Many investors, when asked to define their research process, say something along the line of,
Oh, I just read through the SEC filings, earnings transcripts, listen to other investors, and so forth, and then I just try to make sense of it.
I think aspiring analysts deserve a little more than that.
Of course, there’s a process. Perhaps it changes in each case and context and it may be a little hard to define, but I think every good investor generally follows a definable road to insight even as they may not recognize it. Especially when the company is outside their circle of competence and they’re trying to expand that circle of competence.
This is my attempt to describe my research process. I’ve thought long and hard about how I usually approach understanding a business. I’m talking about that point when you’re at the frightening gate of making sense of something new and the imposter syndrome whispers in your ear that you should just give up now.
Now, I first want to be clear on the fact that there’s nothing wrong with being the dumbest guy in the room full of specialists. I like stepping into the things I don’t know about since I know that’s where I will find the steepest learning curve. Knowing the most details on any subject often isn’t even necessary. The analysis paralysis you get from delving in minutiae might even hinder your ability to make intelligent decisions.
But what you must possess is intellectual honesty; the ability to recognize when you haven’t assembled enough of the puzzle to do something about it. Charlie Munger has said, “I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do.” Over 97 percent of what you study likely shouldn’t lead to a decision. Picking stocks may be the end goal but increasing your knowledge about a variety of businesses and industries should be your sole focus. You just have to push through the imposter syndrome and study as widely as possible.
Here’s how I do it.
Step 1: Assess whether this company is something you are willing to dive into
I think about studying businesses much like reading books. The best strategy for reading books is to skim a lot of them, read a few, and re-read the best ones. The stock market is a big ocean and getting to an actual investing decision will likely require me to read through hundreds, maybe thousands, of pages about the company collectively in terms of legal filings, transcripts, interviews, articles, and so forth. I want to make sure that not just my time is worthwhile but also my interest in the subject.
Keep in mind that I’m not talking about what price the stock is trading at here. It’s solely about what the company does and how it creates value. When I begin to study a company, the price doesn’t matter to me because I cannot assess whether something I yet don’t know about is cheap or expensive based on simple multiples. I want to think a little deeper than that.
Step 2: Read the latest annual report
At this step, I’ve skimmed the annual report and assessed that this is a company worth my attention. Now I sit and read through the full report.
The annual report should contain enough information for me to understand the business and what makes it tick. This all comes down to whether management has chosen to communicate to me as a partner or as a salesman. When the latter is the case, I might try to see through it and continue reading to learn more. But sometimes, I don’t understand something because management doesn’t want me to understand it and they hide it behind gibberish or popular jargon as if it was mass-manufactured at a consulting house. Then I stop reading.
Step 3: Mark the key turning points in the company’s history
If I’ve finished close reading the annual report, I pick up the prior years’ annual reports—depending on the age of the company—and skim through them. What I look for are defining events that have happened in the company’s history, whether that is a change of strategy, a major restructuring, a big write down, and so forth. I then study how these events relate to what happened to the company’s historical financials (using the Sanity Check model).
Step 4: Mark management changes and tenure time frames
Equally important to the company’s defining events is who ran the company by the time they happened. So I once again relate the given management to what happened in the company’s history and how they affected the financials. I furthermore take a look at the management incentives and how they’ve been compensated, either rightfully or unfairly.
Step 5: Write down questions
At this point, I will likely have a bunch of questions in my head that were not covered in the annual reports. I write all these down and let them form the groundwork of my analysis.
Step 6: Build a narrative and add nuance
I take the turning points and questions and flip through historical articles, earnings transcripts, Twitter, YouTube, or anything else on the internet, perhaps reach out to investor relations, and so forth, to build a coherent narrative around how the company evolved and arrived at its current position.
Step 7: Make a list of entities in the company’s ecosystem
I write down the company’s list of competitors, stakeholders in the value chain, and other entities which either might be affected by the company or affect the company in some way. I write down all the entities I can think of to 1) be sure that I didn’t miss anything and 2) get a bird’s eye overview which may help me as I think through the company’s competitive advantages and value creation.
Step 8: Mix all these narratives together and build a story
I either skim or close read the main competitors’ or stakeholders’ annual reports and then shuffle the cards around to see how these fit into the coherent story. The main idea here is to gauge what type of market it is, if the competition is rational, if profits are abundant for everyone, and so forth.
Step 9: Tell the story in light of mental models
Doing hard work counteracts our natural desire to only seek out information that confirms what we believe we know. Mental models help us make sure that what we think we know is coherent with how the world works. At this point, I go through my list of mental models to see how the narrative fits my collection of models—how it can either be reinforced or shot down.
Step 10: Think hard about the company’s advantages
Or, more importantly, I think hard about what advantages they might build up to. By now, I should know enough about the company to give a qualified opinion on how it can continue to create value by protecting its economic castle.
Step 11: Decompose the company into different activities
I then think through how each of the company’s activities creates value, either financially for the company itself or externally in the ecosystem. This is important in order to do a proper valuation.
Step 12: Read the latest report again
Heraclitus once said,
No man ever steps into the same book twice, for it’s not the same book and he’s not the same man.
The second time I pick up the annual report I started with, I already understand the business on a different level, and reading it again is a very different experience. I only read the parts that caught my attention the first time around that I either didn’t understand or looked important somehow. But my main purpose here is to gauge how management has acted in light of my knowledge of the business and to assess the future strategy.
Step 13: Go through the investing checklist
I go through my investing checklist to again make sure I haven’t glanced over any important issue.
Step 14: Value the company
The last step is the easiest. Building a valuation model is not hard work; Everything that preceded it was.
Whether the valuation model is simple or complex doesn’t matter. I could build a simple growing owner earnings projection or Gordon Growth-like normalized model, I could build a three-stage DCF, or I could build a complete unit economics model. The type of model depends on the type of business and they should all yield the same value. The only thing that matters is whether the valuation is roughly right and whether I’m confident in my own research.
If the company ticks all boxes—it’s a wonderful business, it’s within my circle of competence, it’s one of my best opportunities given my universe of options, and the price is right—I buy it. If the price is not right, it goes on my watchlist so that I’m ready to pounce when it approaches something reasonable.
The simplicity of this “blueprint” doesn’t at all blur the fact that analyzing businesses and intelligently picking stocks is hard work. To see it in action, you can see a lot of my process in the company write-ups. If you’re not a member yet, you can find a sample here of FactSet Research and here of Topicus.