The growing insignificance of the annual report

The month of June is an important month for investors. I am an investor myself, holding a portfolio of about 20 odd companies spread across diverse industries. I look forward to the month of June eagerly every year, for it is during this month that most companies dispatch their annual reports to their investors. The annual report contains details of the company’s performance during the financial year, which typically ends on the last day of March for most Companies. Hence it is quite natural for investors to be excited at the prospect of reading about all the happenings in their invested company in the past one year and to get critical insights about its prospects for the future. The annual report is supposed to be just that report. Yet if truth be told, nothing could be further to the contrary. Most, if not all, investors whom I know including myself give the annual report just a cursory glance before consigning it to the realms of the recycle bin. The contents of the annual report is not trash by any stretch of the imagination, yet the utter lack of usefulness of its content for investors year in and year out just defies common sense. Let’s look at the contents of a typical annual report to try and understand the reason behind this anomaly.

The first chapter of any annual report is an introductory statement by the Chairman of the company. The sole purpose of this statement is to create a feeling of warmth and generate goodwill amongst investors. Point taken, yet investors are better comforted by the warmth of wads of notes willowing in their wallets and the assurance of a repeat performance every year. Mere words and motherhood statements that find their way many a time into this section are a drag on investor patience. Hence the Chairman’s statement can be safely skipped without much risk.

Next follows the auditor’s certificate. Considering the fact that auditors are obligated by their profession to follow a boilerplate template while issuing this certificate, this section can be safely skipped as well.

Of late, many companies include a report on Corporate Governance which typically appears at this point in the annual report. In the name of Corporate Governance this report provides attendance records of the directors of the company at board meetings. In effect, investors are informed how many meetings are attended by directors but their contribution at such meetings is conveniently given the pass over. Hence this section is also worthy of skipping.

At this point, we reach the two sections which form the meat of any annual report – the financial statements and the management discussion and analysis. The financial statements and the associated explanations of the numbers that appear in numerous foot notes are about the most useful piece of information that one can find in an annual report. However, in this day of electronic updates, this data is already available on multiple financial web portals weeks before the annual report reaches the investor’s hands in physical form. This leaves the discussion and analysis section from our point and view. There is no defined format for this section. The quality and quantity of information revealed in this section varies with industry, company, management outlook and many other factors. If the company is interested in highlighting the drivers of the company’s performance, it should normally be found in this section. Many companies do try and give as much information as possible in this section about the drivers of their growth, now and into the future. Many others hold back in the fear of revealing sensitive company information. Still others are clueless about the reasons for their growth or lack thereof and end up making general risk free statements in this section.

Of the approximately 20 annual reports that I receive and read every year, I find a great difference in the thickness of these reports. I have read annual reports ranging from 15 pages to more than 150 pages. I have also observed that some companies follow the annual reporting process to the letter disclosing only as much as is legally required while a handful others try to go above and beyond the letter and try to comply with the spirit of annual reporting which is what investors are really interested in. The true spirit of annual reporting requires companies to not only analyze their past performance but also give a fair assessment of its future prospects based on the state of core competencies of the company and external economic conditions. Alas, this remains a distant dream as of now. Yet it can be done easily by including a section the Intellectual Capital of the company. A well designed Intellectual Capital Report that tracks the intangible assets and growth drivers of the company year on year is a good tool for informing investors about the inherent strengths of the Company. It will only take a few leaders to start disclosure of their intangible assets in this manner for the remainder to follow. The alternative is for the government to step in and introduce regulation requiring compulsorily disclosure of such information.

