A stock is a business

This post might seem a bit off the farm, if you're looking for company writeups stop reading and check back later this week.  Otherwise let me step on a small soapbox for a minute or two.

Whopper put up a post recently on McRae Industries discussing the investment potential.  Whopper does a nice job laying out why someone would potentially want to invest based on financial metrics.  My quibble with the post has nothing to do with his reasoning or any accounting aspects but with this line

"McRae sells boots. We could go into a further breakdown of what they do, but there’s honestly no need. As you might expect of a company in the boot industry, McRae is pretty much a commodity company with commodity company like returns."

I think often value investors get stuck in a rut, they do a lot of research, reading company financial statements, reading about competitors (through financial statements), and reading about industry segments.  Left out of this process is the thought or connection that the business under the microscope is a collection of real people who gather in an office each day, talk about American Idol, gossip about each other, surf Facebook, all while taking customer calls and complaining about their boss.  As Avner Mandelman talks about in the The Sleuth Investor (highly recommended) a business is a place where people send checks.  He asks whether the customer being served is worthy (do they deserve to be served?), and how they're served (the business process), along with things like who is the customer, and who are the managers.  The Sleuth Investor really dives into looking at the physical aspect of a company, visiting the plant, talking to workers on their lunch break, and buying their product like a customer would and talking to customers if possible.

I know these things seem strange for most investors, especially value investors who model their behavior after Ben Graham who rarely talked to a company or Walter Schloss who almost never talked to companies.  Ultimately though I don't believe either of them had the detached mentality that has developed amongst a lot of value investors today.

The result of this detached mentality and focus only on financials is what sucked a lot of value investors into China RTO stocks.  On paper these companies looked like absolute steals.  Companies trading for less than cash, growth rates of 30-40% a year selling toasters.  Ultimately a lot of these companies were undone by investors who did the physical checks of these companies.  While vilified there is a lot to be said about Carson Block who counted trucks, talked to customers and sleuthed factories.  It wouldn't surprise me if Block has read the Sleuth Investor a few times.  The physical reality didn't jive with the financial statements and everything came undone.  The opposite could also be true for some companies, the physical could be much better than statements suggest offering a great opportunity for an investor.

The ideas in the Sleuth Investor resonated with me, probably because I work in the business world, deal with small and large companies daily and am mostly detached from the investment world (outside of this blog, twitter, and some emails).  My friends all work for various companies in non finance roles, to them investing is reserved for smart people in New York and London who wear suits to work everyday.  Investment to most people isn't P/B, ROE, or ROIC, it's buying a new machine to reduce lead time, streamlining distribution channels, or removing inefficiencies from a business process.  These are the tangible, physical things that drive a company's financial return.

For a while now I try to answer the question "Why is a company cheap?" when I research a business.  In looking at this question I was getting part way to answering some of the questions about the business itself, but not all the way there.

Why is this important?

Looking at a business as a physical group of people who collect checks for doing some sort of task opens the mind to think about a company differently.  My main goal in investing is to not lose money.  If I find a cheap stock and then look at pictures of it's facilities and realize they are decrepit and in disrepair I stand a chance of losing my investment.  I want the physical reality to confirm the financial reality of the company.

Other times thinking outside financial statements gives reasons as to why a stock might be cheap.  Consider a company located far from an airport, railroad or major urban area.  They might need to truck parts in, and truck out a finished product.  If gas prices rise they are impacted to a much greater extent then a company located in a major city, or near an airport with a short haul.  None of these things are mentioned in the 10-K, but are easy to find just looking on Google Maps.

A lot of people will dismiss this post saying that if a stock is cheap it doesn't matter what the business does, or how it does it.  I can agree at a point, for Japanese net-net's I have had trouble getting a solid grasp of what these businesses do, so I will invest on metrics.  This is fine, but I recognize that it's a somewhat mechanical strategy.  Even so, some basic Googeling can result in a lot of information, even about businesses overseas.

It seems crazy but even for a net-net I think examining the physical business is important, I looked at this with my post on Hickok. A small amount of time, such as 30-45 minutes of looking at maps, street view, and reading about an area online can give great insight to an investment.  Often this sort of in depth research seems to be reserved to people who concentrate hundreds of thousands or millions of dollars into a few investments.  I think it should be considered by all investors regardless of the investment size.  Relatively simple physical checks can yield really good results.

If feasible I think it's even worth trying to buy a product, or at least examining it.  Call the company and act like a client.  I tried this with AEY, they ignored me.  I tried to get quotes on a few pieces of equipment.  If they ignored me why would my experience be any different from any other potential client?

I think the level of research outside of financials probably scales with the size of an investment.  For someone putting $500 into a net-net a quick look on Google Maps and reading product reviews is fine.  For a $100,000 investment I'd expect the investor to at least have handled the product (if possible).  Think of it like this, for a few hundred dollars you could avoid a potential thousand dollar loss or more.

