In sales there is the concept of a "qualifying question." This is a question that a sales person asks a prospect to determine whether to pursue the prospect further. A qualifying question might be "Do you have a budget for this project?" If a prospect doesn't have a budget for a dreamed about project why would a sales person continue to pursue said project? The goal of a qualifying question is to get to "No" quickly and spend time with prospects who meet buying criteria verses chasing dead end leads.
Investors should adopt the qualifying question mindset when looking for new investments. Our time is limited and we don't have the capacity to cover every investable company. Time spent researching a company not worth investing in means less time spent researching a potentially good investment. A common investment meme is that knowledge is cumulative and that all that time spent on dead end investment leads will somehow help with good investments. This is simply not true, time spent on dead end leads is sunk time.
I prefer to research stocks differently in that I take the qualifying question approach in order to save time and focus my efforts. I prefer to invest in small stocks, so I don't look at larger companies. This is a personal preference, but that preference eliminates a lot of the investment noise. Most investment chatter is regarding the largest and most well known companies, the ones I'm not focused on.
I further limit my universe by looking for stocks with a traditional undervaluation on either an earnings or asset basis. If I come across a stock at 45x earnings at 150x book that's growing at 30% a year I will probably pass. This might seem crazy, why would I pass up the express train to unlimited profits via growth? It's because I'm not an expert on valuing growing companies. I like when companies grow, but I can't tell Crocs from Heelys or Starbucks from Caribou coffee. I've learned that I'm good at determining a stock's downside, determining the likelihood of a stock trading up to a higher valuation and I stick with what I know.
This isn't to say that growth stocks are bad, or value stocks are better, neither is better than one or the other. I'm saying that I stick to what I know. I think all investors should stick with what they know, what style works with their own personality.
My guidelines for an acceptable investment are very broad. There are many types of strategies that work in certain market environments, but no strategy that always works all the time. What I mean is this, an investor needs to be flexible. In some markets net-nets are attractive investments, other times low P/B value stocks, and at times companies that trade at earnings discounts to their peers. There isn't a golden strategy, and it pays (literally) to be flexible.
The criticism to this approach could be that by being too restrictive I'm missing great opportunities. The criticism is correct, I'm missing plenty of opportunities, many of them good! The nature of investing is that unless you're buying the entire market you will always miss great opportunities. The converse is that by being more restrictive I'm always forcing myself to pass on bad investments. Or investments that might be fascinating reading, but that ultimately don't have an attractive valuation.
Some investors like to research companies with the hope that one day the company will suddenly trade with a lower valuation. It's an interesting approach, but why not find companies that right now meet your valuation criteria? If the answer is "there are none" then it's time to reconsider your criteria. Of the 60,000 stocks worldwide I would expect that at any given time there would be at least 15-20 investable companies at the desired valuation with desired characteristics.
Spending time on what you own, or what you want to own that is qualified is much more valuable than spending time on something that isn't qualified. If the ultimate goal of investing is to find undervalued investments and invest in them then wouldn't it stand to reason that any time devoted to research should be spent looking for those undervalued investments now?
Investors are usually afraid to pass on a company because it might do well in the future. The truth is there will be many companies that do well that we never own. The fear of missing out is a real fear, but it has no place in investing. Rather focus on what can be controlled, the time spent researching and what you research. Stay up to date on current holdings and look for new holdings in a qualified pool of investments. The best research might be deciding an investment isn't worth further research and moving on.
Looking for value in the overlooked margins of the market.
I completely agree with this post and I follow this approach. I look at a few major elements (industry I know something about, p/e, dividend, debt load and balance sheet health, management and BOD, quality of disclosures, etc). And I am ruthless about eliminating potential investments; for example, the CEO of APD is considered an "Outsider" type CEO, which is appealing to me. And I know something about its business. So, I delved a bit deeper and, among other things, pulled up a recent 8-K with the quarterly earnings press release. I read the first few paragraphs and saw that the only numbers featured were "adjusted" numbers and not GAAP. I understand the need to use some adjusted numbers, but I tune out when you have to rent a microscope to locate the GAAP numbers. APD went into the rejected pile.
ReplyDeleteNate,
ReplyDeleteLoving these simple philosophical explorations of the principles of investment.
Anyone who uses stock screening tools versus "starting with A" as buffett once claimed, understands the wisdom of what you're saying. Let's make our searches narrow, we can always broaden them if we turn up too many dead ends.
Taylor,
DeleteYes, I replied to a comment below clarifying this. Screening of some sort is necessary, either through a tool, or human screening. That is skimming financials from A-Z but eliminating candidates as quick as possible. I've done both, I haven't found one or the other to be better.
