Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.
Scanning through SEC filings is an important component of my process for prospecting for great new investments.
Most investors read press releases issued by the companies they own or are considering owning. However, I’m sure that many investors skip reading through SEC filings. That is a big mistake as there are often gold nuggets in SEC filings that can provide crucial clues as to whether a company is a good investment or a bad investment.
Scanning through SEC filings is an important component of my process for prospecting for great new investments as I describe in My Secret Recipe: Shopping and a Taste Test and is an important part of evaluating a new investment idea as described in My Secret Recipe: Inspecting the Ingredients. The clues you can find in SEC filings are often overlooked by the market and can provide you with an edge over other investors.
While this article focuses mostly on positive pieces of information you can find in SEC filings it also hits on some of the negative items. For more information on things to avoid in investments and to seek in SEC filings, I suggest reading my article Investing Pitfalls to Avoid.
This article doesn’t talk about everything that is included in SEC filings as that could be a topic for a book. Rather it focuses on those nuggets of information that you should try to find in SEC filings. Some of the items covered in this article may be discussed in a company press release and/or conference call but rarely are all of the important points in filings covered in those venues and some companies gloss over most of these items. Also, there are some companies that only issue SEC filings and have no press releases. I have made significant money on these kinds of companies as they are really off the radar.
While this document focuses on US SEC filings, almost all of what is included in this article is applicable to Canadian SEDAR filings and likely regulatory filings in other jurisdictions.
Generally the most important SEC filings to read are the quarterly and annual filings. With the exception of certain foreign companies, these are known as 10-Qs (quarterly) and 10-Ks (annual) filings. Below I detail some of the things I look for. In this analysis I’m going to assume that the company issues press releases that include both the statement of operations (AKA P&L) and the balance sheet. So, I’m not going to cover obvious things like earnings and revenue growth.
Commentary on the Results
Companies often give detailed commentary on their results for the reporting period within a 10-Q or 10-K. If included, the information usually can be found in Item 2 of a 10-Q and Item 7 of a 10-K. These sections should be entitled Management’s Discussion and Analysis of Financial Condition and Results of Operations.
This commentary may provide all kinds of useful information about the results. For example, it may provide reasons for revenue increases or decreases. Perhaps there is a macro trend that is causing revenue to increase or decrease. Perhaps there was a large, one-time order that will not repeat. Comments on revenue changes provide clues to the future as it may tell you that the results for the period were an aberration or they may indicate that a new trend is starting.
Two other areas that companies may discuss in this section include gross margins and expenses. The reasons that these metrics are better or worse for the quarter can provide very important clues for the future.
Backlog and Deferred Revenue
Backlog is a favorite item of mine to investigate in a filing as it provides a very useful clue for the future. If backlog is increasing significantly, you usually will see increased revenue going forward. The opposite is true for decreasing backlog. Note that many businesses don’t report backlog either because they choose not to provide the information or because it isn’t relevant for their type of business.
Deferred revenue is another area that is similar to backlog and will be located on the balance sheet if it is applicable to the company. Like backlog, significant increases in deferred revenue are often signs that revenue is going to increase in the future.
Some companies provide guidance within their SEC filings. This isn’t extremely common but it is done by a small percentage of companies. Guidance may be provided overall on revenue or earnings or it may be on particular financial metrics such as gross margin, or expenses. Usually guidance in an SEC filing is more about general expectations (e.g. We expect revenue to improve.) rather than specific guidance (e.g. We expect revenue next quarter to be $3-4M.).
Major New Contracts
Some companies announce major new contracts in SEC filings rather than issuing press releases. These can be particularly valuable nuggets as it can indicate an inflection point for the company which others may not know about until they hit the bottom line at which it may be too late to take advantage of the information.
The cashflow statement is often not contained in a press release. It can provide valuable information about the company. For example, one can examine how cashflow compares to earnings as that will provide some clues on the quality of earnings.
A section on risks is contained in 10-K filings. This section is sometimes included in 10-Q filings as well. Much of the risks are legal boilerplate information that isn’t that important. However, there are some things that come out in these sections that provide important clues. For example, customer concentration can be an issue particularly in microcaps. The risk section should tell you if there are large customers that would have a significant impact on future financial results if they were lost. The list of risks can cover a large range of issues. The important thing is to find those that are truly critical to the company and properly incorporate them into your analysis of the company.
The terms of debt (e.g. interest rate, covenants, & due dates) are included in 10-K filings and often in 10-Q filings. Any debt is important to monitor to know in advance if the company may have a problem paying back such debt.
Companies will indicate the number of shares outstanding for each class of stock (common and preferred) in each 10-Q or 10-K and will also indicate any potentially dilutive shares to be issued in the future (e.g. options, warrants, convertible debt, convertible preferred, etc.). It is important to examine any growth in the share count to make sure it is justified. Issuance of a large number of shares can be a red flag that indicates you should avoid the company particularly when the company has repeated stock offerings. What is important to understand is the necessity and reasonableness of the issuance as well as what it means to the overall investment thesis.
Sometimes companies will indicate in filings when they are looking to raise money and the preferred method they will use for financing (e.g. share issuance via private placement, debt, management loan, rights offering, etc.). Raising money especially via share issuance can potentially have a significant impact on the stock price (almost always negative) so it is important to be aware of a company’s need for capital.
For more information on this topic read A MicroCap Investors Worst Enemy is Dilution.
Any material legal issues should be published in a 10-K and may also be indicated in a 10-Q. Most businesses have some level of legal issues that are normal in the course of business and aren’t a problem. However, sometimes there are major issues (e.g. patent lawsuit) that can have a major impact on the company. Keeping abreast of such legal issues is important for analyzing a company.
Companies indicate material events that happened after the end of the reporting period but before the date of the filing as subsequent events. These events can cover a wide variety of topics such as new customers, lost customers, product problems, stock issuance, departure of executives, new legal agreements, etc. These nuggets are often very important clues for the future.
Subtle Clues as Compared to Prior Filings
Sometimes there are subtle clues in SEC filings that can provide great insight. Occasionally, I find it interesting to compare the wording between filings from the same company. I’ve seen companies change a word or two in a sentence or remove a sentence altogether. For example, past filings may have indicated that they expect future revenue growth but then they suddenly omit the sentence that indicated that. That may indicate that they believe that the good times have ended but you would only know that by comparing a current filing to a prior filing or filings.
Another example is that sometimes a company writes a concern of theirs in the filing which you may find worrisome as a new investor. However, when you look back through the history you find that they have written the same thing for the past several years. A company’s attorney may have them write something conservative that has only a remote chance of happening. So past history can definitely be a clue.
In short, sometimes just knowing management’s past disclosures and comparing them to current disclosures tells you much more than what you would figure out from reading just the latest filing.
Information in 8-Ks
Companies report material corporate events in 8-K filings. These filings are used to fill in the gaps between quarterly and annual filings when important events happen. While these events are material, they may not be published in a press release particularly if they are negative developments. If you have invested in a company it is important to look at each 8-K filing to keep current on the developments of the company.
In conclusion, you can see that there are many nuggets of gold you can find in SEC filings. They can be dry documents to read, but reading them is crucial to proper analysis of a company. I have found that reading SEC filings can provide significant opportunities to make money as the information is often overlooked by other investors. That is why I spend multiple hours each day reading SEC filings.
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Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.
Nicolai Tangen is the CEO of Norges Bank Investment Management, Norway's $1.4 trillion sovereign wealth fund.
Dilution is the subtle erosion of ownership. This hidden, persistent addition of new supply of shares leaves shareholders with less and less of the company’s value. Dilution, like inflation, is a silent killer of returns.