Read company annual reports for red flags

Every listed company has to release an annual report at the end of the financial year. It’s often packed with promotional filler, so it can be tempting to skip the verbiage to focus on the figures. Don’t. Research suggests that careful reading can pay off. In particular, there are four “red flags” to watch out for.

Lack of clarity

If the chief executive or chairman’s letter that opens the accounts is vague or hard to understand, that’s a warning sign. Several studies suggest that firms whose reports score poorly for readability tend to underperform those with clear communications. Most studies don’t tell us whether this is because bad news is simply harder to communicate (particularly if you’re trying to put a positive spin on it), or if it’s because firms deliberately try to mislead investors. But a 2014 study by Kin Lo of the University of British Columbia found that lower readability was associated with firms manipulating their earnings figures.

A gloomy tone

The CEO or chairman will rarely make explicit predictions about the future in his or her letter.  But if they sound subdued, then watch out – Sina Yekini of Coventry University found a strong correlation between the number of positive words used in a  FTSE 350 company’s annual report, and its subsequent stock returns. So if a report leaves you with a distinct “glass half-empty” feeling, be on the alert.

Accounting complexity

Some firms are more complicated than others. But if a firm’s accounts are overly complicated compared with others in its sector, then it may well be fudging the figures to make things look better than they are. Notable complexities include special purpose vehicles (which take risks off the balance sheet in theory, but often not in practice) or “one-off” expenses that recur year after year. Another red flag is a stream of footnotes explaining how the company came up with its figures or policies. Kyle Peterson of University of Michigan found a strong correlation between the number and length of footnotes in a report, and the odds of a company having to restate its earnings within a year.

Cautious auditors

Small firms are particularly vulnerable to having auditors question if they are a “going concern”. Each year, about a third of US companies with a market capitalisation of below $75m receive such a warning. This tends to be bad for the share price. But don’t be tempted to catch these “falling knives”. Research by Richard Taffler of Warwick Business School and Alok Kumar of the University of Miami suggests that the market in fact under-reacts to such news – these stocks tend to lag the market by more than 20%, even after the initial shock wears off.