Financial Statements and What Really Matters | AWM Insights #140
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Episode Summary
Does evaluating financial statements for publicly traded companies lead to better returns? This may seem like a simple question on the surface, but understanding the magnitude of the question is important.
There are roughly 60,000 publicly traded companies worldwide according to the World Federation of Exchanges. A company, like Apple, generates a summary of financial performance in a document called a 10K that has 80 pages, 1000’s of data points, and countless footnotes to qualify the data (as different companies report on metrics in different ways.)
That information is also mainly backward-looking, and only relevant for a short amount of time in our ever-evolving world. What you are left with are billions of numbers that don’t relate to each other. Also, there has been no proven method of using any of these figures for consistent returns.
All of this may seem stressful (and it is), but it can also be harmful if it takes attention away from the most important elements in your financial life, your structure and plan. Focusing on your plan, lifestyle, and the factors you can control will lead to far more benefits than looking at Apple’s Commercial Paper holdings.
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Episode Highlights:
0:00 Intro
1:01 Do we read financial reports and try to value companies based on fundamentals?
2:00 Public vs. Private Market Dynamics
2:46 Recent Rally was a result of the market repricing interest rate expectations
4:26 Trying to be an active manager and outguessing the markets has been shown to be impossible to do consistently
6:13 What an active manager believes and how it would relate to a company (i.e. Tesla)
8:14 What is a relevant baseball example for being an active manager
9:13 There are different elements, themes, and dynamics in Public and Private markets
11:15 Going through fundamentals and the data is more productive in the private space
12:47 Wrap Up
+ Read the Transcript
Brandon Averill (00:02): All right, Justin, we're back for another one and this time I think at least we've got some positive stuff going, the markets are up, so good time to have a little discussion. Wanted to throw out at the top, as you guys know, we've got a text number, you can shoot us a text. Rest assured it does go directly to our phone, but that number is (602) 704-5574. And it'll add you on a list, we'll get you brief summaries of this, some zingers certainly that you can refer back to and just understand how we're investing your money. And then also a place to submit topics or questions for future episodes and that's what we get to do today. So pretty fun, we actually got a question that we get to ponder on and pontificate about, but the question that came in was, "Do you guys actually read financial reports and then try to value companies in comparison with how the market's valuing them?"
(01:01): So there's a lot of good news stuff going on, but that's a question we're going to tackle today. I mentioned markets are rallying, there's this expectation that's being interpreted by the market that the Fed might actually cool off some of this rate hiking because some of the inflation numbers are coming in lower. So a lot of information that's out there and digesting, I think it ties really well into our question. So I'm looking over at all the, just kidding, 10K reports that are sitting on your desk, Justin, but maybe-
Justin Dyer (01:33): Got some reading up ahead.
Brandon Averill (01:34): Yeah, get into this question a little bit. Shoot to the punchline, why don't we pull up the annual reports and dig in company by company and try to make investment decisions?
Justin Dyer (01:45): Yeah. Well, first of all, it's a great question and I want to even specify further, why don't we do that in the public markets versus private markets? The answer to the question is very much dependent on which market you're talking about. We're talking about the public markets here and your statement certainly is targeted there. The short answer is that markets are relatively efficient. And that's a simple statement but actually a really complicated subject which we're going to really try and not go too deep, not try and bore people too much, but hopefully give you some takeaways, some zingers, as you said, that gives you the foundation of the why. And using some present examples, which you highlighted, some news items, current events, the markets rallying, we got job numbers for the month of December last week.
(02:39): That's part of the reason why markets are rallying and to connect the dots here. So throughout most of 2022, it was a bad year for markets, a large driver of that was the Fed increasing rates. As we've turned the corner into 2023, the expectation that the Fed continues to raise rates is changing. It's very dynamic, so we don't know exactly where the market stands on any given day, but right now it seems like the market is saying, "Hey, the Fed is not going to increase rates as much for as longer period of time based on the information that we have available to us." Jobs, like I referred to, the job numbers were still good, but they're coming down a little bit and so that is a variable that the market digests almost instantaneously to reprice securities. Do they get every security right all the time? No. That's why when I say efficient markets, I put a little bit of an asterisk there that says, most of the time or relatively efficient.
(03:44): What we then do is say, "Hey, let's look at what the data says over long periods of time." I'm just talking about a two-day period right now, but guess what? The data shows that that's basically how markets function over long periods of time. They take in information that is publicly available, that's part of being a public company, you have rules and requirements and what type of information, when and how you're allowed to do it. And so the market digests information incredibly well and reprises securities. Trying to outguess that process is incredibly difficult to do. And that's not just a statement that I'm making, there is plenty of academic research and not academic research, you could call it, from financial institutions that support that statement. If you're at all interested in some evening bedside reading, it'll tell that story, but it's dry academic research that basically says, "Hey, in the public markets, outguessing what the market is pricing in is not a recipe, a repeatable way in which to successfully invest."
(04:56): I mean that is the punchline, the repeatable way. And the simple data, and I'll pause after this, the simple data is something called the S&P Index versus Active report. Look it up, S-P-I-V-A, type that into Google and you'll have all sorts of information at your fingertips and it will show how difficult it is for active managers, those are people who are reading financial reports and saying, "Okay, this is what I think the company is valued versus what the market thinks the company is valued. Maybe there's mispricing there, I'm going to take advantage of that." And it shows how difficult that is.
(05:34): More often than not, especially over longer periods of time, I think 3, 5, 10 years, 10%, 20% of those individuals, those fund managers who are practicing that endeavor fail basically, they underperform. And then the next question is, how often do people end up in that 10% or 20% that do outperform? And guess what? There's no predictability there, there's no repeatability. So that's hopefully a quick and dirty intro into why this just doesn't make sense and it's because the data basically doesn't support it.