Putting it in Action

So I want to just consider a few questions about McRae in the vein of this post.

Where are the boots manufactured? - The army boots are manufactured in the US, the cowboy boots appear to be manufactured overseas.  This raises a whole other host of questions regarding leather availability in China (an issue facing Danier Leather).

Who buys these boots? - Identifying the customer is critical.  It appears there are probably four customers, soldiers, horse riders, industrial users, and possibly fashion buyers.

How easy are they purchased? - I was unable to find a way to purchase the boots online, they appear to only be sold in stores (why is this?).  I did a search of stores near where I live.  The closest one is a western apparel store right up the road.  So here's my impression, this western store is a place that my wife and I comment about each time we drive by, there are never any cars there, and we don't know how they stay in business.  Other friends have made similar comments.

Looking at the western store prompted another thought, these boots will probably never be purchased as a fashion item.  I know if I was looking at boots I would not go to the western store due to the stigma attached, I'd probably look online.  So the product doesn't have a big general market from what I can see.

Is the brand known to people who would likely use the product? - No idea, this would need to be further researched.

Why buy McRae boots over a competitor? - Again no idea.

This is just a start, and these are some of the things we need to think about when looking at companies.  I know I'm guilty and have been of paying lip service to the fact that stocks are companies.  Heck, this post is more of a reminder to myself than anything else.  I think as investors we need to look at a stock as a business first, and the financial component as just that, a component.  I know one value investor who has been putting these sorts of questions into action is Richard Beddard over at the Interactive Investor Blog.  This is an area I want to get better at myself.

If you are interested in the financial aspect of McRae I'd check out the Whopper link above and the great post at OTC Adventures here.

Questions, comments?  Talk to Nate

Disclosure: I make a small commission if you buy the Sleuth Investor through Amazon.com.  There is no markup on the book if you visit through my link verses going to Amazon.com directly.  I purchased this book on my own on the recommendation of someone on the Corner of Berkshire and Fairfax message board.


  1. Interesting thoughts Nate. Bought the sleuth investor and looking forward to reading it.

  2. Good thoughts, Nate. I agree that many investors (myself included) spend too much time going over financials and too little thinking about the qualitative factors. Things like customer satisfaction, brand differentiation and management quality are hard to estimate, but have a profound effect on the success of a business.

    Also, I appreciate the link!

  3. I really like this post, Nate. I think this speaks directly to my philosophy as an investor. Although I consider myself a value investor, I have a hard time buying net nets or other stocks solely on assets because they are often mediocre or even awful businesses. I want to understand and like the underlying business before I can invest.

    The problem I have is that my circle of competence is not the largest, and so I often get stuck when I find what looks like a good investment based on financials but I don't have much of a clue how to begin analyzing the business. I just do the best I can. While I can take some solace in avoiding a few investments that were revealed as duds after some sleuthing, I also passed on a few good opportunities because I couldn't get comfortable with the underlying business.

    1. Greg,

      I agree with you in regards to most net-net's especially US net-nets. Most are terrible businesses, a few are decent businesses hidden by a mound of cash, but not many. I think a lot of people get hung up on US net-net's because that's what they know. I think unfortunately American net-net's probably offer the worst value right now.

      I think Japan is interesting in that they have a lot of good businesses selling for terrible prices. This is truly the sweet spot, finding an decent business with growth prospects selling for less than liquidation. Of course most investors are scared out of Japan which is why the market is offering these opportunities.

      As strange as it sounds given the content on my blog I would actually prefer to own a dozen excellent businesses for the long haul. My two biggest positions are companies like this (America Movil, and Mastercard), both have pseudo monopolies and are compounding machines. The problem I find is getting companies like this at a reasonable or cheap price is rare, very rare. I would say buying BRK in August was an opportunity like that, I loaded up! I guess you could say one of the ways I pass the time is looking at the special situation stocks, the net-net's, some liquidations and spinoffs. Overall the stocks I write about most are about 20-25% of my portfolio.


  4. Two thoughts:

    One, looking back at your write ups on SODI, is there anything you would add / change after writing this post? (I say this b/c I find SODI to be one of the best net-nets out there from a quant. standpoint, but yet every author I've seen uses this as a crutch and has yet to communicate any solid, qualitative thoughts behind their products, the defense industry, etc)

    Two, Mr. Gannon just put an article out today (http://www.gurufocus.com/news/169207/dont-see-stocks-through-mr-markets-eyes) that seems to contradict your "know why it's cheap" mentality. Would love to see your rebuttle to this. I think he means well, but he's wrong.

    1. TC,

      Two great comments.

