Three ways to find gold in annual reports

You might not think you have time to wade through a company's annual reports. Indeed, many analysts don't even bother reading them. But you're missing a trick. Get past the self-promotional guff that pads out many such reports, and you'll find extremely useful information that can help you to work out whether a company is a good investment, or one to be avoided. Here are three areas to pay special attention to.

1. The directors' report

Managers are more likely to serve shareholders well if their interests are aligned. How do you work this out? Well, firstly, look at the number of shares owned by the company's management. Have they been buying or selling during the past year? It's good to see managers with large personal stakes in a company, as they are more likely to think and act like owners ie, like you. A decent-sized shareholding would be around twice an individual's annual salary. Less than this, and you should be asking questions if a management team doesn't want to hold its company's shares, why should you?

The list of substantial shareholdings can also be quite revealing. Does a large shareholding indicate that the company could be a takeover target? Is there a controlling shareholder that may act against your best interests? These considerations can influence your decision to invest or not.

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Also look at long-term incentive plans for managers. Do these encourage managers to do the right thing? Some plans are linked to earnings per share (EPS). You should be wary of these in a low interest-rate environment, such as the one we have now. Why? Because managers can buy companies to boost profits rather than grow the business organically. Using debt to buy up a rival can lift EPS in the short run, but damage the long-term interests of shareholders if the company overpays.

Also, is the company buying back its own shares? Again, in a low-rate environment, given low borrowing costs and tax deductibility, shares can be repurchased at earnings multiples of more than 20 and still enhance EPS. But while this may enrich management, buying overvalued stock even in their own company isn't a good deal for owners. A better bet is to invest in a company where managers are incentivised to improve returns on capital as the extra profits made have to take into account the money spent. This will discourage overpriced acquisitions and costly share buy-backs.

Finally, investors should look at the potential volume of new shares that could be issued if managers hit targets, to see how their shareholdings could be diluted.

2. Plant and equipment note

Depreciation can offer an easy way to manipulate profits in asset-intensive companies, so if you own shares in a manufacturer, for example, you should study this. Some simple calculations can reveal a lot about asset condition, the quality of profits and future cash requirements. The 'net book value' of plant and equipment as a percentage of its original cost will show you how heavily depreciated the assets are. Assets that are heavily written down could signal that a company has been under-investing. That means significant amounts of future cash flow will be needed to replace worn-out equipment. However, it may also be a sign of very prudent accounting (over-depreciating), which suggests its profits are conservatively stated against its peers.

So perhaps a more useful indicator is to calculate the annual depreciation charge as a percentage of original cost. This gives you the depreciation rate, which should be compared over a number of years and with similar companies. If the depreciation rate has been falling or is lower than that of competitors, this should be treated as a red flag and investigated.

3. Debt and pensions note

The automatic refinancing of debt used to be taken for granted until the onset of the credit crisis. Investors should look at the current maturity profile of company borrowings and look out for large amounts of debt that need to be refinanced in the short-term. Pay particular attention to the cost of existing debt compared with current interest rates. How will the firm's financial position impact on the cost and availability of new credit and what could happen to profitability?

Meanwhile, the experience of companies such as BT and British Airways highlights the significant cost of final-salary pension schemes. Investors should study the note on pensions carefully to see if the assumptions concerning pension assets and liabilities are realistic. This is of vital importance to the investor as pension shortfalls have the potential to limit dividend payments and even threaten the solvency of a company.

For example, what is the asset allocation of the pension scheme and what returns are assumed? It is amazing how many schemes still expect equities to return 8%-9% a year, despite their dire performance of the last decade. Assumptions on employee life expectancy, salary and pension increases can also lead to significant variations in the estimate of pension liabilities. Basically, the more prudent the better.