Investing starts with reading financial statements

One of the key tenets of Warren Buffett’s investment style that I think needs to be preserved and emphasized in today’s markets is its focus on financial statement analysis.

One of Buffett’s funny quotes is, “Other guys read Playboy. I read annual reports.” He is known to read annual reports as far back as possible for any company that Berkshire Hathaway is considering acquiring. This is an essential part of any stock picking or investment analysis that drives the investment process.

And this is one of the reasons why, as Buffett explains, the irony is that “investing is simple but not easy.”

Investors, more so analysts, need to strengthen their understanding of financial statements.

Buffett points out, “You have to understand accounting and you have to understand the nuances of accounting. It’s the language of business and it’s an imperfect language, but unless you are willing to put in the effort to learn accounting — how to read and interpret financial statements — you really shouldn’t pick stocks yourself.”

If one wants to be as great an analyst as Buffett, his advice is, “You need to read a zillion annual reports and their financial statements.”

Does that mean investors need to be accountants? Not really. Learning how financial statements work and the interpretation of key financial ratios, though, are critical.

The analysis of financial statements is the “check” to the other Buffett-based principles of economic goodwill and the economic moat that were discussed the past couple of weeks.

We can talk all about the strategy of a company, how it enjoys a competitive advantage in this or that industry, and why it can generate awesome returns, but at the end of the day, it needs to be seen in the numbers.

Competitive advantage needs to be reflected in the historical return on equity (RoE), the working capital ratios, how the company’s assets are funded, and what assets are driving earnings. The execution of a company’s strategy must be demonstrated in the financial results.

With the growing use of artificial intelligence (AI) and the entrenchment of cryptocurrencies that do not have financial statements, is there a risk that this discipline of investing, as epitomized by Buffett, would become obsolete given his imminent retirement?

The value will always be there, but the choice and the integration with the investors’ DNA are something that is becoming uncertain in my view.

For instance, questions surrounding the balance sheet are becoming rarer in briefings (there could be some recency and/or selection bias in this statement, of course).

Buffett said he spends more time looking at balance sheets than income statements because “some items are harder to hide or play games with in the balance sheet than in the income statement.” This is true and I often begin my review of a company with the balance sheet because it shows the big decisions made by management.

In training and elsewhere, future investors and analysts should begin their inquiry or investigation with the annual reports and financial statements. If there are no annual reports or financial statements, be wary, but also be creative in seeking information to understand the long-term narrative of the company.

The one thing that is fascinating about Buffett’s approach is its applicability to life. When he says that “we should invest in companies that a fool can run, because someday a fool will,” only a human can relate to that. Robots and algorithms cannot determine what a fool can do, in my opinion. Perhaps they can assume an irrational agent exists but only humans can tell the difference.

Despite the advancement of AI, Buffett’s disciplined and focused investment style will always be there. New generations may prefer to leave it up to robots and algorithms most of the time but unless investors lose their humanity, the strength of Buffett’s approach is in its being grounded in the human experience that resonates with each story we tell each other.