Investors are constantly told to read prospectuses and annual reports. Yet many do not. This is a shame because doing so can reveal important information.

Consider the following details from a registration statement that was recently filed with the U.S. Securities and Exchange Commission (SEC):

• The company has a very limited operating history and profits have only been realized during the past three years.
• The primary source of revenues is advertising, but customers are changing to a platform (mobile devices) that the company does not generate any meaningful revenue from.
• Subscriber growth will slow because of the company’s high penetration rates in its current markets.
• The CEO controls the majority of all voting power, including final say over who gets elected to the board of directors. Furthermore, because the company is a “controlled company,” the board of directors does not have to be independent.
• The CEO says his company “was not originally created to be a company” and that he has “always cared primarily about [the company’s] social mission.”
• Last year, the company spent nearly $700,000 on a corporate jet used in part to fly the CEO’s friends and family.
• The company anticipates that a substantial number of shares could be sold up to 18 months following the completion of its initial public offering.

If this was all you knew about the company, would you buy shares in it?

If the company’s name is Facebook (FB), many investors will likely answer “yes.” Depending on the size of the initial public offering (IPO), it is possible that demand will outstrip supply for the IPO shares. Enthusiasm about owning stock in the current “next big thing” will cause some to pass over Facebook’s weaknesses.

Speculative investments always come with risks, but sky-high valuations magnify those risks. Media reports estimate the social networking company could be valued between $75 billion and $100 billion at the time of its IPO. If this estimate holds true (details about the price and the number of shares being offered have not been set), Facebook would rank among the 70 largest publicly traded companies. Furthermore, FB shares would command a price-earnings ratio of 150 and price-to-sales ratio of 27. (The price-earning ratio is based on 2011 net income of $668 million attributable to Class A and Class B shareholders.)

As you can see, there are several negatives about Facebook as an investment. Not mentioned yet are concerns about privacy, Facebook’s inability to penetrate China so far and CEO Mark Zuckerberg’s lack of experience. The last point is particularly worth considering because running a privately held start-up is very different from managing a closely-watched public company that has to report results on a quarterly basis.

Most of the information above came from Facebook’s S-1 filing. This is a registration statement filed with the SEC before a company goes public. You can find significant information about Facebook, or any other soon-to-be public company, by skimming through the S-1 and looking for potential red flags. Be sure to also look at the footnotes, where you will find such things as the jet used by Zuckerberg’s friends and family.

For companies that are already publicly traded, look at Form 10-K. This is an annual report filed with the SEC. Now that year-end numbers are being reported, companies will soon file updated 10-Ks. It is well worth your time to look at these filings, because they may give you reason to think twice about a stock that looks appealing at first glance.

More on AAII.com

• The IPO Prospectus: How to Read the Fine Print – This 2005 article discusses what you should look for when reading a company’s S-1 filing.
• Using SEC Filings to Identify Risk Factors – Michelle Leder of the Footnoted.com blog discusses which SEC filings investors should read and what they should look for.
• February AAII Journal – The new issue features our 31st annual mutual fund guide.
• Do You Look the SEC Filings? — Tell us on the AAII Discussion Boards.

The Week Ahead

Approximately 60 members of the S&P 500 will report earnings. Included in this group are Dow components Coca-Cola (KO) and Walt Disney (DIS) on Tuesday, as well as Cisco Systems (CSCO) on Wednesday.

The economic calendar will be light next week. December wholesale trade data will be published on Thursday. Friday will feature the preliminary February University of Michigan consumer sentiment survey and December international trade.

San Francisco Federal Reserve Bank President John Williams will speak publicly on Wednesday.

The Treasury Department will auction $32 billion of three-year notes on Tuesday, $24 billion of 10-year notes on Wednesday and $16 billion of 30-year bonds on Thursday.

AAII Sentiment Survey

Bullish sentiment remained above its historical average, while bearish sentiment rebounded to a five-week high in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell to 43.8%, a 4.6 percentage-point decline. Despite the pullback, optimism is above its historical average for the sixth consecutive week and the seventh out of the past eight weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, slipped 1.6 percentage points to 31.1%. Nonetheless, neutral sentiment is above its historical average of 31% for the fifth time in seven weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, rebounded by 6.2 percentage points to 25.1%. This is the highest level of pessimism since December 29, 2011. Even with the increase, bearish sentiment remains below its historical average of 30% for the sixth time in seven weeks.

Though the level of optimism declined in this week's survey, individual investors continue to remain hopeful about the six-month direction of stock prices. Since bearish sentiment had been at unusually low levels and AAII members are concerned about Europe's sovereign debt problems, a rebound in bearish sentiment is not surprising.

This week's special question asked AAII members what impact, if any, the Federal Reserve's decision to leave interest rates unchanged until at least 2014 had on their six-month outlook for stocks. The majority of respondents said it made them more bullish, particularly toward dividend-paying stocks. Those who said the Fed's decision had no impact or a negative impact on their sentiment thought the news was already priced in, said Europe was a bigger issue, or expressed concerned about future inflationary pressures.

Here is a sampling of the responses:

• “It reinforced my decision to have quality, global, superior dividend-paying stocks and ADRs make up the majority of my portfolio.”
• “The extension of very low interest rates encourages me to seek dividend-paying stocks.”
• “I’m slightly more positive, but this action pales in potential impact when compared to the ongoing soap opera in Europe.”
• “No impact. The announcement wasn't too surprising.”
• “I think they are out of their minds.”

AAII Asset Allocation Survey

Individual investors boosted their allocations to equities last month according to the January 2012 Asset Allocation Survey.

AAII members allocated 60.9% of their portfolio stocks and stock funds in January, an increase of 4.8 percentage points from December. This is the first time equity allocations were above their historical average of 60% since July 2011.

Bond and bond fund allocations declined 0.8 percentage points to 20.9%, a three-month low. Even with the decrease, January marked the 32nd consecutive month that fixed-income allocations remained above their historical average of 15%.

Cash allocations plunged 4.0 percentage points to 18.2%. This was the smallest allocation to cash since May 2011. The historical average is 25%.

Equity allocations rebounded strongly as AAII members became more upbeat about the short-term direction of stock prices. Improving economic data and growing corporate profits have led to above-average bullish readings in our weekly Sentiment Survey. This optimism has filtered through to portfolio allocations. Equity allocations are close to their historical average, however, as individual investors continue to cast a wary eye toward the European sovereign debt crisis.

Last month’s special question asked AAII members if they thought they were overweighting or underweighting stocks relative to the allocations suggested for their age. The majority of respondents said they were overweighting stocks. Many cited low bond yields as the primary reason for doing so. Several said they were not reliant on their portfolios for income or were otherwise able to handle the higher volatility from overweighting stocks. Some also viewed stocks as having the most upside potential.

Here is a sampling of the responses:

• “Overweight stocks. Yields are too low on bonds. I feel that stocks offer a better risk-reward tradeoff.”
• “For my age, I’m overweight stocks, but I draw income from my portfolio, so I want a more aggressive investment focus.”
• “I’m overweight stocks because I feel that this is a buying opportunity.”
• “Underweighting due to volatile market conditions and personal preference toward risk aversion and capital preservation.”
• “Underweight, but I am looking for opportunities to deploy cash.”

» Take the Asset Allocation Survey

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor