Stock picking doesn’t have to be a shot in the dark. The straight shooters do their homework. Don’t sit and wonder. Most of what you're looking for is already available for free, in a report called a 10-K. You just need to know how to find and use it. Learn to decipher a company’s 10-K and you’ll find all the information you need neatly bundled.
How To Pick A Stock Using Fundamentals
Picking a stock is one of the greatest challenges for new investors. There are thousands of publicly traded companies on American stock exchanges, and each of them seems to have a thousand moving parts. There are so many variables that it seems impossible to interpret them.
Don’t worry, everyone starts somewhere. Warren Buffett is the most famous stock investor in history. How does he pick stocks?
"Read 500 pages like this every week. That's how knowledge builds up, like compound interest." -Warren Buffett
Buffet says smart fund managers learn to relax by putting their feet up and burying their nose deep in as many 10-K annual reports as they can..
If you know anything about Warren Buffet, you know that he famously evaded the dotcom bubble by avoiding investment in the tech industry all together. Warren Buffet doesn’t invest in businesses he doesn’t understand. He’s dedicated to the fundamentals of investing, and since he leads the multinational conglomerate Berkshire Hathaway (total holdings just under $200B), it’s safe to say that he knows a thing or two.
Buffett doesn’t get his information from the bookstore. He isn’t talking about thousand dollar industry reports either. He’s talking about 10-Ks, a document all public companies are required to file with the U.S. Securities Exchange Commission (SEC).
How to Find Company 10-K Reports & Other SEC Filings
Thanks to the SEC, all publicly traded companies are required to divulge the details of their business activities. Annual 10-K reports are a company’s single most detailed report, and they contain information that’s essential to determining whether or not a stock is worth your money.
Public companies usually have their 10-K reports available on an “investor” page. They also usually have other SEC filings, stock information, corporate governance, and more. 10-K reports are also available in the official SEC filings archive.
How to Read 10-K Reports
A 10-K is a deceptively boring document. The text and photos (if they have photos) are tiny and monochrome. They’re also usually very long. For example, the Alphabet Inc. 10-K is more than 100 pages.
It’s difficult to keep your eyes from glazing over in the face of such a never ending barrage of text. But the reward for getting through it is a high resolution image of the company’s health. Many sectors of the company are hashed out in fine detail. You’ll be surprised how much companies divulge in 10-Ks. There are nuggets everywhere, and some of them are golden.
You can read the entire document if you have the time. But if you don’t have time, you can skip a lot and still get a good sense of the company’s health.
The sections in a 10-K are called items. Here are the items you need to read in every 10-K.
Item 1 - Get an Overview of the Company
Start with item 1, the business description. Don’t invest in a company if you don’t know how it makes money. This section lives up to its name, providing an overview of the company’s main operations. It describes how the company makes money by listing sources of revenue, customer segments, and other companies it owns.
Item 1 also broadly describes the risks a company faces such as competitors, government regulators, and public relations issues (this is described in more detail in Item 1A discussed below). Item 1 gives you insight into the mind and body of the company.
Item 6 & 7 - Understand the Company’s Money
Next read items 6 (financial data) and 7 (management’s discussion and analysis). These sections answer questions like:
- How has the company performed over the last few years?
- Has the balance sheet improved since last year’s findings?
Item 6 contains the company’s financial reports—including the balance sheet, income statement and cash flow statement. Analyzing financial statements requires education and practice. Make sure you’re in the right mood for pouring over spreadsheets, and then dig in.
Item 7 expands on item 6 by explaining in the company’s words the changes in the financial reports from one period to the next. In this section the company’s managers discuss the operations of the company in detail. The section is intended to explain the effect of operational changes on the company’s revenue.
Item 7 is important because it puts you in the point-of-view of the company’s managers. You leave this section feeling like you understand the internal circumstances that will make or break the company for the year.
Item 1A & 3 - What are the Company’s Risks
Items 1A (risk factors) and 3 (legal proceedings) cover the company’s dangerous details. In item 1A the company has the responsibility to warn investors (and potential investors) about serious risks facing the company. These risks may be part of the economy, the industry, or even the company itself.
The risks are explained in greater detail than in item 1 and are typically shown in order of importance. Keep in mind, however, that while this section identifies risks the company faces, it doesn’t focus on how the company plans to address those risks.
Item 3 builds on item 1A by listing the company’s legal risk. This is where the company lists any ongoing lawsuits or other legal proceedings. For instance, an industrial company might list a pending environmental lawsuit while a retail company might disclose a class action suit for a security breach.
If you want to be especially diligent, don’t stop with items 1A and 3. Grab the 10-K report from the year before and compare it to the one you have for this year. Then, take a look at how items 1A and 3 have changed over time.
You’ll want to check on the risks. Have new risk factors have been added since the previous 10-K report? If they have, consider that a red flag. As Christopher Bartel, head of global equity research at Fidelity Investments, says, “If there’s a change, that’s because lawyers told them they had to put that there.”
You’re also going to want to know if risks have been reprioritized. For example, Lululemon, a company that sells yoga apparel, listed “maintaining the value of the brand” as risk #9 in 2011. By 2012, that became the company’s #1 risk.
By paying attention to risk factors—and how they’ve changed over the past year or two—you’ll be doing what experienced investors do. As a result, you’re far more likely to pick a winning stock than invest in a dud.
Try Reading a 10-K
Now it’s your turn. Find the 10-K for your favorite company and dig in.
How is their cash flow?
What’s the biggest risk affecting the company’s future?
Tom is a contributor to WealthFit. His goal is to provide a high-level glimpse into the many and varied areas of learning that WealthFit covers.