In-depth research

I must admit, I love doing research.  I have an innate curiosity about almost everything, so when I get to dig into a company and its industry, I’m in hog heaven.

Recently, I’ve been digging into the technology field and it’s amazing how many nooks and crannies there are to understand. 

Just in computers, you have two major sides: hardware and software.  Both of those can be divided into customer sectors: consumer, small and medium business, public, and enterprise.

Just in the enterprise part, you have storage, servers, mainframe/virtualization/cloud software, networking equipment, database software, operating systems software, middleware, and applications.

Some businesses compete across all categories, like IBM, HP and Oracle.  Others pick niches that allow them to work with competitors in one market and against them in another.

The hardware side also has a long chain of providers.  If you buy a disk drive, the company you buy from probably out-sources assembly and buys parts from others instead of manufacturing itself.  In the case of enterprise storage companies like EMC and NetApp, they are more software than hardware companies!

And then there are services.  Some businesses are pure consulting with no products to sell, others provide services in one particular niche, like storage, and still others do everything from top to bottom, like HP.

Is it better to be a niche company, or cover the whole field?  Which companies have sticky products that are hard to dump, and whose products or services are easy to quit?  How is the landscape changing?

Technology seems to be more rapidly changing now than five years ago, and a lot of that is a culmination of widely available and cheap high speed broadband, both wireline and wireless. 

Will old businesses that were once dominant be toppled, or can they adapt to the new landscape?  Or, will customers be the ones to benefit because stiff competition reduces profitability?

To truly understand all these nuts and bolts, and to be honest enough with yourself to know what you don’t know, you need to do a lot of homework.  Sometimes that homework pays off in insights that generate better than average returns.  Sometimes it’s just a dead end.

Either way, in-depth research is the best way to go when it comes to investing.  I believe that is one of the reasons it’s so hard for part-time investors to generate above average results–they are competing with people who are digging deep in areas and ways that no part-timer can match.

But, it’s not enough just to understand the companies, the technologies and the competitive landscape.  You also need to understand the financials and be able to value individual securities. 

In many ways, I think I’m one lucky duck, because I get to do what I love, what interests me, what I’m good at, and what the market needs all at once. 

For me, in-depth research isn’t just a means to other ends, it’s a very enjoyable end in itself.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

In-depth research

Your returns depend on the CEOs you invest with

Not surprisingly, what’s happening in a CEO’s life impacts the performance of their company and it’s stock price. A September 5th article in the Wall Street Journal by Mark Maremont highlighted this fact, recently.

Several studies have shown that a death in a CEO’s family negatively impact the company’s stock price. The death of a child resulted in an average loss of 20%. The death of a spouse led to a 15% slip in price. Amusingly enough, the death of a mother-in-law led to a 7% rise in stock price.

Other studies showed that the stocks of companies run by CEOs who buy or build megamansions sharply under-performed the market. This hardly seems surprising to me, but it’s good to see the statistical backing.

Another study showed that narcissistic executives, those who tended to take all the credit for what their companies accomplished, tended to take greater risks that led to bigger swings in company profitability.

Although I’ve never done a statistical study of these issues, I’ve always looked hard at the leaders of the companies I invest in. Not only does this result in better investment results, on average, but it also allows me, and my clients, to sleep better.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

My evolving investment approach

It’s interesting to note how my investment research process has changed over the years.

From the time I first read about value investing in 1995 up until 1998, my focus was almost exclusively on the numbers. Basically, I picked investments based on my assessment of the value of each business with a much lower emphasis on other factors (management, economics, product life cycles, etc.). I crunched the numbers and bought if something looked remarkably cheap.

From 1998 until 2001, my focus began to include a more thorough analysis of business economics. Here, my aim was to gain an in-depth understanding of the competitive advantages of each business and to what degree they were sustainable. This effort was much more qualitative than quantitative.

In 2001, I started to include a much more thorough analysis of management, too. For this, I looked at management’s tenure, their competence in the field, their compensation structure, their ownership of the business, the way that they talked to shareholders, etc. This, too, was a more qualitative effort.

What I’ve found is that you can never stop learning in this field (or in any other for that matter). Every year, I bring new elements into my analysis. Every year, I read books or articles that lead me to dig deeper into certain aspects of each business.

Although my general approach has remained the same–I look to buy underlying businesses, not stocks, and I try to buy them significantly below their assessed value–I continue to add more and more layers of analysis and experience on top.

I keep very good records of the investments I’ve looked at over time, both the ones I invest in and the ones I don’t. This has allowed me to review my past decisions and prevent sins of both omission (not investing) and commission (investing when I shouldn’t have) going forward.

I love my job, and I love learning more and more each year such that I can improve my expertise and, more importantly, my results going forward. And, as Charlie Munger and Warren Buffett have amply demonstrated, that’s a great way to build wealth and enjoy life.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Mutual fund over-diversification (the artist formerly known as di-worse-ification)

One of John Mauldin’s recent Outside the Box articles by James Montier (of Dresdner Kleinwort) highlights the fact that the average mutual fund holds around 160 stocks.

