by Michelle Leder

Michelle Leder is the founder and editor of footnoted.com. a free website that analyzes company SEC filings. I spoke with Michelle recently about things investors should watch for when reading company reports.

Charles Rotblut, CFA

Charles Rotblut (CR): Could you explain what the U.S. Securities and Exchange Commission (SEC ) filings are and which filings investors need to pay attention to?

Michelle Leder (ML): There are a couple of key filings that investors need to pay attention to. And just to be clear, these are filings that investors really need to be paying attention to if they own individual stocks. And when I say if you own individual stocks, I mean if its a significantly large position for you. If you own a relatively small number of shares, then perhaps you dont need to spend much time with these filings. But if its a significant position for you, I think that it makes sense to read some of these key filings, or at least certainly to skim them.

The first filing to pay attention to is the 10-K, which is the annual report. When I talk about the 10-K or the annual report, what I refer to is very different from the annual report that perhaps investors might have been used to over the years, which is the glossy report with all of the pictures. I joke around often when Im giving a presentation: Its the one where the CEO is shaking hands with the janitor and looking like a regular Joe; usually the guys in short sleeves and looking like a happy-go-lucky sort of guy. Thats the annual report, but its usually different from the 10-K.

The 10-K is often small type, its black and white, and there are no real pictures. But theres a lot of important information in there that that you really need to be paying closer attention to if you own enough shares. The annual report comes out once a year, obviously.

Then we have the 10-Qsthe quarterly reportand there are three 10-Qs a year. Right now, as we speak in late April, were in earnings season. For companies that are on a December 31 fiscal year, were starting to see 10-Qs for the first quarter. The deadline for that is May 10. Over the next two weeks or so, were going to see a lot of 10-Qs come in. The quarterly report is much more comprehensive than the typical earnings report.

Most investors make the mistake of just paying attention to what the earnings number is: Company A was supposed to report $1.00 per share in earnings and it reports $1.01 per share in earnings. And that is the extent of the attention span that many investors often give. I feel that that is a very superficial view, and theres just a lot of detail in the 10-Qs that you should be paying attention to, much more so than just figuring out that the company beat the number. The reason is that there are so many ways, quite frankly, to manipulate the numbers, and to get earnings to beat the number, that if youre not paying attention, you can wind up getting burned in the end. And thats really what this is all about. Its often about spotting potential problems before they blow up in your face.

When I talk about this, I talk about it from experience. One of the reasons that I got really interested in SEC filings is because I was an ordinary investor (this was about 10 years ago), and I had bought some shares of Qwest CommunicationsI think at about $39 a share. I watched as the stock marched up to about $56, before it started to make a dive. Now, instead of looking at it going from $39 to $56 in a relatively short amount of time and thinking, Hmm, lets get out; weve made a nice little profit; lets get going, I thought, Oh, if its $56, maybe it could be $64, maybe it could be $70-something, who knows?

I also wasnt paying attention to the filings. Had I spent about an hour reading Qwest filings at the time, I would have gotten out when the going was still good and I would have been able to make money instead of riding the stock all the way down. Unfortunately, by the time I had learned my lesson, I had lost a lot of money. The way I often describe it is that it would have taken me about an hour to skim the filings and see enough red flags in there to avoid the stock or at least get out when the going was good. Had I done that, I feel like I would have been able to avoid this particular problem.

Instead, I used it as a teaching lesson. I learned that if Im buying a stock, and its a significant holding for me, I want to quickly skim the filings and look for certain things, and look to see if I think the company is being aggressive with its accounting. And thats really where my bookFinancial Fine Print (John Wiley & Sons, 2003)sprang from. It talked about the lessons that I learned as an investor from investing in Qwest and not reading the filings: why its important to read the filings, why ordinary investors can do this sort of thing and why they can take it on and start to gain a better understanding of whats really going on.

CR: What are some of the things you look for in the 10-K or the 10-Q?

ML: One, I look for significant changes in the accounting policy, whether the company is making a lot of changes to the way it accounts for certain things. In the end, theres basically two ways that you can manipulate the numbers. You can overstate your revenues, or you can understate your expenses. Of course, thats a very simplistic view because within that universe, there are thousands of different ways to really manipulate the numbers. But basically you want to look for any kind of signs that the company is engaged in either of those thingsoverstating its revenues or understating its expenses. And throughout history there are lots of examples. Enron would be an example of a company overstating its revenues. WorldCom: overstating its revenues. Qwest: overstating its revenues, just being super aggressive on how it was counting every single thing before it really was money in the account. There are also lots of examples of companies understating their expenses or manipulating their expenses in one way or another. Those are the sorts of things that I like to look at. Obviously, theres a lot of different ways that you can manipulate expenses and revenues, but I think in general thats sort of what youre looking forsigns of aggressive accounting.

One of my mentors, [Thorton] Ted OGlove, who wrote an excellent book called Quality of Earnings (Free Press, 1998), told me very early on: Imagine you have two identical companies, Company A and Company B. Now, obviously, you never have two identical companies, but lets just say you do, for arguments sake. Based on current accounting rules, Company A could report $0.75 per share in earnings and Company B could report $1.50 per share in earnings. Now remember that these are two identical companies. So how could one company report such a significant difference in its earnings from the other? The answer is that its all based on the accounting rules and the interpretation of those accounting rules: Whether the company chooses to be more aggressive or less aggressive.

I would argue that, especially for long-term investing, you do not want to be in companies that are playing fast and loose with the numbers, companies that are being overly aggressive. You make one false assumption and the stock can just blow up on you; weve seen it happen time and time again with a company that just looks like everything is going great. One of my earlier finds was Krispy Kreme (KKD). back when I first started my website, footnoted.com. Krispy Kreme was trading in the $40s back then; who would have thought that something would have gone wrong and that the stock would have gone down to $2? We didnt predict the $2, but we said there was something very wrong about the companys accounting long before others caught on. That kind of accounting is the type of thing that I think investors need to learn how to avoid.

CR: Where in the documents should investors lookare there any specific things that suggest that the company is being aggressive?

ML: When it looks like companies are booking revenue, I often joke that its like counting their chickens before theyre hatched. A company announces a deal and they book all of that revenue up front. Lets say theyve announced a $100 million deal with XYZ Company. Theyre booking all of that revenue at once, even though its a multi-year deal. Those sorts of things are obvious red flags, but I think that there are others too. There are many examples of companies that are just playing fast and loose with the numbers. And its not always cut and dry.

In accounting, everyone thinks that a number is a number. How could a dollar be anything other than a dollar? Thats sort of your common thinking about it. But if you think about it a little more, there are different ways to count that dollar. And whether the company has an aggressive or non-aggressive chief financial officer, how willing the board of directors isthose are the sorts of things that you need to take into account.

If this is something that you find is too much for you, then perhaps you shouldnt be in individual stocks. If youre not willing to take all of these different factors into account, maybe individual stocks are not for you and maybe it makes more sense to have someone else do this for you.

Discussion

J from PA posted over 3 years ago:

Robert from VA posted over 3 years ago:

Very helpful article, I think that I have a new found respect for SEC filings. I am going to do a bit of research on the companies that I have stock investments in and see just how they stack up. One other comment, about Krispy Kreme, I had looked at buying their stock, but I just couldn’t see the stock at the price that it was going to in relation to the amount that they were charging for a box of glazed doughnuts. It just didn’t seem that there was enough volume there for me, so I bowed out.

Cliff from NH posted over 3 years ago:

outstanding article. it’s always about buyer beware. You can’t know too much about the company you entrust your money to.

Richard from OR posted over 3 years ago:

Excellent article. I would have liked to see more specific examples of things to look for in the SEC filings but, after reading this I will read the 10-K more carefully.

