Outsourcing is alluring. Let someone else do the research and ride to success with little to no effort. The problem is when everyone relies on everyone else leaving no one to do the primary research.
There is a term "hedge fund hotel" that's used to describe a stock with a shareholder register littered with well known hedge fund names. Funds all pile into the same names because they like the characteristics of the stock, but also because other popular funds are in the name. The cycle is self perpetuating, as more funds enter a name it attracts even more funds. Many of these funds do their due diligence before investing, but it wouldn't be a stretch to say that some have outsourced their thinking to others in the group. The thought is if there are a number of great investors in a name it makes sense that they've all done their research, and if these popular investors have all researched and determined an idea is great that little additional due diligence is necessary.
The spectrum of due diligence extends from "Bill Ackman is invested so I will too" all the way down to examining invoices and receipts before investing (in a private company, but also possible in a small public company).
There is a natural tension between doing enough research to determine an investment is worthy of a portfolio position, and doing too much. Research and due diligence experience diminishing returns. In my view the determining factor on how much due diligence an investor needs to undertake is determined by the size of the position in the portfolio as well as the absolute size of the position.
For smaller positions it's reasonable to research a stock without ever leaving your easy chair. This includes reading quarterly and annual reports, reading conference call transcripts and Googling the company. A lot of investors, especially value investors get caught up in reviewing the notes for a company. I think it's important to read annual reports and notes, but I've never seen an investing situation where minutia in the notes was the determining factor for investing or not. Additionally I've found many cases where Googling can turn up information about a company that's much more impactful than a note about how the company computes their pension or handles inventory accounting.
It's helpful to think outside the box. Companies release periodic financials, but that doesn't have to be the only source of research. Consider reading employee reviews on Glassdoor or contacting current and former employees directly on LinkedIn. Glassdoor is perfect for the armchair analyst. Glassdoor has salaries and reviews for most companies in the US. The site is anonymous and employees tell the world what they'd never tell HR in an exit interview.
Employee salaries and management perception is important. You cannot have an average or above average company if employees universally hate management and are underpaid relative to peers. If you are looking to avoid duds in your portfolio you need to invest in companies that have at least an average workforce. If a company has a below average workforce the company will need to work that much harder to produce results on par with peers.
Beyond Glassdoor there is a lot of information available online in non-traditional places. On CompleteBankData.com we have hundreds of financial details that never appear in a bank's financial statements. Many of these can be pivotal pieces of information that could make or break an investment. We also have a lot of information that highlights banks that have the potential to torpedo a portfolio.
Another treasure trove of information is the court system. I've referenced the Horsehead Holding (ZINC) investment in the past, but it's worth mentioning again. A friend pointed out that the company was involved in multiple lawsuits in Allegheny County on the public record a year before their bankruptcy filing. This information would have tipped off investors to their imminent failure almost a year ahead of time. Courts require companies to disclose details they wouldn't otherwise disclose. Horsehead Holdings was suing their suppliers and contractors for not knowing what they were doing. They were also involved in a lawsuit with a competitor for poaching the designer of their manufacturing plant. A PACER subscription to scan for lawsuits can be incredibly valuable.
The last and at times most valuable source of information regarding a company is management itself. Without management there is no company. Managers hold the pieces of a company together and push employees towards a singular goal.
Bad management can destroy shareholder wealth in a few quarters. Benjamin Graham believed that the quality of a company's management was reflected in their financial statements. This is something I agree with, but it has limitations. A company with continual losses and perpetual secondary offerings does not have a star management team. Likewise a company with a seemingly high ROE might not have a great management team either. Sometimes it's worth peeking behind the financials to see who's really running the show.
The best way to gauge management is by talking to them. Either picking up the phone or talking in person. For large cap companies management is inaccessible to individual investors, but that's not the case with smaller companies. It's very easy to pick up the phone and talk directly to the CEO or CFO of a microcap company.
A lot of investors shun talking to management because they feel they'll be fed a rose colored view of the world. Or that management is biased towards their own company, or that a CEO is just a sales person. All of these things are true, and they should be, and if they aren't don't invest. If a CEO isn't out selling their company I don't have much confidence in them. Likewise senior management should believe in what they're doing and believe they're the best at it, if not they need to find another job.
The job of the investor isn't to hear management's narrative and invest based on it. But rather to use management to fill the gaps in their investment thesis. Sometimes financial statements don't describe a situation accurately. For example Kopp Glass (KOGL) appeared to have a large pension problem based on their financials. The company's CFO had a much different view on the situation. When I spoke with him he said the pension was the last thing he worried about, the payments were fixed and he had a model capturing all scenarios. He had other issues he was worried about, and I would have never understood that if I just relied on the company's financial statements.
Talking to a company's management on the phone is valuable, but it's even more valuable to talking to them in person. Body language is an important element of communication. Sometimes people will give two answers to the same question, the verbal answer, and the body language answer. If you're on the phone you only hear the verbal answer, but in person you get both. And both is important when the answers don't agree.
The problem is it's hard to find the time to fly around the country visiting companies. I try to attend as many annual meetings as I can in person. At these meetings management makes themselves available to discuss issues with investors. And meetings are a chance to observe the body language as well as the verbal language of management.
Another solution is to attend an investment conference like our Microcap Conference in Toronto at the Hilton April 11th and 12th. At this conference there will be 40-50 companies presenting to investors and taking questions. But beyond that we also set aside time for one on one meetings allowing investors to sit face to face and ask management questions or offer suggestions directly. If you've ever sat and thought "I wish management would do this.." a one on one session is the perfect opportunity to suggest a change to management in a non-hostile setting. If you're interested in registering you can do so here.
The key to any investment is doing your own due diligence. Don't invest in a company just because someone else has, regardless of how great of an investor they are. We never know exactly why someone else invested in a position, or what their goal is with the position. Conducting your own due diligence gives you the information and confidence needed to investor your own money in a stock. Also consider the size of your position, and then conduct the appropriate level of diligence for that position. If you have a $100,000 portfolio and are investing in 20 stocks it probably doesn't make sense to fly to Wichita to tour a plant. But if you are putting $15,000 or more into a position it's worth the time to go beyond the financials if possible. In the end you are responsible for the money you invest, and conducting an appropriate level of due diligence can result in gains and protects against losses.
Nate,
ReplyDeleteRegarding this, what would you say is the biggest mistake that investors make when they're doing or are lacking of a good investment research? Thanks!