      With regards to SODI, and MPAD two companies I bought at less than NCAV and do similar things, throw RSKIA in there as well. I've actually been thinking of placing a small order for parts from all three. I think honestly the reason no one ever writes about their products is that most investors don't actually understand what they do. Whether it's a blessing or a curse I can mostly understand what the little components are. Just as an example, if you have ever looked inside a computer on the circuit board (the green thing) there are resistors and capacitors. These are wires with little ceramic bulbs coming out. Next are little chips or block things with wires (in pairs, or three or four wires) that go into the board, this is what Solitron makes. Sometimes they regulate voltage, other times they are tiny chips with small instruction sets in them.

      I've actually had a number of conversations with investors regarding the military spending, and applications for the products offline which has been fascinating. Some investors are interested in this stuff!

      So my take on the products of those three:
      Solitron - Decent catalog of products, mostly focused on the same areas. They claim most parts are customer order and built to client specs so they aren't as commodity. I'm not really sure how to validate this claim.
      Micropac - Similar to Solitron but more commodity, they're churning out the same think their competitors are probably at higher costs.
      George Risk - Glad they're focusing on the security stuff, some of their products are terrible. I almost avoided investing in them because of this. Check this out: http://www.grisk.com/keyboard/8095.html You could go to any computer recycling facility and get thousands of those for free, yes thousands. They make some ancient computer parts, I guess someone needs to for some tiny market out there.

      One more point on Solitron, I tried to convince my wife and in-laws to drive us past the plant last year. I wanted to poke around some in person. My wife and mother-in-law put the kibosh on that, and since we were all sharing a car.... I still want to visit, won't be down there this year, probably next year though.

      Geoff's article.

      I read the article, I disagree. From my own experience some stocks I thought were cheap irrationally were actually rationally priced and I lost my shirt. If I would have investigated why they were really selling that low I would have saved a lot of money. Sometimes the reason isn't readily ascertainable. I think this is more important as a market climbs higher. Some places like Japan all equities are cheap, not much digging required there. At market lows, or when pessimism is running rampant this could be relaxed.

      Thanks again for the comment, I wrote a book here. If you're interested shoot me an email at oddballstocks at gmail to talk about Solitron. I agree it's attractive, but I have a few queasy points with the stock.


  5. Good post Nate and thanks for the mention! I need to understand the risks, and that means how the company operates. I don't so much want to know why the company is cheap, I'll take the cheapness, but I want to know if it's strong enough to prove investors wrong. So yes, I want to verify its weaknesses and strengths, and match them to what the financial statements. If the company has consistently high ROE I don't just want to be able to assume what the competitive advantage is, I want to be able to articulate it. If profitability has collapsed I don't want to assume it will revert to the mean, I want to be able to articulate the recovery plan and the headwinds the company faces.

    However, I also recognise I could go too far and up needing to know as much as the company's management does even to make an investment. This is, of course, not possible if I want to own shares in tens of companies! So there is a balance to be struck, hence a recent post: http://blog.iii.co.uk/giving-up-on-being-a-master-of-the-universe/

    The book looks like an excellent read and I've added it to my long reading list!

  6. I like this blog. Regarding the article, some thoughts. At the end of the day, there are lots of ways to make money investing and outpeform the market. For example, there's the more mechanical Schloss approach (buy a bunch of really cheap stocks, wait for valuation uptick, sell, recycle capital back into really cheap stocks, repeat again and again for 50 years) and there's the Buffet/Munger approach (hold cash and then pounce on a handful of fairly priced compounding machines and hold them basically forever). Both have worked historically and will continue to work prospectively. Neither is right, neither is wrong. Your returns using the Schloss approach are driven primarily by multiple expansion -- i.e. the cheapness of the stocks you buy; your returns using the Buffet/Munger approach are driven primarily by the rate at which the underlying business can compound capital -- i.e. the quality of the businesses you buy. The return on time spent trying to understand every little nuance of a business is low using the Schloss approach and high using the Buffet/Munger approach. They're just two totally different approaches to investing. Neither right, neither wrong. While you might want to try and understand every aspect of MRINA's business, that's your call. That makes you comfortable within the context of how you're managing your portfoiio. It's not right, it's not wrong.

    1. pbrace,

      I agree with you. I actually embrace both types strangely enough. I like the net-net cheap mechanical type of stocks, and I like to own some quality businesses purchased at good prices to round things out.

      My takeaway from your comment would be that both types of investors probably need to adopt a bit of the other's approach but temper it. So the Schloss investors need to be mindful of the business but not dive into the guts. Even those simple questions I asked don't take long but are useful in thinking about an investment. And the Buffett/Munger folks need to ease up a bit, a passive investor will never know all the details about the interworkings of a company. Maybe a small company can be sleuthed to no end, but you really are looking for quality, if quality is found in product, customers, employees and managers that's what you want, you let the business do the rest.

      I'm always hoping as I look through cheap stocks that I'll stumble on a good business as well. It's happened a few times, maybe once a year at most. In the meantime the cheap stocks keep me busy.