Brandon Averill (06:09): Yeah. And I think a good exercise to run through really quick is clearly this is our take, it's supported by the evidence, it's supported by academic research and all the data that has come before us, but there are a lot of people out there that still do this, they still read the financial reports. So I think going through the exercise of what they're banking on is that they are going to have some keen insight from that information to say, "Hey, the millions of people that trade this stock..." So let's use Tesla as an example, everybody knows what Tesla is, but the millions of people that traded Tesla stock last year were wrong and I have some information to believe that their pricing of that stock is wrong.
(06:53): And when you think about it, if we zoomed back 12 months sitting down at the beginning of the year, reading the financial reports, what you're really looking at is historical information. So what is that telling you about the future? You start to peel back and go, "Okay, how could I have such a belief in the information that is available to everybody that I'm going to draw a different conclusion?" And you could say, "Oh well, I see Teslas running all over the road and everybody's buying them and they're great cars." I don't know when I've ridden in yours, they're fantastic cars and they're super fun to drive and it seems like the electric car market's going crazy. All these things would be in support, yet last year Tesla's stock was down something like 85%.
Justin Dyer (07:37): Totally.
Brandon Averill (07:37): So I think at the end of the day the market said, "This is what the stock is worth at the end of the year based on financial performance, et cetera." But to do a forward looking prediction of where things are going to go is like you said, it's just really difficult. I think if you've met with Eric recently, he's been using this example and I think it's a great one, it's basically like saying, "Hey, let's sit down and pencil out who's going to start in the 2023 Major League Baseball All-Star game." There's probably some pretty safe bets, Mookie Betts being in the All-Star game, Mike Trout, probably pretty safe bets. Jacob deGrom probably a safe bet a couple years ago, well guess what? He wasn't in it last year because he was hurt, things happen. And so at the end of the day, predicting the future is just really difficult even with earnings season upon us and everybody's pontificating.
Justin Dyer (08:28): Yeah. And going back to this idea of efficient markets, and I'm not going to go into the academic side too much, but just the reason why that seems to exist is because of the level of competition. So at the outset of this, I talked about public markets versus private markets. Public markets are incredibly competitive. You think about it, there's very little barrier to entry and everyone could have a say in what they think something is worth. That aggregation of information, the wisdom of the crowds, if you will, is incredibly powerful. And again, I think that the takeaway here is that it is the best model in which to invest for the long term. It gives the most amount of predictability and confidence in a very good return for your priorities. The private markets, that's a whole nother conversation, maybe we'll do that one next time, where we almost flip this conversation on its head.
(09:28): And it's important to keep that in mind, this isn't just a black and white conversation around how you invest your money, it depends on what market you're talking about, public versus private, what your priorities are. And we really want to use the data in a way that gives us the most amount of confidence. And really at the end of the day, the most amount of confidence in the public markets is this broad-based diversified approach, keeping costs low, not buying and selling individual stocks that just don't give us increased confidence in you meeting your priorities.
Brandon Averill (10:02): And I think in the public markets, to sum it up, it just comes down to access to information. And the fact that everybody has the information and there are millions of participants makes it really difficult to find some keen insight. But I do think we have a couple seconds here, we should talk about the private side. And I use this analogy a lot with clients of, hey, if we're going to sell AWM Capital, we could go to one of our clients and we could give them all our financial data and we could show them who our clients are and they could make some estimation about what might come in from a revenue standpoint in the future. They're going to come to a price, probably a pretty good price if we give them all the information.
(10:45): Whereas we could go the affinity type play and we could go find some super fan and just show them our client roster and they're probably going to put a value on the business and who knows what they come up with? Limited information, but they're going to be completely two different values. So when we're analyzing the private markets, we are digging into these financial reports. The data rooms that you sift through when we're looking at a fund investment on the private side or a direct investment is pretty intense when you go through everything.
Justin Dyer (11:20): Yeah, it's exactly this practice. You say, "Okay often, here's the round or the price at which an investment is being offered." Unless you're leading the round, then you get to set that price. But you're comparing these two things, you're saying, "Hey, let's dig into this company. What's its revenue doing? What did it do last year? What do we think it will likely do looking forward into the future?" There is that element of predictability, but hey, let's stress test it, let's be conservative. What does all that then result in, in a comfortable valuation? I mean, it is this exact process where we feel confident because we know an industry or we're being presented with an opportunity and others aren't and so there isn't as much competition that's going to come in to potentially drive up the price. It is a completely different dynamic, but it is this practice.
Brandon Averill (12:11): Yeah, I think that's huge and I think it's just a good reminder. We're always going to bring everybody back in investing their money in a way to meet their priorities. That's the goal at the end of the day. It's not to produce the highest return, it's to ultimately meet your individual priorities. We certainly want the returns that we deserve and so we're going to go after every penny. We'll get into this maybe in the future, but we're going to try to outperform the public markets.
Justin Dyer (12:39): Oh, for sure.
Brandon Averill (12:40): It's still going to happen.
Justin Dyer (12:40): There are ways, right?
Brandon Averill (12:41): There are ways to do it. And on the private markets, that's where information advantage is huge and where we spend a ton of time. But it all ties back to ultimately not putting your financial structure at risk by doing something that isn't supported by evidence that we've seen in the past.
(12:59): So thanks for sticking with us today and getting that question in. Hugely helpful, hopefully it's helpful for you guys that are listening. Again, that telephone number to shoot us a question or comments is (602) 704-5574. And until next time, own your wealth, make an impact and always be a pro.