The process that is required to get to know a company is relatively straight forward. Every investor is going to have a slightly different approach, but good investors typically begin with primary source material such as S.E.C. filings, news releases, and the material posted on a company’s website. Reviewing the company’s latest 10-K efficiently is extremely important. Obviously, much more due diligence is required to come to any conclusions but the 10-K can be viewed as the foundation of the process.
Over time, an investor will be exposed to more and more businesses and may begin to follow dozens of companies either due to an actual investment or because a company is on a watch list for purchase at an appropriate price sometime in the future. Significant work is required to “maintain” knowledge in a company over the years. The list of reports to review can become overwhelming because most companies will post reports close to the deadline mandated by the S.E.C. We are now close to the 10-K filing deadline for most larger companies with a December 31 fiscal year-end so the flood of incoming 10-Ks can seem a bit overwhelming. How can we keep up?
If Everything is a Priority, Nothing is a Priority
It probably goes without saying that reports of companies that are actually in an investor’s portfolio should take precedence over companies that are on a watch list, barring some unusual circumstances. Beyond that, we need to intelligently prioritize our reading. To use a word common in medicine, there needs to be some type of “triage” process. We should want to look at companies that have some significant developments taking place before looking at companies that have little that is new to report.
Let’s consider how to look at incoming 10-Ks to determine which deserve our attention first. Berkshire Hathaway released its annual report along with Warren Buffett’s annual letter to shareholders two days ago but only filed its 10-K report this morning. A 10-K report contains much information that is not necessarily included in an annual report. Many Berkshire shareholders spent a good part of the weekend with the annual report and might feel like they are fully up to speed. In the case of Berkshire, this is probably a good assumption because management is unlikely to try to “hide” something in the 10-K. The 10-K still deserves to be read fully but should it be done right now or can it wait a few days?
Obviously, some kind of major change in the business might be reflected in the earnings press release or by management and this could determine whether to review the 10-K immediately or to put in on the back burner. Assuming that we have already looked for the obvious newsworthy items, let’s take a look at the differences between the 2015 and 2016 10-Ks in a systematic manner.
Step 1: Download the 10-K for 2015 and 2016
We will be using Microsoft Word to compare two versions of the 10-K. The first step is to obtain the 10-K file from the S.E.C.’s Edgar website. We will start by searching for all of Berkshire’s reports using the company’s ticker symbol which is “BRKA”:
After the results come up, we will filter for only 10-K reports:
We need to download the html files for the 2016 and 2015 10-K reports (published on 2/29/16 and 2/27/17, respectively) which appear in the first two rows of the table shown above. To obtain the files, click on the Documents button next to each report and then on the first link named “Form 10-K”, as shown below in the red box for the 2016 10-K:
Clicking on the link (d303001d10k.htm) will bring up the actual 10-K report in html format. The image below is the report as seen in a Google Chrome browser. To save the html file to your local computer, right click on the document and select “Save As”, highlighted below in a red box:
Save the document to your local computer using a name such as BRK201610K. Then, repeat the same process for the 2015 10-K report and save that document to your local computer using a name such as BRK201510K.
Step 2: Compare the 10-Ks Using Microsoft Word
The next step is to take the raw html files that we have downloaded and to use Microsoft Word to compare the documents so we can scan for any changes. Microsoft Word 2007 is the version used to generate the output shown in the screen shots, but presumably newer versions of Word have similar functionality as well.
Open Microsoft Word and click on the “Review” tab of the ribbon at the top of the application, as shown in the red box of the screen show that appears below:
Clicking on the compare button should bring up the “Compare Documents” dialog box. Use this dialog box to specify the 2015 10-K as the “Original document” and the 2016 10-K as the “Revised document”. There are a number of options available as comparison settings. Our goal is not to analyze changes in the financial results as shown in various tables in the report. That type of information is best done in Microsoft Excel after entering the relevant data, a step that is distinct from what we are doing here. Our goal here is to spot changes in management’s explanation of the business or the risk factors. As a result, we will uncheck the “Tables” check-box in the dialog box but keep all other default options checked:
After clicking OK, Microsoft Word will take a minute or two in order to analyze the changes to the document and present the results. Once the results are presented, you can save the file locally to have it for future reference.