  7. I think my point is slightly different. There's Schloss (diversified and cheap and mechanical) and there's Buffet (concentrated and high quality and qualitative). I worry about strategies that fall in between these two extremes. I'm not saying I adhere to one rigidly -- I would probably characterize my approach as sort of similar to yours -- although most of my capital is invested in a more Schloss-like fashion. My own view is that in investing, I'm not sure you want to be in "no man's land" in terms of an approach. An example of "no man's land" would be: (1) screening through U.S. net-nets and then (2) reading the MD&A of the companies that passed the net-net screen and eliminating half because upon this further research, you "don't like what you see". While you might feel like you're doing something productive because you just invested time and you "feel" better about your portfolio, I'm not convinced that the time you just invested learning about these businesses will have any positive impact on your portfolio's performance. In fact, I could argue pretty easily that it would have a negative impact on your performance. Net-net back-tests will show something like 25-30% returns. Unless you feel like you will be able to do BETTER than that (I don't know that I have THAT high of an opinion of myself as an investor), are you not doing a dis-service to yourself by mixing the Schloss and Buffet approaches? Food for thought...

    1. I understand the concern, and do agree that too much research could lead to avoiding a net-net altogether because for the most part they are mediocre to bad businesses. The reason I want to look further than just the mechanical is because some are actually terrible and have no chance of rebounding. Graham actually makes this distinction in Security Analysis, he points out that all net-net's aren't worthy of a purchase just because they're trading so low, but only net-net's that are profitable, or have been profitable in the past and are likely to be profitable in the future.

      I think the time invested in learning more about a net-net isn't about passing on a company, it's really more about understanding prospects. So say I screen, find 10 net-net's that are profitable, then I go looking into them. Two of them upon deeper analysis look like they have new products with great potential, are spending cash wisely, and have divested so they could be acquired. I want to own those companies over the other eight that are just generally average businesses. That's not to say that all ten aren't worth owning, I might buy all ten, but might buy more of the two with better potentials.

      Even with value stocks at the end of the day it's the business that wins out now the asset value unless management has indicated they are looking at a resource conversion to unlock asset value in which case assets matter a lot.

    2. Pbrace, you make great points, but I question how many retail investors in practice are wiling to absolutely follow the Schloss approach (as in, buying a large basket of stocks, on a mechanical basis). I know I can't afford the transaction costs, and I also know I don't possess the gumption to cling to a mechanical style of investing through a downturn. I will never be able to achieve the backtested 25-30% returns (in that manner), which is a perfectly realistic premise for most people. I also imagine most people would have a tough time rounding out that basket of stocks with those that provide the majority of the 25-30% returns - those knocking at death's door that stage some sort of a comeback.

      Instead, I (personally) like the idea of a concentrated portfolio, which can include net-nets. With big positions, I cannot afford a permanent impairment of capital, so I need to know what I own, within reason, which is beyond the #'s and beyond just looking at some silly F score to rank stocks. Doing work can also lead to finding catalysts, which help offset another of my concerns with net-nets (the dead money problem).

    3. TC,

      Your points on the ability to stick to a strategy are key. No matter what the strategy if an investor can't follow it through thick and thin it doesn't matter what the back tested returns are. Incidentally most of the returns come from when most investors are inclined to give up on a strategy.


  8. Great article Nate, i have shared it with my Vancouver Value Investors Club students: http://www.meetup.com/VancouverValueInvestorsClub/messages/boards/thread/21627452

    I believe Ben Graham illustrated it best: "Investing is most intelligent when it is most businesslike."

  9. Great article. I responded with a post. :-)


  10. Nate,

    I agree with most of what you said and I have employed similar methods in avoiding a few stocks which were attractive from a quantitative POV (e.g lumber liquidators, after reading reviews about the stores and service ) but I think we have to be careful about not coming to incorrect conclusions based on too small sample sizes or anecdotal experience.

    Personally, I buy net nets not because they are great businesses ( in fact they are rarely so) and I am not planning to hold on to them for a long time. In fact, a lot of value investors, I know, buy a basket of net nets to reduce the risk from a single dud. Finding out about the company can help, as that may narrow down your choices to include the best net nets. But sometimes I find myself unable to pull the trigger because of a minor quibble about some qualitative aspect of a company which otherwise is a very attractive value proposition.

    Btw, I am curious about your experience with AEY. I am not sure about the specifics but as a person who works in the semiconductor/hardware industry, I know that a lot of companies do not entertain inquiries from random persons because of threats from counterfeiters( a big problem for global companies selling parts in China) or competitors trying to get free samples or buy a small lot so that they can reverse engineer the parts ( which is not too difficult). In fact, some companies ( e.g. one of our competitors) would not even talk about their products unless you provide some credible evidence of your identity and sign a non-disclosure agreement.