Someone who reads the blog sent me this email:
What is your process for reviewing an idea? What do you make sure to read? (documents, news, history of business, industry report, etc?) I was impressed by your discussion of CCL, and thought that many of the details you had included weren't readily available in a 10-k or company document. How and where do you go to get that type of data (thing like unit economics, for example)?
I used to have a fear that I can’t find enough information to analyze a company. I don’t remember when that fear went away. But that’s not because I got more information. That’s because my process improved.
One problem I see in a lot of books is the hammer bias. To a man with a hammer, every problem looks like a nail. I think authors usually start a project with some hypotheses and they look at data and information from that point of view. They give examples and explain by their thesis. But things are usually results of many reasons.
Ten Points to Look at
We can easily fix that problem. As Charlie Munger suggests, the cure is to equip the man with as many tools as possible. My tools are my investment checklist. I have 10 questions to answer in my research:
- Competitive Position
- Product Economics
- Return on Capital
- Capital Allocation
- Future Prospects
And I have a sub-checklist for each item in the checklist.
Twelve Books to Start
My checklist was initially based on ideas from the books I read. If I started over studying value investing today, I would read these books:
- Security Analysis by Ben Graham
- Common Stocks and Uncommon Profits and Other Writings by Phil Fisher
- The Little Book that Builds Wealth by Pat Dorsey
- Profit from the Core by Chris Zook
- Beyond the Core by Chris Zook
- Unstoppable by Chris Zook
- Repeatability by Chris Zook
- Talent is Overrated by Geoff Colvin
- Built to Last by Jim Collins
- Good to Great by Jim Collins
- How the Mighty Fall by Jim Collins
- Great by Choice by Jim Collins
Security Analysis and Common Stock and Uncommon Profits are the best investment books I’ve read. The former gives us a complete understanding of value of a company. The latter shows us important aspects of a company to analyze.
The Little Book that Builds Wealth is a good introduction to moat. There’s a lot of interesting examples. But there’s a weakness. Pat Dorsey underrates the role of management. He looks at a moat in static terms. I think we should look at a moat in dynamic terms. That’s why I think it’s important to read Chris Zook’s books.
Chris Zook’s books are about repeatability. The idea is to utilize organizational capabilities to adapt to changes in the market or to repeat success in growth opportunities like a new customer segment, a new geographic markets, or adjacent products.
I find that Talent is Overrated is a good addition to Chris Zook’s book. Great performers are those who repeat practicing in learning zone. That also applies to business. Companies that repeat sharpening their key capabilities will widen their edge over competitors.
I think investors undervalue Jim Collins’ books. He broke some myths about management. I think the books show how to build a great organization. It’s helpful for investors to judge management.
Improve My Checklist from Real-life Observation
But more important is practice. Each company is a real example. Analyzing each company helps me realize what’s important to each checklist question. And I just keep updating my sub-checklist. My process improves after each research.
For example, I didn’t have a clear idea about how to judge an organization. But overtime, I realized unionization and internal promotion are something to look at. It’s helpful to see if the organization is sales-driven or research-driven or operation-driven. The distance from front line employees to CEO and the company location are also useful.
Reading interviews, earnings call transcripts and compare what the management said with results also make me better at judging people. I can easily find that Royal Caribbean’s management is quite promotional. Carnival’s Micky Arison is honest and blunt. Or Western Union’s management is competent but overly optimistic.
Practice also improves my understanding of moat, even though it’s a topic that economists and investors pay a lot of attention to. For example, I think customer behavior doesn’t get as much discussion as it deserves. Perhaps that’s because it isn’t easy to describe customer behavior in a formula like economies of scale or network effects. Many times, customer behavior is explained by psychology. Again, a checklist is a powerful tool.
For example, looking at frequency and purchase price is helpful. High frequency with low purchase price is good. Customers are rational only when they first choose a product. Once they are satisfied with their choice, they’ll be loyal. They don’t want to think and choose every time they buy the product. They rely on habit instead. That’s why consumer products are such a good business.
Low frequency with high purchase price is bad. Customers are rational. They spend a lot of time to compare alternatives. That’s why I think selling to business customers is difficult. That’s why I don’t like consumer electronics companies.
Low frequency makes auto part retailers like AutoZone (AZO) a good business. Customers don’t buy often so they don’t know much about price. Auto part retailers don’t compete on price. They compete on service instead. AutoZone focuses on “Yes rate”. AutoZone doesn’t want to say No to customers. It wants customers to know that AutoZone will solve their problems. So, frequency is low but the awareness is high.
On the contrary, low frequency makes fine dining restaurants like Ark Restaurants (ARKR) a difficult business. Customers go to these restaurants on special occasions. There might be a lot of planning. Customers may not be loyal. But once the service is bad, customers will never come back. So, despite the crisis and rising food cost, Ark couldn’t reduce payroll. They must maintain good service.
Among my 10 points, I didn’t find much discussion about product economics in books. But it’s very important. Strong competitive position with bad product economics is bad. Railroads has strong moat but bad product economics. They earn only an adequate return on investment.
So, it’s important to see whether costs are fixed or variable; whether the business requires a lot of capital investment; whether growth requires much capital; whether the product cycle is long or short; or whether cash collection is faster than cash payment; etc. The list of questions just keeps expanding as I gain more experience.
I Didn’t Get More Information, My Eyes Just Get Keener
As I mentioned above, the information I look at didn’t change. I read all conventional sources. I read 10-Ks, transcripts, and interviews. I try to read all books about a company. I read all articles I can find about a company. I read from the oldest to the most recent article. That helps me see how the company evolved over time.
I do the same thing to customers and competitors. So, it’s a good idea to analyze end-customer and go up the value chain.
I look at data and information with my checklist (and sub-checklist) in mind. I make notes or do calculation with data whenever I see something relevant. I update my checklist after each research. And I’ll reduce the amount of important information I miss in later research.