Step 3: Scanning the Comparison Document
There will be a very large number of changes detected between the two 10-K reports and it is up to us to know what to look for as we scan through the comparison document. Looking at each and every change is unproductive and will not save us any time compared to reading the entire 10-K from beginning to end, which is actually something that needs to be done eventually. Remember that our goal here is only to identify major changes that might warrant our immediate attention and cause us to prioritize a review of Berkshire’s 2016 10-K over competing 10-Ks that are being posted to the S.E.C. website early this week. In this section, we will just take a few examples illustrating the types of changes that can be spotted by running a comparison. This is not an all encompassing analysis or an assessment of which changes are most important.
Example #1: Business Overview
Let’s take a fairly trivial example just to get a feel for how Microsoft Word presents the changes. The screenshot below shows the first part of the “Business” section of Part I, Item 1 of the report which is a very high level description of Berkshire (click on the image for an expanded view):
We can see that there are some minor wording changes between the two documents. Beyond that, the interesting fact is that Berkshire’s total employment level increased from 331,000 to 367,700 during the course of 2016. For some reason, Berkshire has omitted the number of employees working at corporate headquarters from the 2016 report.
Example #2: Clayton Homes
There are a large number of changes in the business description that are interesting, particularly related to changes in the size or scope of various business operations and, sometimes, subtle changes in wording. One can also get a general sense of the trends in a business by looking at the descriptive text (obviously, in addition to looking at the figures in the reported financials). For example, the exhibit below shows the section describing Clayton Homes (click on the image for a larger view):
We know that Clayton has been growing based on the data in the annual report and some of Warren Buffett’s commentary. The comparison shows that the company now operates 38 manufacturing plants, up from 36 plants at the end of 2015. Additionally, the network of retailers grew from 1,726 to 1,923 over the course of the year. We can also see that the average down payment fell from 17 percent to 15 percent.
Example 3: Risk Factors
Risk factors are often just boilerplate text supplied by a company’s legal department and it is easy for a reader’s eyes to glaze over reading this section of any 10-K. Comparing the risk factor section for two years brings to light subtle and major changes that could warrant further study. One of Berkshire’s risk factors involves the concentration of the company’s investment portfolio. The text appears in the exhibit below (click on the image for a larger view):
What is interesting in this section is the addition of information regarding the change in GAAP that will change the accounting treatment of unrealized gains and losses in the investment portfolio starting in 2018. Currently, most unrealized changes in the fair market value of Berkshire’s investment portfolio are recognized as other comprehensive income. These changes do not impact Berkshire’s consolidated statement of earnings. Starting in 2018, all changes in the fair value of investments will be recognized as gains or losses in Berkshire’s consolidated statement of earnings.
This change has been pending for quite some time and has been disclosed in 10-Q reports during 2016. It represents a major reporting change because the volatility of Berkshire’s reported earnings will dramatically increase in the future. From an economic perspective, the change is a non-event because the value of the investment portfolio has always been reflected in Berkshire’s book value. However, the media and analysts may not grasp that reality when the volatility in Berkshire’s income statement increases starting in 2018.
The comparison approach described in this article can be a useful way to spot important changes in a 10-K but it definitely is no substitute for reading a report comprehensively. It makes sense to take the time to read a 10-K once a year for a company that is in one’s portfolio or might be a serious candidate for the portfolio at the right price. The time investment required to read a report in full is not unreasonable for a serious investor. At the same time, we must prioritize our reading and this can be difficult to do when 10-Ks are flying into the inbox at a rapid pace. By scanning certain sections of the 10-K for changes (principally the business description and risk sections), it is sometimes possible to spot companies that have had significant and, perhaps, unadvertised changes of a fundamental nature. We can then prioritize these companies for review before those that have not appeared to change very much.
In the case of Berkshire, the three examples in this article are not really very significant. They are meant only as an illustration of the type of information that can be revealed through a comparison process. The comparison technology is not that sophisticated. In some cases, especially in the management’s discussion and analysis, the comparison tool might consider entire paragraphs to have changed because they shifted in the order in which they are presented. The management’s discussion and analysis section, the financial statements, and in most cases, the footnotes need to be reviewed in full. Nevertheless, using this comparison approach can occasionally help to prioritize the order in which to review incoming reports.
Disclosure: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.