Reading An Annual Report (Finding Unexpected Risks)

Benjamin Graham used to say that reading an annual report was largely a “negative art” because usually something compelling about a business would make you curious enough to read the company’s financials, and then you would “disprove your idea” over the course of reading the annual report because you would often find the reason why the purported discount in the stock price was not a discount after all. It is the instances when you are unable to disprove your idea that you actually end up making the investment.

After I started this website, I would get asked: “How do you identify a good investment?” or sometimes even specifically “What do you look for in an annual report?” The answer is that some random interaction in the outside world puts an investment idea in my head, I tie it by reading the annual report, and then I usually encounter some reason why it’s not a good investment. “The remains” are what actually becomes worthy of investment.

In almost every case, I will find something unique to the company that carries a risk that couldn’t be known without reading through the company’s annual report.

For instance, I had noticed that Smucker’s stock (SJM) has been drifting towards a valuation of 17x earnings in the past two years after spending much of the past twenty years valued in the 18-22x earnings range. Earnings per share have been increasing at 8.5% annualized, so it seemed like a case where a steadily growing business was becoming unduly cheap.

Then, as I read through the financial statements, I noticed something unusual. The net profit margin of Smucker’s, which had hovered between 11% and 11.7% for much of the 1996-2016 time frame, had fallen to 10.0% in recent years. Given that the packaged foods industry had been following Kraft-Heinz’s lead in slashing costs and boosting profit margins in the past year, the lower profit margins at Smucker’s stuck out.

Was this a company resolutely sticking to quality while the rest of the packaged foods industry cheapens its product? Maybe.

But on page 63 of the most recent Smucker’s annual report, I found my answer:

“Sales to Walmart Inc. and subsidiaries amounted to 31 percent of net sales in 2018, and 30 percent of net sales in both 2017 and 2016. These sales are primarily included in our U.S. retail market segments. No other customer exceeded 10 percent of net sales for any year.”

The lower profit margins were a byproduct of Wal-Mart being responsible for a third of Smucker’s sales. The lower P/E ratio over time reflects that Wal-Mart went from being responsible for 16.1% of Smucker’s sales in 1996 to 24.3% in 2006 to 31.2% in 2018.

I would argue that the P/E ratio of 17 accurately reflects the risk inherent in having one retailer now account for approximately one third of the company’s sales. A disastrous supplier contract negotiation between Smucker and Wal-Mart could destroy a lot of the business’ value quickly, or alternatively, Wal-Mart could be quite aware of Smucker’s reliance on it and be able to negotiate more favorable sales terms accordingly.

Smucker’s reliance on Wal-Mart wouldn’t prevent me from investing in Smucker’s. But I would require a lower P/E ratio starting valuation. My guess is that Smucker’s right now is trading for about what it’s worth. A 20% or so price decline would probably make it attractive on a risk-adjusted basis. But even though the current price appears to be a historically discounted P/E ratio, I don’t think you can say Smucker’s stock is a discount at 17x earnings because it is far more reliant on Wal-Mart than it was twenty or even ten years ago.

When you read an annual report, these are the types of risk you are trying to identify. Is there debt coming up due soon? Is one customer responsible for too high a percentage of sales? Are pension assets being too optimistically counted in the form of projected return rates? Are too many shares of stock being issued to managers as compensation? The identification of these elements is the point of reading an annual report, and every company except Berkshire Hathaway will have things in its annual report that you do not like. Then, you have to figure out if that disqualifies you from investing in the stock, or if you should insist upon a lower starting price before making an initial investment.

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