Steven from TX posted over 3 years ago:

yes, I agree, very good article. I liked the fact you brought up Krispy Kreme. I do not understand how a company can falsify accounting like they did. Then go chapter 11 when caught, take all your money, and back to business as nothing happen. Steve

Nolan from OK posted over 3 years ago:

I WOULD LIKE TO SEE MORE SPECIFIC EXAMPLES. THE ARTICLE IS TOO GENERAL WHICH DOESN’T HELP VERY MUCH. THAT IS THE TROUBLE WITH MOST INVESTMENT E-LETTERS AND ARTICLES THEY SEEM TO THINK THEY WILL TELL ONE OF THEIR SECRETS IF THEY GIVE SPECIFICS

James from PA posted over 3 years ago:

I agree with the comment that this article is too general and not of much value. I read 10K’s and have trouble really understanding what they say.

Steven from IA posted over 3 years ago:

Amen to James who says this is not simple or easy. I remember one corporation sending me a flow chart of operations that I thought was more complicated than a television schematic. I bought a textbook that made an example of a balance sheet and such of a child’s hot dog stand. Simple, yes. Now go try to figure out Citigroup or IBM.

Steven from IA posted over 3 years ago:

I just wanted to add — Of course it is successful analysis is very difficult. If it was easy so anyone could do it then How to get Rich in the Stock Market would be taught in junior high and no one would go to high school. No one would work for a living because we all would be billionaires in mansions. I have taken some comfort lately in ETFs and accepting that I cannot see into the future or outwit professional corporate accountants

Michelle Leder from NY posted over 3 years ago:

If every company were exactly the same, I could easily provide specific examples of what to look for each and every time. But since that’s not the case, I tried to be more general and explain some of the things the people need to be looking for. At some companies, it may be aggressive accounting, at others, it could be subtle changes to risk factors, and still others could have legal issues that are worth paying close attention to.

Like it or not, reading filings is very much an art, as opposed to a science, so coming up with an exact formula that you can follow every single time is simply not possible here.

I’ve been reading filings closely for close to a decade now and there’s still things that surprise me every single time.

Michelle Leder

Bob from Michigan posted over 3 years ago:

Taking college accounting (2 semesters) and corporate finance really helped me in understanding company financial reports even though I didn’t complete requirements for a BA degree.

Mike from CA posted over 3 years ago:

One of my interests in SEC filings is executive compensation. I own some shares of CEP and noticed that the executives had recently added a very generous compensation payout if the shares stayed above $3.50 for over 20 days between now and the end of 2012 or 2013. I couldn’t remember which. It appears to be a pretty easy target to hit (too easy for my taste) so I figured at $2.25 it was worth buying and holding until at least that point. I’ll look at it more carefully if it gets into that 20 day period I mentioned.

I’m not pushing the stock, (it may be crap) I’m just saying I’m making a small bet on the greed of management in a company I happen to have a few shares in.

Betting on executive greed in this day and age is rarely a losing proposition.

Joseph from KS posted over 3 years ago:

The article dosen’t help much.It is a good general over view of the need to check the required reports. I doubt many of the highpayed CEOs could justify their salaries.It looks to me that there is a real back scratching between the CEOs and the boards of directors.

I have been had by a number of companie’s by not paying close attention to there reports.

There is also some outright misleading things

that come from analyst.

Dominick from WA posted over 3 years ago:

Enjoyed the article’s analysis.

What does the author feel about free cash flow as a better potential indicator of company profit and value? Is it less easily manipulated than earnings or just as easily manipulated?

Curious to hear Michelle’s thoughts on this. For me, I prefer to look at cash flow more-so than earnings.

Judy from NC posted over 3 years ago:

Thanks for a great article for us beginners. I especially learned (became aware) of the various report listings for both domestic and foreign companies.

I think most investors rely on stock pickers and ideas from the informed and did not realize that even some of them may not do their due diligence.

I got burned on holding ccj (uranium stock) when Japan’s woes turned it up-side down. Yes, i really thougt after a month or so the stock would return to its highs so i held on to it. The unexpected thing, however, was that the various nations world-wide turned chicken and dropped nuclear plans. But after closing in near a full year; it looks like nuclear is back in or will slowly return to an up stock. I’m still holding but it has been a long year watching it do nothing. With time it should return my money back; but then i may just hold on to it longer after it gets going again.