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Ideas Farm: Never start at the beginning

When reading company accounts, investors must focus on what they need to see ahead of what management wants them to see.
Ideas Farm: Never start at the beginning
  • Intelligent and persistent...
  • ...or cunning and unprincipled?
  • Read accounts from the front…
  • ...or higgledy-piggledy?
  • Your bias depends on your starting point
  • Loads of idea-generating data

Why on earth are investors always advised to read company accounts in a higgledy-piggledy order? 

For readers not familiar with this idea, broadly speaking it is considered best to start reading company accounts towards the back. Likewise, when reading the three consolidated financial statements that companies are required to produce, the one that's presented first, the profit and loss account, is usually regarded as the worst one to start with. 

For anyone interested in a map for navigating accounts, the book the Smart Money Method by former hedge fund analyst Steve Clapham includes an excellent description of how its canny author weaves his way around company reports.

But the idea of not starting at the beginning can feel very counter intuitive. 

After all, most companies go to the trouble of laying out their wares clearly and simply on the first page of their results statement. It’s there that shareholders can quickly and effortlessly see all the highlights from the year. Likewise, the earnings numbers produced by companies in profit and loss statements are sweated over by finance directors to provide a clear and simple view of the year’s corporate achievements.

The issue is one of an unreliable narrator. Regardless of how honest management teams are, they would have to be dolts not to put a bit of gloss on what they present to shareholders. After all, all their rivals do. It’s practically a fiduciary duty - or so many executives would seem to think.

Surely though, we’re smart enough to see through this type of thing?

Sadly, the truth is that we’re not.

In the recently-published book “Noise: a flaw in human judgement” the authors - Daniel Kahneman, Oliver Sibony and Cass Sunstein - outline the three biases that they believe most harm quality of judgement. One of these is “excessive coherence”. The book's example of how it works provides an excellent illustration of why no one should read accounts from the front.

The book presents a scenario where we are asked to assess a “candidate”. Let’s say it’s a chief executive (CEO). We are provided with two of her four key attributes: she is intelligent and persistent.   

How do we feel about her? 

Pretty good.

The authors then give us her two other attributes. She is cunning and unprincipled.

We definitely feel worse. But possibly it’s not so bad. Her cunning and unprincipled nature could in fact give her an edge? 

However, individuals that hear about the CEO’s negative attributes first are far less bowled over by her intelligence and persistence. Surely these will just be used to reinforce her cunning and unprincipled nature. She’s a danger.

First impressions count.

The purpose of entering accounts by the side gate or back door is to overcome the biases we all quickly develop on first impressions, or possess due to familiarity. Finding a route into accounts that makes a narrative harder to construct and produces more questions than answers early on is of huge value to the analytical process. 

Even for journalists like myself, who often need to get quick takes, there are tricks. Mine is to start with the cashflow statement which tends to naturally lead me to look for answers in the notes to the accounts, balance sheet, statement of key risks and the finance-director report. Also making a point to look at certain items early on, such as auditors reports and contingency notes, can quickly identify the most salient information.

We can all be more intelligent and persistent than we otherwise would be if we take a cunning approach.