City Builders

Block 26: What to Read

Good investors must be voracious readers. There’s no way around it. So let’s talk about some of the documents you need to be familiar with and how to analyze them. We’ll go in order of importance as well. It will also help if you pull up the documents while we go through it just so you can see how to do it for yourself. 


  1. Annual Reports (10-K)


Every publicly traded company is required by the SEC (Securities Exchange Commission) to file a 10-K, or annual report. This essentially has all the information you need to know on the company. But 10-Ks are usually around 100 pages so you need to be strategic to make the best use of your time.

Let’s all be on the same page, so click here. Then click on the 02/02/18 10-K for Amazon under the “Form” column. Open it up and locate the table of contents on page 2. You’ll see a group of blue hyperlinked sections. The first section will be “Business.” This is always a good section to read because it is important to know the background of the business, especially how the company makes money. You might think it is obvious how Amazon or Google makes money, but it might surprise you.


Under the general section in “Business,” you’ll see that Amazon operates in three sections: North America, International, and Amazon Web Services (AWS). So these are the three ways it makes money; the two retail segments including Alexa, Kindle, and everything in between and then AWS.


Under the “Business” section, is the Risk Factors. Our advice is to read through the first five to seven risk factors. If they seem uber-general for the lawyers to cover their bases, then move on. However, risk factors can be of utmost importance. If a company notes that one customer accounts for 70% of revenue that is pretty darn important because if that relationship ends, the stock will be destroyed. So make sure you give the risk factors a chance because there could be some crucial information.


The next and in our opinion, last section you need to read is the Management’s Discussion and Analysis of Financial Condition and Results of Operations. You need to read most of this section because it will give you the run-down on the operational and financial health of the company. In this case, it is pages 19-32. At the least, read the “Overview” and the “Results from Operations” subsections. So those are pages 19-20, 25-31.


Remember how we said you want to find out how the company makes money? Well we find out more specifically on page 25. We can see that AWS accounted for over $17 billion in revenue in 2017, almost 10% of the total revenue. We can also see that AWS as a section grew the fastest in 2017, at 43%.


Moving down to page 26, we see the Operating Income section. AWS made over $4.3 billion in operating income for Amazon. This accounted for 105% of operating income. How can that be? AWS is only 10% of revenue but it made up more than all of Amazon’s operating income? It is because AWS is extremely profitable for Amazon. $4.3 billion as a percentage of $17 billion is 25%. That is AWS’s operating margin, meaning for every dollar of AWS sales, Amazon makes 25 cents in operating profit. To put it in perspective look at the North American section. $106 billion in sales and $2.8 in operating income. 2.6% margin. So AWS is nearly 10 times more profitable than the North American retail segment.


The numbers might be a bit confusing right now, but trust us, the more you look at this stuff, the quicker you will figure it out. It might not make sense now, but struggle through it; it will eventually click. The more you look at it, the easier it becomes. Just like in anything else.


Moving down to page 27, we see the operating expenses for Amazon. You can see the operating expenses have been increasing pretty rapidly. If you do the calculation from 2016 to 2017 (173 billion – 131 billion)/131 billion)), operating expenses grew about 32%. If you look back at the consolidated revenues on page 25, the growth was 31%. So operating expenses grew slightly faster than revenues, meaning the company is less profitable this year. However, you have to look at this in context. Everything needs to be put in business context. Amazon has a huge market opportunity in front of it as it has entered many industries. So as an investor, you want to see them invest for the future. Because of this though, the company is not “cheap” based on valuation metrics.


Valuation Interjection


Many investors value companies based off of P/E ratios (or price-to-earnings ratios). This is the price of the stock divided by the earnings. So a stock that trades for $100 per share and has $10 of EPS (earnings per share), will have a P/E ratio of 10. Plus, the historical P/E of the market indexes is around 16, meaning investors are willing to pay 16 times one year of earnings for stocks. This means that, theoretically, it will take 16 years for the investor to receive those earnings.  So why would an investor pay that much for the earnings of a company? Because it could be a good value actually. If our company grows its $10 earnings by 25% for 5 years and the price of the stock stays the same, the earnings will be $30.5 and the resulting P/E ratio will be 3.3. Incredibly cheap. Of course, the stock price wouldn’t stay the same if the business was performing that well.