Now, this may not sound ludicrous to you, but let me walk you through why I think this is nuts.

First off, 160 is average. That means that some managers hold many more and some hold many less than 160, but let’s just work with 160 to illustrate my point.

There are around 250 workdays in a year (52 weeks minus 2 weeks for vacation gives 50 weeks, multiply that times 5 workdays per week).

Most companies report their earnings once a quarter and provide a conference call with that.

That means a mutual fund manager must monitor around 5 companies every 2 workdays (160/(250/4)x2).

Given an 12 hour work day and a 5 day workweek, that means each mutual fund manager can devote 4.8 hours per company each quarter.

Most conference calls last 1.5 hours, so that leaves only 3.3 hours to understand, model, value and evaluate each company.

Let me add that this doesn’t include time to visit companies, watch additional presentations that almost every company gives, look for new investment ideas, interact with clients, vote proxies, do administrative tasks, talk around the water cooler, etc. You get the idea.

Granted, such managers may have a herd of analysts chasing down details. But, the mutual fund manager is the one who has to make decisions, and how well can he understand a company and make decisions if he has so little time to follow and evaluate each company?

I know that when I look at a new investment, it usually takes me 3 hours just to read one 10k (annual report filed with the SEC). But then, I still need to read old 10k’s (at 3 hours a pop), plus 10q’s (quarterly reports filed with the SEC, 0.5 hour each), listen to conference calls and presentations (1.5 hours each), read current and old reports to shareholders (1.5 hours total), look up articles about the company (2 to 4 hours), read competitor’s reports (another 10 hours), etc.

In other words, just to look at a new investment idea, I have to spend around 20 to 30 hours just getting to understand the business. And then, I need to think about the business analytically, evaluate management, analyze competitive advantage, drill down into the business’s economics and business model, model the business into the future, analyze financial statements over time, etc. It takes a lot of time to thoroughly research a new investment idea.

To keep up with current investments, it usually takes about an hour to read the press release and think about and analyze the financial statements, 1.5 hours to listen to the conference call, 1.5 hours to update my model of the company, 1.5 hours to analyze the latest 10q or 10k, etc. It takes me about 6 hours per company just to stay up.

And then I still need to vote proxies and listen to annual meetings and analyst presentations!

It takes all my research time to keep up with 40 companies, have time to screen through a bunch of new ideas, and thoroughly research 10 to 20 new ideas a year.

So how can a mutual fund manager hold 160 stocks? By not doing a very thorough job of understanding the companies he owns. I think that’s an irresponsible way to invest. Perhaps that’s why 80% to 90% of mutual funds under-perform the market over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Academic research on investing isn’t all bad

A great article by James Montier at Dresdner Kleinwort (“Modern Portfolio Practice: A view from the Ivory Tower”) provided some remarkable evidence of what makes for successful investing. The truly amazing thing is that his evidence came from academia, a field that generally insists that no one can beat the market except by luck.

What are the secrets revealed by extensive academic research? Be a stock picker, run a focus fund, do something different, know when to sell, keeps funds small, keep turnover/trading costs low, stick with your principles, and have some skin in the game. Now, I’ll expand on each of these.

Be a stock picker means focus on picking good investments instead of trying to mirror the market over the short term. Most money managers try to hug the market to avoid short term under-performance, but this lack of conviction leads them to always under-perform over the long run. The best investors focus on picking good investments, not on the mirroring the market or indexes.

Run a focus fund means concentrate on your best investing ideas instead of diversifying over too many investments. Too much diversification is a bad thing if you are trying to out-perform the market. Most investors don’t have the conviction or long term time frame to do this.

Do something different means think and act independently. If you’re focusing on what everyone else is doing and paying too much attention to short term results, you will get the same below average results as others. As Sir John Templeton put it succintly, “It is impossible to produce superior performance unless you do something different from the majority.”

Know when to sell means most investors focus too much on buying and not enough on selling. The investors with the best records follow rules for buying and selling and then adhere to that discipline religiously!

Keep funds small highlights the fact that the best money managers manage smaller amounts of money. As Warren Buffett puts it, “Size is the enemy of performance.” The marketing organizations that focus more on getting new clients than getting good returns are not a good deal.

Keep turnover/trading costs low seems simple enough. The average mutual fund manager buys and sells his whole portfolio every year (100% turnover) generating high trading costs and tax issues for taxable accounts. The best money managers trade infrequently to keep costs down and performance up.

Stick with your principles means don’t change your discipline just because it isn’t working right now. Most money managers and investors chase performance. That leads them to sell recent under-performers and buy recent out-performers right when the under-performers start to out-perform and the out-performers begin to under-perform. Sitting tight, even in a strategy that isn’t doing well in the short run, works better than changing discipline every time it’s not “working.”

Have some skin in the game means that managers with their own money at stake get better performance. Always ask a money manager where his money is. If he doesn’t have his own money in the same place he’s recommending you put your money, walk away quickly!

These rules may seem like common sense to you, but you can rest well and follow it more freely now that the rocket scientists in academia have blessed sound advice with their research.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.