Before you even look at a financial statement, make sure you understand these 3 things

If you’ve ever watched an interview with Warren Buffett before, he will always bring up a concept known as his “circle of competence”. Knowing what you know and don't know is an art which is, in my opinion, so highly underervalued in the economy of free information.

And related to that is knowing the business you are invested in. So, here are the 3 things you should look at before you even look at a financial statement:

1. The Business Section of the Annual Report

The annual report (also called the 10-K) basically is a summary of how the business has done in the previous 12 months. It contains information such as financial statements, management direction and importantly, a business summary.

The business section is usually the first section of a 10-K and it’s where the author basically summarises the business. It usually outlines what the business sells, who’s buying and any changes that have been made in the last 12 months. So why is this important to read through this section particularly before you move forward with valuing a company?

Well simply put, if you read through the business summary, especially if this is a business you are encountering for the first time, and you can’t identify with the product or service then you should move on.

Remember, in order to actually invest in a business, you need to love the product and understand its fundamentals. That way, when Mr. Market values your business at 50% less than it’s worth, you won’t be spooked into selling your business.

So, make sure when you read the business summary, that you see the value the business provides and that their business lines up with your vision and your view on where the world is going. The point here is to quickly be able to weed out businesses that either you don’t and probably won’t ever understand or businesses which are fundamentally against your beliefs or view of the world.

2. Management Discussion and Analysis

So where the business section was a summary of the business, this is more of a deep-dive into what makes the business tick. In this section, management will discuss revenue breakdowns, how the business is structured, what drives revenues, competitors and a management plan for the next 12 months.

Where the business section was like a first date, this is really a full-on relationship counselling session. Here, you get to really understand who is buying what the business is selling and how management plans to improve performance. You’ll also get a pretty good idea of if you understand the business here.

The point of a “circle of competence” is to make sure you know what you are putting your money in. If you can’t understand how a business is achieving its revenue, where it should be deploying its capital or where operating margins should be, you should reconsider if this business is worth your time.

Remember, no one is rushing you to invest. You have all the time in the world to analyse hundreds of businesses. And if it takes you 5 years, so what? Rather sit and wait for the perfect pitch than lose your hard-earned money.

3. Competitor Analysis

The final thing I would do before looking into financial statements is look into the company’s’ competitors. Firstly, you’ll always need to understand who the competitors are, because that’s just good business. But second, it will give you a good idea of how other businesses in the industry are running their businesses.

Now, if you feel you have a good understanding of a business, then it won’t take you long to understand the competitors. Look for things like:

·        Differences in capital allocation – especially in areas of Research and Development

·        Market segment analysis – do the competitors sell to the same demographics? If not, do they do better and why?

·        The general outlook for business in the next 12 months – maybe all the other businesses are scaling back because they expect a difficult 12 months, but your business is ramping up. Why would that be and is there good reasoning behind that?

Understanding the main players in any industry is important, but that is especially so when you are valuing individual businesses instead of investing in sectors, such as index funds and ETF’s. If you don’t know the competitors, then you leave yourself open to risk, and possibly remove the possibility of finding an even better business than you were looking at in the first place.

So why did I mention “circle of competence” again?

As you can see, business analysis involves a fair amount of art. It’s not a simple as plugging numbers into a spreadsheet and buying at a certain price, although that analysis is essential.

Business analysis involves completely understanding a business and its surroundings. This means that you will so no far more often than you say yes. If a company is outside of your knowledge base, then why would you gamble with your hard-earned money?

The above picture is iconic to the Buffett story. Basically it shows a grid with different batting percentages based on where a pitch is thrown. What is remarkable is that if the pitch is thrown just off centre, your batting percentage reduces by 2.5%. And if it’s thrown just above your hitting zone you could see more than 25% reduction.

But the good news is, you aren’t playing a baseball game. You don’t have to hit as many pitches as possible, because you have time on your side. You can stand for years just watching pitches go by and no one can say a thing. And then one day a pitch will be lobbed up into your hitting zone and you can smash a perfect one.

So, don’t rush investing because you feel like you’re missing out. Most hedge funds return what you could get from a low-risk bond or even worse. You have the benefit because you can wait for your pitch and no one can pressure you into swinging. So make sure you understand the business you’re buying. Take time with these 3 steps ad really make sure that if you had to walk into a meeting with the board of directors, you could tell them more about their company than they could.

Because the most successful people I’ve ever know are the ones who have a deep knowledge of the things they invest in.