How to Read 10-K Filings like Hedge Funds

By Chika

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Last Updated: August 4, 2021

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Tracking Hedge funds is one way which less knowledgeable investors have tried to beat the market. Investors usually comb through 13-F filings of hedge funds looking for stock positions and buying opportunities. Analysts use it to get an idea of where the market is headed.

According to research from Barclays and Novus, investors who replicated the investment decisions of hedge funds had a return of almost 4% above the S&P 500.

While the 13-F filings can be an incredible pool for investment ideas, investors, it is possible to replicate their stock market wizardry of hedge funds. One sure way of doing this is learning to read quarterly reports like the highly paid portfolio managers in hedge funds.

If you understand what metrics to look out for when going through 10ks, chances are you would be able to attain the same level of financial performance, if not more. Here are some tips on what metrics look out for when going through various sections in the 10-K reports.

 

Business overview.

 The business overview tells you what the business is all about in a summarized form. When hedge funds go over a business overview they lookout for several critical points such as the market ecosystem (Who are its suppliers, distributors, partners? How is the company's operation costs split across its supply chain), revenue model (How do they make money? Subscription? Ads? Product sales? Transaction fees?), and product portfolio.

The business overview also allows you to identify possible red flags in the form of regulation and risk factors associated with the business. For example, Biden's clean energy plan spells doom for fossil fuel companies but portrays a booming market for renewable energy companies. 

 

 Management discussion and analysis (MD&A)

This is a section within a company's 10-K report where the management analyzes the company's performance. The section includes risks, and plans of management for the company such as new projects or acquisitions. 

You should look out for management growth outlook and future, earnings forecast and guidance, new products, partnerships, and plans for market expansion, including government and regulatory changes. 

 

Financial Statements

Financial statements are the crux of 10-K reports. This is the part that tells you how the business has performed financially. Financial statements show where a company’s money came from, where it went, and where it is now. It comes in three sections: income statement, cash flow statement, & balance sheet. 

In the income section, look out for: YoY revenue growth (or loss), profit margins, write-offs, and discontinued operations. In the cash flow section, look for changes in working capital or days sales outstanding (DSO) as they indicate solvency and how well the company is managing its credit sales which gives an inkling of how solvent it is. Also, keep an eye on Cash Flow From Operations (CFFO). If CFFO is less than net income, it is most likely a sign of earnings shenanigans.

Another metric to look out for in this section is capital expenditure (CapEx)and depreciation. if a company has more CapEx than depreciation, this means that its asset base is growing. If the reverse is the case, this indicates that management is not plowing back profit to grow the business. 

When going through the balance sheet, things to look for are debt/equity ratio (if greater than 200% it is a sign of impending liquidity crunch), interest coverage ratio (the lower the interest coverage ratio, the higher the company's debt burden and the possibility of bankruptcy) and goodwill (if high, it indicates low fiscal discipline, reckless spending, and the potential for damaging write-downs in the near future). 

 

Executive Compensation

Executive compensation details the financial compensation and other benefits accorded to the company’s executive in return for their service. Though the CEO is usually responsible for growing the company's top and bottom line, they are also interested in maximizing their bonus.

If bonuses are tied to the performance of the company, then you can be rest assured that the executives would be willing to improve the fortunes of the company. If the company is performing poorly financially and the board approves a lay rise or higher bonus for its executives is a red flag. 

Other things to look out for are the percentage of ownership by insiders. A high percentage implies that management believes in the company. If there is insider buying, this is a green light to own the stock because it shows that management believes that the stock is undervalued and would rise. 

 

Final Word

 Though company annual reports are public documents, not everyone has the expertise to read and understand them. There are nuances contained in the reports which can only be detected by the trained eye. However, with some of the tips outlined above, you can improve your understanding of 10-k reports and be able to forecast which direction the company is headed.. This would enable you to position your investment appropriately and reduce the probability of future losses.

 

Photo by bruce mars on Unsplash

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