Your on target as usual Nate. I don't know how many wonderful early stage pharma candidates I've missed, but that is so not my circle of competence. I also don't do semi-conductor stocks no matter what either. There are so many different ways to make money in the stock market that I just applaud folks who can make money in ways I can't and stick to ways that don't require me to make uneducated guesses.
ReplyDelete"I further limit my universe by looking for stocks with a traditional undervaluation on either an earnings or asset basis."
ReplyDeleteWhere do you generally get your ideas? This line would suggest screeners.
I do screen, I screen with tools and with the "human screen".
DeleteA screener is simple, I screen over very broad criteria and dive in from there.
The human screen is this: I will spend a day or two on OTCmarkets looking at every single financial filing. I skim quickly looking for items that disqualify an investment and move on. If you've ever done this you know how quick it is to eliminate 99.9% of these companies, but sometimes there's a gem.
Nate, thanks for the nice article. A couple of questions for you since you've got a lot of experience in this. Do you find that screening with tools is quite competitive with all the people out there doing the same? I feel that technology has made this much more competitive than was the case when Buffett/Graham/any-other-really-old-value-investor did it. What are your thoughts on this? And then, as far as human screening, the quantitative bargains would've already been seen in electronic screening, so are you basically looking for an area where something is not obvious? If so, can this be quickly noticed from a 'skimming' of the financials? Or is it more hidden? For e.g. there's one security I'm looking at where it doesn't 'screen' properly because of a some accounting particular to that industry. But I don't know if I would've found this by quick skimming had I not already known the accounting policies in that space, which really did take a lot of time. How do you deal with this situation if you want to rapidly rule out some but still have an eye out for bargains?
ReplyDeleteHi Nate,
ReplyDeleteI have actually been eyeing your blog for a while, but just started delving in recently. Most likely catalyst is the conference which caught my attention. Shame I didn't find out about the one in Philly till after it was over.
I have noticed that Andrew (when he used to be whopper), Fred Rockwell, and you- namely, the most visible microcap bloggers that I am aware of- seem to focus on pretty decent companies that are relatively undervalued, as measured by net assets, earnings power, valuation mutiples, and the like. Fair enough.
However, I would like to open up a whole new can of worms- the kind of companies that I have been looking at. The huge percentage of OTC companies that are not yet making money, (often with minimal revenue), have huge debt on the books, and have no choice but to disclose that they may not be able to remain viable as a going concern.
Many of these companies wind up folding, but some succeed .
Some of these companies can be found presenting at the well known conferences, such as Rodman and Renshaw, LD Micro, Marcum, and See thru Equity. As you are well aware , the OTC is littered with them.
When I try to analyze these companies, I often find that there is almost nothing to analyze- How do you assign a valuation to a young company that is boasting some new technology on how to ascertain the level of purity of marijuana.... but no sales yet, and millions of dollars of debt and negative s/h equity. Or the media company that claims to have found the solution to media piracy? Or the leader of equity crowd financing in Europe? These, and dozens more like them, are all companies that I have researched and interviewed. Many great and reasonable stories, with some being run by very decent people . I have found that often, there is very little- at least as far as insight into the business- to be gleaned from the filings, and the only time efficient way to get a snapshot of what is going on is by either watching a presentation by mgmt, or by speaking to them. The filings are good for due diligence afterwards.
I am curious to hear if you have ever tried to value these weak and distressed companies. If you had to, how would you go about analyzing these riskier microcaps.
I would like to point out just one assumption. Even those that do not believe in the EMH, myself included, concede that the public markets are still mostly efficient. If so, there must be some way to account for the billions of dollars of market value that these companies comprise.
I would be delighted if any of your blog entries, comments or links come to mind that address this very point- I would love to read about how your mind approaches this challenge.
Thanks, and looking forward to more dialogue,
Barry
Great post. I take the same approach. I always explained it like convergence tests for infinite series. The key is a qualifier or a few of them that you can check fast without having to do lots of valuation work. That is why I find most of the valuation screen ideas really pointless. Naturally an outstanding investment will rarely "screen" well.
ReplyDeleteSo, I follow a WB approach (start with the "A"s and work my way through a list of investments from an exchange, like the NYSE MKT or Pinks, what have you). I screen out industries where I know I have to particular insight (although I try and expand the range of industries about which I think I can take an intelligent view).
Then, I tear into the statements to see how much equity management is being "granted" for its efforts. If that number is large, I can already pass without even having to dig into ops or something else.
I have other qualifiers, too, but I find that I avoid quite a few nasty issues by making sure that management is treating OPMI like partners and not like sheep for shearing.