An asset that appreciates with time

We live in very interesting times. The economic transformations that are changing the fundamental s of our social behavior and the very fabric of our life are tremendous. For instance, email was unknown in the corporate world prior to 1990. Today in a span of just under 20 years email has become so pervasive that, most if not all, businesses would be unable to function efficiently without email communications. Mobile phones were largely unknown prior to 1994. Today, in a span of 15 years the mobile phone has become so ubiquitous that it has rapidly shed its image of a luxury item and now become a necessity. In the Indian context, ATM banking was largely unknown in the country prior to 2000. Today in a span of just 10 years ATMS have proliferated so fast and so much that some banks have actually started limiting the number of teller assisted cash withdrawals that customers can make each month.
Economic change is not only happening, it is happening more and more rapidly. Consider this. Until the 1800s, farming was the main occupation of people. The primary requirement for farming is land - the more the better. Unfortunately, the land that we have inherited is not only limited but with time the increasing population has only hastened to increase the per capita demand on it. In the 19th and 20th centuries the focus shifted from farming to manufacturing, driven to a large extent by the industrial revolution. The spotlight during this time was on increasing productivity, using machines in place of human labor. Machines had a huge advantage over humans – they could work faster, they produced output of consistent quality, they did not get tired and they could work all three shifts if needed. During these two centuries machines came to dominate our lives like never before – their acceptance eased by their promise of freeing us from drudgery and making more free time available for our creative use. While machines changed our lives forever during the industrial era, it took many centuries for the focus to shift from farming to manufacturing.
Yet the next change happened within the next 200 years, when we crossed over from the industrial era into the knowledge era. Today machines are no longer a source of competitive advantage. If I can buy a machine so can the competition. The increased productivity that both of us have is not enough of an advantage anymore. To sell our goods, we both need to add value. There are various ways of adding value – but all of them require leveraging the intellectual capital of the organization to provide a product or a service that is superior to what the competition can provide. This in turn requires the systematic management of Intellectual Capital, since that is the very source of competitive advantage in the knowledge era. In fact, unlike physical assets like machines and land which get depreciated over time and financial assets which get depleted with time, intellectual capital is the only asset that appreciates with time. Doesn’t this sound a bit like having your cake and eating it too? Yet it is true. Very few businesses have realized this truth since we are still in the formative years of the knowledge era. But those that have will surely survive and even thrive in this era and survive into the next.

Value sustains through recessions

Many economists believe that the present economic depression is as bad as the great depression of the 1930s. I was not born then, neither were most people around me, hence I cannot tell for sure. But as I wade through these most difficult times I dare to ask, how has this recession changed our spending habits? How many of us have stopped dining outside in restaurants because of the recession? Or stopped seeing movies in multiplexes? Or visiting shopping malls and buying stuff, we probably could do without? To those who can sincerely answer these questions in the affirmative, I bow my head in salute. To the remaining vast majority of mere mortals like myself, I say that although we cannot curtail our basic inclination to splurge (thanks to the multiple credit cards that have been thrust upon us by ever willing banks) , we can definitely fine tune our instincts to seek out the best value deals and extend our purchasing power ever more. We need to stretch that dollar and make it go further. We need to chase value. Whether you are a seller or a buyer, you need to chase value. Individuals, businesses, suppliers, customers and investors, all need to chase value. While this is a most noble intent even in the best of times, in recessionary conditions like these it could mean the very difference between survival and extinction. And why is that? Simply because history has proven time and again that recessions and booms are cyclical. One simply follows the other. Much as we believe the adage that whatever goes up has to come down, it is also equally true that whatever goes down has to come up! The point being that this recession will end for sure – in the meantime we have to survive by seeking more bang for our buck.

Which brings us to the question – how should investors seek value? And how should businesses publish and report value. As far as investors are concerned, value investing is a field which is very well researched and understood. Yet it fails in many situations because the value investor relies solely on the published financial results. In times like these, the value investor has to look at more than just the financials. He has to understand the underlying value creating processes of the businesses that he is investing in. Similarly, business houses need to publish more than just the financial statements. They need to inform their investors about the characteristics of their business that generate value for their customers and how they are focused on managing and growing those very parameters.

Interestingly both purposes can be served easily via an Intellectual Capital (IC) Report. Business houses need to start publishing an IC report along with their annual report or even with their quarterly disclosures. Investors on the other hand need to start demanding such reports from the management of their holding businesses and use it for making value based investment decisions.