The way I find new stocks to research has changed over time. My approach changed from greedy to aggressive to curious and finally to practical.
For the story of another investor and blogger’s change from mechanical screening to human screening – read Richard Beddard’s blog post about his Human Screen.
This is my story.
Greedy and Aggressive
I used to think that good investors can make 50% annual return. I had read a quote from Warren Buffett saying this was true. This was before I knew anything about investing. So I wanted to find stock like that. Stocks that could return 50% a year. So, I looked for companies with low P/E, and a big drop in the share price from its past peak. If I found some famous value investors holding it, I’d start analyzing the company.
One such stock was Alliance One International (AOI). This is one of the two biggest leaf tobacco processors. It has about 40% market share. It seems obscure. People know cigarette brands but don’t know where the tobacco leaf is from. The company could be a hidden champion. And at the time I found Alliance One International, it was one of the stocks Seth Klarman owned.
I think one problem with this approach is vulnerability to bias. I aggressively searched for undervalued stocks. I started my analysis with a thought that this stock seems undervalued. In my mind, I wanted that “seems” to be “is”. I was more likely to look only at information that confirmed my belief. I was less likely to watch the downside.
That might explain why I bought AOI. I saw the bad product economics but I was blinded by the low P/E, the past peak price, and the duopoly. I saw the high level of debt, but I reasoned that the demand for cigarette is stable. The equity value would be realized as the company reduced debt.
After all, Seth Klarman bought the stock.
I didn’t know when I realized my mistake. It’s not like I had a terrible experience with the first stocks I bought. I never lost 90% of my money in some value trap. But, for some reason, my process for finding new stocks to research started to change. Perhaps I changed the way I looked for stocks after exchanging emails with Geoff. I sold a lot of stocks I owned after talking with Geoff.
Coming from one extreme to another, I went from totally ignoring the downside in a stock – just looking for a stock that might return 50% over the next year – to totally ignoring the potential upside. I knew that Warren Buffett analyzed companies in the Moody’s manual in alphabetical order.
Why shouldn’t I?
So, I decided to expand my circle of competence. I ignored stock price, and started my learning experience. I wanted to learn about how companies actually make money. I did research on companies without any intention to buy those stocks. I thought I just need to gain understanding of companies. One day in the future, something might happen to the stock price and I could quickly decide whether to buy. And I wanted to give priority to better businesses.
There’s two good metric that might indicate a good business. One is profit margin. The other is return on capital. I don’t know any stock screen that gives a normalized return on capital so I didn’t use that metric. So, I used Google Finance screener to find stocks with high 5-year or 10-year average profit margin. There are profitable companies with low profit margins. But nothing is perfect and high profit margin is a good place to start. Among those high margin companies, I started from the highest ROE to the lowest.
Even though that list was generated automatically for me, I still had to select companies to do further research. I started by reading the business description. I wanted companies with unique products. Due to my limited knowledge, I usually didn’t understand what the company did after reading the description. The basic business description used by websites like Google Finance is often
I then took a quick look at 10-year results at MSN money. I looked at balance sheet to see whether the business require high capital investment. I looked at earnings and cash flow to make a quick calculation about profitability. If my feeling was that the company is profitable, I would start doing further research.
As a result of using screener with only one variable (profit margin), I jumped randomly from an industry to another. One disadvantage is that I usually started my research with completely no familiarity with the company. But the advantage is that I expanded my knowledge. I studied about sports and entertainment and a little bit about cable network after analyzing WWE. I studied some medical device companies like Landauer (LDR) and Masimo (MASI). I analyzed IT service companies like Ebix.
As my knowledge widened, I sometimes found companies in business close to the businesses I already know. For example, ISCA is similar to WWE. Bio-reference (BRLI) is nowhere similar to MASI but they both provide tests. Netflix can be seen as similar to ESPN or a cable operator.
I didn’t limit my research to good businesses. I was willing to read about companies with good long-term stock performance. I don’t know anything about commodity and my perception is that commodity driven business is bad. But Seaboard’s long-term record was good enough to trigger my curiosity to learn about the company. Seaboard stock has returned more than 16% a year over the last 34 years. And that’s excluding dividends. That’s enough to get any investor’s attention.
My approach now is more practical. It’s now more about finding a stock to buy than finding a business to learn about. I have a checklist to decide whether to do research on a company. Whenever I see some company names on the street, on a blog, or anywhere, I’ll run the checklist to see if I’m interested in analyzing the company.
I want familiar companies or companies in familiar industries. My business knowledge is broader now than in the past. But I didn’t really expand my circle of competence. My knowledge is just a set of several disjointed points scattered over the business space. But that’s a good start. I’ll now expand the points into circles. I’ll start with companies I’m familiar with.
I’m more interested in obscure companies with special, unique products. I like hidden champions with no analyst coverage. There can be higher chance that the stock is mispriced. And unique product can mean high profitability.
I like simple companies. I like a company with simple business model that I can understand. I don’t like high tech companies. Those are too complicated to me. And in my point of view, simple also means focus. I don’t like companies with a lot of unrelated products.
Because I’m a buy and hold investor, I like companies that have some sense of permanence. It’s impossible to predict the future. But I can say that people in the future will continue to cruise, unless fuel prices reach to the point that cruising is more expensive than land-based vacations.
Necessity can be an indicator of permanence. People will always need grocery stores to buy fresh foods. Lack of change in customer habits also contribute to the permanence quality of a company. I’m reluctant to buy Microsoft (MSFT) or Apple (AAPL) because of my uncertainty about customer habit.
Finally, I like companies with stable demand. To me, it’s just impossible to estimate the normal earning power of a company without stable demand.
So, that’s my qualitative screen. I don’t screen stocks by any metrics. If I know a company scores well on some metrics, I can start my research with some bias. And I don’t pay attention to price. I just look for some companies that I can own, and wait for someday to buy.