry and some of them are (1) Read Trade journals specific to that industry (2) Read the Industry section of a buy side analyst report. Do not bother to read anything else (3) Talk to knowledgable people in that industry; scuttlebutt (4) Someone smart should have written a book about that industry. Go and read that book. Apply Porter’s 5 forces framework to the industry you are studying. If you are new to Porter’s 5 forces then read the book given below.
6. View the company as an unfolding movie
At this point you know the business of the company and the industry it is operating in. Now you need to read the Management Discussion & Analysis and Chairman/CEO letters for the last 10 years. If possible go for 15 or even 20 years. Why should I read the reports that are a decade old? Human brain works on a contrast scale and it is not good in identifying changes when it comes in small pieces (contrast effect). But it is very good in spotting trends over longer periods. By reading reports for 10+ years we can clearly see trends in the industry, business, and the quality of management. This is not possible if you read the report for an year or two.
Take notes while reading the reports. Some things you should watch out for are (1) Did the management execute on its promise (2) If things go bad does the management blame itself or someone else (3) Does the management treat shareholders as its partners (4) Is the moat strengthening or eroding (5) Can the company raise the price for its goods and services. In 2011 shareholders meeting Munger explained how he would study a business. Simply the best. Just follow it.
If I were teaching business school I would have Value-Line-type figures that took me through the entire history of General Motors and I would try to relate the changes in the graph and data to what happened in the business. To some extent, they faced a really difficult problem—heavily unionized business, combined with great success, and very tough competitors that came up from Asia and elsewhere in Europe. That is a real problem which of course… to prevent wealth from killing people—your success turning into a disadvantage—is a big problem in business.
And so there are all these wonderful lessons in those graphs. I don’t know why people don’t do it. The graphs don’t even exist that I would use to teach. I can’t imagine anybody being dumb enough not to have the kind of graphs I yearn for. But so far as I know there’s no business school in the country that’s yearning for these graphs. Partly the reason they don’t want it is if you taught a history of business this way, you’d be trampling on the territories of all the professors and sub-disciplines—you’d be stealing some of their best cases. And in bureaucracies, even academic bureaucracies, people protect their own turf. And of course a lot of that happened at General Motors.
7. Applying Buffett
At this point you have seen the unfolding movie and know everything about the company. It’s time to apply the principles of world’s greatest investor on your company. Go and reread selected sections from Buffet’s shareholders letters on the quality of business, management, and moat. Does the company you are studying exhibit those qualities?
If you think that the company you are studying has low cost advantages then compare it with the low cost companies that Buffett owns like Costco and GEICO. On the other hand if you think that the company has a powerful brand then compare it with Coke and Gillette. Similarly to know if the management is good in capital allocation do Buffett’s earnings retention test. By rereading and applying Buffett’s principles again and again, we will rewire our brain and start to think like him.
8. A 10X Force
Great businesses like Kodak and Xerox had wide moat but it got eroded over time. What happened? New technologies like mobile phones eroded the moat of Kodak. Better and cheaper copier machines from competitors eroded the moat of Xerox. In the book Only The Paranoid Survive – Andy Groove refers to this phenomenon as 10X force.
When a business goes from the condition shown in the first figure to the second, the changes it faces are enormous. In the face of such “10X” forces, you can lose control of your destiny. Things happen to your business that didn’t before, your business no longer responds to your actions as it used to. It is at times like this that the telling phrase “Something has changed” is apt to come.
To manage a business in the face of a “10X” change is very, very difficult. The business responds differently to managerial actions than it did before. We have lost control and don’t know how to regain it. Eventually, a new equilibrium in the industry will be reached. Some businesses will be stronger, others will be weaker. However, the period of transition depicted in the diagram below is particularly confusing and treacherous
Now, nobody will ring a bell to call your attention to the fact that you are entering into such a transition. It’s a gradual process; the forces start to grow and, as they do, the characteristics of the business begin to change. Only the beginning and the end are clear; the transition in between is gradual and puzzling. What such a transition does to a business is profound, and how the business manages this transition determines its future.
For the company you are analyzing ask what if one of the forces becomes 10X powerful. Study all great failures like General Motors, BlackBerry, Kodak and Xerox and extract underlying patterns behind these failures by mapping it back to the force that got powerful. See if this can happen to your company. Do not assume anything. Things change all the times and every moat gets breached at some point.
BlackBerry got killed by competition from Apple which became a 10X force.
Barnes & Nobles got killed by technology from Amazon which became a 10X force.
9. Valuation
If you are convinced that you have found a solid company with a moat run by able and honest management, you should go ahead and value the business. If the value of the business is below the quoted market price then go ahead and buy the stock. If not wait patiently until the value goes above the price. One day I will write a separate post on valuation. For now if you want learn about valuation then pick up the book given below.
Closing Thoughts
Is this not a lot of work? Yes it is. Munger once told that Investing is not supposed to be easy. Anyone who finds it easy is stupid.