How To Read A 10-K Like A Hedge Fund

Good Evening! 👋

Happy Wealth Wednesday! In this newsletter, we will break down how to read a 10-K like a Hedge Fund.

Here’s What You Missed Last Week:  

1. The Bean Breakdown

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3. Warren Buffett’s Favorite Investment Metric

Dear friends,

If you're investing in stocks, understanding a company's fundamentals is key—and that's where the 10-K comes in. This annual report is a goldmine of information, telling you nearly everything you need to know about the business. But how do you read one without getting overwhelmed?

In this edition, I'm breaking down the 10-K and showing you how to sift through it efficiently—focusing only on the most important parts so you can get the information you need without wasting time. Whether you're just starting or you're a seasoned investor, knowing how to read a 10-K is essential for making informed investment decisions.

While 10-K reports can look daunting (they're long, after all), you don't need to read the entire thing. Trust me, it's not like cramming a college textbook (I made that mistake, too—sorry, Mom). Instead, focus on the sections that truly matter. Let’s walk through them together.

How to Find the Annual Report

The easiest way to find a 10-K report? Just Google it. For example, search "Apple 10-K 2023" and boom—there it is. Alternatively, you can visit the company’s Investor Relations page or use the SEC’s EDGAR database, where all filings are stored.

Once you have the report, here’s how to navigate it:

Key Sections of a 10-K

1. Business Overview

Start here. This section gives you the complete picture of what the company does and how it makes money. When reading through, ask yourself:

• What does this business actually do? (Are they selling products? Software?)

• How do they make their money? And more importantly, how do they spend it?

• What is their marketing strategy?

• Who are their competitors, and how do they stack up?

Let’s use Apple as a real-world example. The business section of Apple’s 2023 10-K provides a deep dive into the company's product lineup. We learn that most of Apple’s revenue comes from iPhone sales, with significant contributions from services like the App Store, iCloud, and Apple Music.

What’s interesting here is how Apple continues to diversify its revenue streams.

Over the years, Apple has shifted its focus toward services to create a more predictable, recurring income model.

Understanding this shift is important when evaluating Apple’s long-term strategy because it shows how the company is positioning itself beyond just hardware sales.

If you can’t explain what the business does after reading this section, it might be time to move on to another company. A clear understanding is crucial.

Start of Apple’s Business Section:

2. Risk Factors

Next up: the potential risks. This section outlines what could go wrong for the company. Pay attention here because these risks can affect its profitability and your investment.

For example, if you're investing in Apple because you believe they’ll sell 100 iPhones a day, you must understand the risks that might prevent that from happening.

You want to know what could impact your sales targets, whether it’s supply chain issues, economic slowdowns, or regulatory changes.

One of the key risk factors in Apple's 2023 10-K is the global supply chain.

Apple is heavily reliant on its suppliers in Asia, and any disruptions—whether due to geopolitical tensions or public health issues—could significantly impact production and sales.

Another major risk is the increasing scrutiny from global regulators over data privacy and antitrust concerns, similar to 2022.

Pro tip: Don’t get bogged down by the legal jargon. Companies list risks like “stock price volatility” to cover all bases, but it’s not always relevant to your investment thesis. Focus on the new or company-specific risks, like Apple's reliance on its ecosystem or potential market saturation in developed countries.

3. Management's Discussion & Analysis (MD&A)

This is where you really get the inside scoop. Management explains the company’s performance, compares it to previous years, and outlines future plans. Here, I recommend you spend most of your time, especially if you’re a long-term investor.

Let’s dig into some key insights from Apple’s 2023 MD&A:

• Total Net Sales: Apple reported a 3% decrease in total net sales in 2023, dropping by $11 billion compared to 2022. This decline was largely due to weaker foreign currencies relative to the U.S. dollar and lower sales of Mac and iPhone. On the flip side, Services continued to grow, offsetting some of the decline.

• Macroeconomic Conditions: Inflation, fluctuating interest rates, and global currency movements had a direct and indirect impact on Apple’s results. Despite these challenges, Apple remains focused on innovation, announcing several new products and services in 2023, though the headwinds were still felt in their core revenue drivers.

What’s important here is seeing how Apple is adapting to challenges and continuing to innovate. Whether expanding its service offerings or enhancing its existing product lineup, Apple remains committed to maintaining its competitive edge.

Want to dig deeper? Warren Buffett reads Coca-Cola’s annual reports dating back to 1919. Long-term investors should consider reading multiple years of MD&A to understand how a company's strategy has evolved over time.

4. Financial Statements

This section shows you the money. The three statements you need to focus on are:

• Balance Sheet: What the company owns (assets) and what it owes (liabilities). It’s a snapshot of the company’s financial health.

• Income Statement: How much money the company made or lost during the year. This is where you see revenue, expenses, and profits.

• Cash Flow Statement: How cash moves in and out of the company. It tells you if the company generates enough cash to fund its operations.

Let’s look at Apple’s 2023 financial statements as an example. Apple’s balance sheet shows over $51 billion in cash and cash equivalents, a sign of a strong financial position. They also report a significant amount of assets in marketable securities and inventories, essential for meeting customer demand.

The income statement reveals that Apple generated $383 billion in total revenue in 2023. However, this represents a slight decline compared to 2022, reflecting the challenges mentioned in the MD&A. iPhone revenue still dominates at $200.58 billion, while services remain a strong growth area at $85.2 billion.

The cash flow statement provides insight into how Apple allocates its cash. In 2023, Apple generated over $111 billion in operating cash flow, reflecting its strong ability to convert its earnings into actual cash.

Pro tip: Check the footnotes for hidden gems. Sometimes, crucial information is buried in the details. For instance, Apple often provides more granular details about their product categories and service growth in these footnotes, offering a clearer picture of how the business segments are performing.

5. Executive Compensation

Lastly, ensure management’s incentives align with your goals as an investor. If the CEO is overpaying themselves while the company underperforms, that’s a red flag.

Let’s look at Apple’s CEO Tim Cook’s compensation in 2023:

• Base salary: $3 million

• Stock awards: $47 million

• Performance-based bonus: $10.7 million

• Other compensation (like travel, insurance, and 401(k)): $2.5 million

Cook’s compensation package is tied to Apple’s revenue and operating income, which means he’s directly incentivized to grow the company and increase shareholder value. Additionally, Cook holds substantial stock in Apple, ensuring his interests align with those of long-term investors.

As Peter Lynch said, "Insiders might sell their stock for various reasons, but they only buy it for one: they think it will go up."

Wrapping Up

At the end of the day, investing in a stock is like investing in a business. Understanding that business—its risks, management, and financial health—is non-negotiable. The 10-K is your roadmap, and now you know how to read it efficiently.

With Apple as a prime example, these key sections help us understand the company’s business model, its challenges, and the path it’s taking to remain dominant in the tech industry. Whether you're investing in Apple or any other company, the principles stay the same: do your homework and make sure you truly understand the business.

Cheers,

The Bean Team

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