What are some big red flags in a 10-K?
A company whose message is changing from year to year is never a good sign. New risk factors, for example, are a red flag, Bartel said. Say a big industrial company suddenly adds an environmental liability, like asbestos liability. Or it could be a patent lawsuit, he said, explaining, "If there's a change, that's because the lawyers told them they had to put that in there."
You should also be wary anytime you see a change in the accounting practices. "If it's a more aggressive revenue recognition, that's a real red flag," Bartel said. For example, an impairment charge, or a big change in reserves. "That's going to cause me to think: 'They massively overpaid for that.' It's going to cause me to question that management team," he said.
Kane also has an eagle eye for any change in accounting principles. In today's environment, companies report adjusted earnings. In the 10-K, earnings are re-reported and adjusted again. "We call them 'chiropractic reasonings,'" Kane said. "The earnings are always adjusted for some reason or another." For instance, they'll make an assumption about what the tax rate will be at the end of the year. At the end of the year, you might have to true those numbers up.
An obvious, and big, red flag is a change in auditors, Norton said.
Does it matter how much CEOs are paid?
The 10-K is accompanied by the proxy statement, which shows how much executives are compensated.
Yet it's not the often headline-generating huge paycheck figure as much as the amount in which executives have invested personally in the company that is telling. "That's absolutely critical," Bartel said. Security ownership by senior executives shows if their interests are aligned with shareholders.
"I would suggest investors never read a proxy before lunch, because it will ruin your appetite," Kane said. "You can find some very interesting things."
Take compensation. "They'll give you a list of metrics. A growth company will give you things like, 'We want to increase sales by 20 percent,'" Kane said. As value investors, Artisan is attracted to companies that have managers who are focused on factors such as cash flow, return on invested capital, and operating profit, he explained. "You get what you incentivize people to do."
When it comes to executive perks, the 'other' category is useful for detecting abuse of company resources, such as aircraft, private cars and company real estate. Norton said this info was not disclosed as well in the past but now is much better. The "certain relationships" section can also be informative in disclosing any conflicts—for example, a company using a CEO's brother as a big supplier.
Kane also likes to review the resumes of the management team for clues in the culture of how they manage a business. For instance, Apache is an oil and gas company. Anybody that's worked at Apache over the course of their career is inculcated with a certain style of management that focuses on return on capital. They carry that with them wherever they go. "If I see someone that worked at Apache, I know that's a sign," Kane said.
Bartel agreed, claiming that researching the directors and their backgrounds can give you a sense of whether the company is being properly managed.
—By Elizabeth MacBride, Special to CNBC.com
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