Here’s the thing, valuation really depends on the industry. Software companies with no earnings will be valued much differently from airlines or blue-chip healthcare businesses. But at the end of the day, all investors are trying to find good value; it’s just that sometimes it looks different and unconventional. For instance, Amazon’s P/E ratio, at the time of writing this, is around 250. So it would take a quarter millennium to receive back the earnings! What on Earth!? Investors are basically saying that they think there is some serious growth to come. But if it doesn’t, then the value might not be great. That is valuation: finding a good value based on what you think a company can achieve. Most investors use “multiples” methods to value companies. The P/E ratio is a multiple, a multiple of earnings. So investors compare companies based on their P/E ratios to see if certain companies are cheaper than others.


That, in our opinion, is overly simplistic and offers no real edge. Valuation is much more nuanced since there are factors like brand, management, future growth, and competitive advantages that cannot be found in a backward-looking P/E ratio. Investing is about the future. If a company is deteriorating, it might be trading for cheaper than it is worth and it could be a good investment. However, would you rather own a bad, cheap business or a fantastic but more expensive business? Over the long term, our bet is that the fantastic businesses will outperform the bad businesses, even if they may be cheap. After all, opportunity costs still exist. Each dollar you put into a bad business, is a dollar you can’t put towards the best businesses in the world.


Back to Amazon’s 10-K


Speaking of best businesses in the world, moving down to page 30, let’s take a look at Amazon’s cash flow. Free cash flow reads nearly $8.4 billion. This is about double operating income and as a percentage of revenue, this is almost 5%. So the company is free cash flow positive, which is important (remember the accounting block?).


So now that you know a little bit more about Amazon and reading a 10-K, we’ll move onto the second thing you should read for a company you are interested in putting some money towards.


  1. Quarterly Earnings Transcript


Every public company is also required to hold quarterly earnings conference calls to update investors about the progress of the businesses. These conference calls are transcribed and it is easier to read through them than listen to the actual call. SeekingAlpha is a great resource for earnings transcripts. Google’s latest earnings transcript covered the first quarter of 2018 and it can be read here. Read through the whole thing. Sometimes the analyst questions at the end are pretty confusing and so narrow that they aren’t entirely useful. However, it is a good idea to read through everything. If you have the time, read back through the last two or three earnings transcripts to get an idea of where the business is headed. If you already own some stocks, make sure to read every earnings call transcript. Just set a reminder and then make sure to read them.


  1. Proxy Statements (“DEF 14A”)


It is a good idea to skim through a proxy statement. A proxy statement is a company’s mandatory filing that goes into detail on management’s compensation. To access proxies, google “Edgar” and click the first link or click here. Then type in the name of the company you want. So type in Amazon. Make sure you then click on the WA (Washington) incorporated option under the “CIK” column. Then find a box named “Filing Type:” and punch in “DEF 14A” and press enter. This is the government code for proxies like 10-k is for annual reports. Then click the blue box, “documents” under the “Format” column. Choose the 2018 filing (2018-04-18). Now we are on the proxy document for Amazon. It’s seems too hard to find, coincidence? Hopefully.


On page 21, you can find the stock ownership for management. This is important because, as investors, we want the people running the business to be aligned with our interests. If a CEO owns a lot of stock, he probably wants to increase the value of it. It’s skin in the game. So this is key.


Down further, on page 26, you can see how much management is paid. This is important only if it is outrageously excessive. Executives also get stock options and restricted stock units which can skew the pay. Usually, the salary is not outrageous but the stock grants and options can be. If the company is doing well, management probably deserves it, but there are always limits.


Proxies are not read by many investors in our estimation so it might be a good idea to go above and beyond and solidify your edge. However, our time also has an opportunity cost so don’t get down too much in the details…unless you like that sort of thing, then by all means, go for it.


So as you may have seen, reading is pretty important. These three documents allow you, as an investor, to get a clearer picture of your investment. The stock market is a strange place after all. People will spend hours determining what dishwasher gives them the biggest bang for their buck but then they will hear a stock tip on the subway and go home and buy it, even if that stock costs multiples of the dishwasher. We don’t understand it. Give your investments the same focus in which you buy a dishwasher, or even a car, and we bet you will do pretty well. After all, you now are in the business of buying businesses. It takes time to do your homework. But what exactly should you focus on once you’ve read these three documents?...