Value investors are always told to be like Warren Buffet and read a company’s 10K and 10Q reports. It turns out that a lot of people are being lazy and not doing that. Or at least they’re skimming over parts of the reports that don’t appear to change that much from quarter to quarter. The interesting thing about it is that even though some of those sections don’t change that much for most companies quarter to quarter, when they do change it can indicate a significant repricing of the company’s stock is about to occur.
This insight was discovered by Lauren Cohen, Christopher Malloy, and Quoc Nguyen. In Lazy Prices they detail how they scraped all the 10Qs and 10Ks for publicly traded firms in the United States between 1995 and 2015. They constructed portfolios of firms that had few textual changes and firms that had many changes and found that changes in the Risk Factors section were the most informative, predicting abnormal returns of 1.88 percent per month, or over 22 percent per year. The bulk of the changes, roughly 86 percent, were negative sentiment changes and implies that adverse changes to the company’s outlook had been previously under-reported and not fully incorporated into a company’s stock price.
Invacare: an example
At the end of 2010 Invacare received a warning letter from the Food and Drug Administration related to documentation and procedures at the Company’s Sanford, Florida facility. This warning letter came to light in their Outlook section of a press release that reported on their quarter and year ended December 31, 2010 and provided guidance for 2011.
In December 2010, the Company received a warning letter from the Food and Drug Administration (FDA) related to documentation and procedures at the Company’s Sanford, Florida, facility. The letter does not call into question the safety or efficacy of Invacare products, and production has not been impacted. In fact, of the complaints that are detailed in the letter to illustrate the FDA’s points on documentation, investigations to date show that no injuries or deaths were caused by a product defect. That said, the Company does have areas to improve and it is taking these issues very seriously. The Company has added resources to ensure it is addressing all of the FDA’s concerns in a timely manner. The costs related to making the process improvements are not expected to be material and have been included in the Company’s 2011 operating plan and guidance.
The paragraph seemed pretty innocuous. After all, dealing with the FDA was a normal part of their business. But previously the risk factors involving the FDA were pretty generic. This updated risk factor was pretty specific.
On the day of the press release the Company’s stock price had a wide daily trading range but ultimately remained about the same at around $28.50 per share.
The issues identified in the press release would then make an appearance in the Company’s 10K Risk Factors:
As part of its regulatory function, the FDA routinely inspects the sites of medical device companies, and in 2010, the FDA inspected certain of the company’s facilities. In December 2010, the company received a warning letter from the FDA related to documentation and procedures at the company’s Sanford, Florida facility. The letter does not call into question the safety or efficacy of Invacare products, and production has not been impacted. The company is taking these issues very seriously and has added resources to ensure it is addressing all of the FDA’s concerns in a timely manner. However, the results of regulatory claims, proceedings, investigations, or litigation are difficult to predict. An unfavorable resolution or outcome of an FDA inspection or investigation could materially and adversely affect the company’s business, financial condition, and results of operations.
Again, the market didn’t make much of the inclusion of the additional risk factor as dealing with the FDA was a normal part of Invacare’s business.
In subsequent 10Qs the language was altered and updated as the situation evolved. In the 10Q filed on May 5, 2011, they included the following language:
In terms of regulatory compliance concerns raised by the FDA, the Company is providing updates to the FDA regarding the improvements that it is making in response to the regulatory compliance concerns raised by the FDA, including as a result of the FDA warning letter that was previously disclosed by the Company. The Company is in the process of adding resources to its regulatory affairs and corporate compliance departments and is engaging outside experts to accelerate implementation of various corrective actions. At the time of this filing, the matter remains pending and the Company views its regulatory compliance actions to be among its highest priorities.
Again, fairly innocuous and the price kept trending upwards as the market focused on the reaffirmation of previous revenue and earnings guidance.
While the Company was able to address the issues raised by the FDA regarding their Florida facility, more bad news would trickle out and it would culminate in the FDA’s Consent Decree. This decree hamstrung the Company’s ability to make products at one of their main manufacturing facilities (Taylor Street plant in Ohio) and forced doctors to jump through additional hoops to “prescribe” Invacare products impacted by the Consent Decree. The fact that doctors were still willing to jump through those additional hoops spoke well of the Company’s products but it severely impacted the Company’s ability to turn a profit.
By April of 2013 the Company’s stock price had dropped by two-thirds and was trading just under $11 a share as the Consent Decree decimated sales and profits in North America.
The problems with the FDA would drag on through 2017 and the Company’s management would go through heroic efforts to sell non-core assets, restructure businesses, and raise additional capital in an effort to keep Invacare alive.
And it all started with one little paragraph in a press release that then slipped into the 10K’s risk factor section.
Practical Risk Management: how to use the Risk Factors
I’m sure there will probably be an ETF out soon that takes these findings and turns them into an investment strategy in an effort to capture the excess returns. However, the immediate way to use these findings is to apply them to the individual stocks you own in your portfolio. Instead of skipping over the risk factors section like most investors and going straight to the financials and then the MD&A, take a look at the risk factors section (or outlook section if management doesn’t provide a full risk factor section in each 10Q) and compare it against the previous quarter. If you see a new risk factor that includes words like “adverse,” “negative,” “detrimental,” or the like, think very carefully about either selling the position entirely, adding a long-term moving average as the trigger to get out, or at the minimum paring back the position to be a smaller percentage of your overall portfolio.