Someone sent me this email:
But how does one analyze any stock if one has to know the inside and outside factors especially when one is only an investor and really does not know the ins and outs of the business but only knows the info of the 10-ks,14As or S-1 when available?
How would we know that it is the agents of the Western Union Co. that are a big factor in purchasing this stock?
How would we know Carnival Cruise keeps its costs down compared to the other cruise lines?
In my opinion we can only know that info if we know everything about the businesses and that is impossible for the average investor.
As you mentioned in your article, even Warren Buffet did make mistakes and if he did and it looks like he did it a lot, the average investor who knows no executives that are passing info on what the company plans to do almost has no chance to make the right decisions on investments.
What do you think about that and how can we get info like that?
You need to go beyond a formulaic approach. You need to use common sense. Questions are the key to analyzing a stock. You need to keep asking questions. And it is often best to actually ask those questions in writing.
Whenever you read a 10-K, 10-Q, 14A, S-1, earnings call transcript, etc., you want to have a notebook, a pen, and a calculator. Jot down questions whenever they come up. Don’t try to standardize your approach. Instead ask questions that would be relevant to someone buying the entire company.
Basically, imagine you were acquiring the whole company. What questions would you have? What due diligence would you do?
You don’t have to limit yourself to the SEC reports. In fact, you shouldn’t. There is no limit to the research you can do. No limit to the sources you can use. And, honestly, talking to a company executive would not be my first choice. Even if you had complete access to the CEO – I’m not sure that’s what would be most helpful in analyzing the stock.
In fact, I’ve invested in many micro caps. In some cases, I know I could have talked to management. I didn’t. I know plenty of people who do. I’ve never believed it would help me much. And I’ve always believed it would bias me.
I prefer looking at past behavior. I’ve seen plenty of company presentations about the future. With few exceptions, I ignore them. When I say I think a company will buy back stock, do dumb acquisitions, etc., it is almost always simply because that’s what they’ve done over the last 10 to 15 years.
The only exception to this rule is when management has already achieved long-term goals in terms of capital allocation, economic value added, etc., and then sets out another five-year plan. If a company like Ball (BLL) laid out future plans – I would listen. But that’s rare.
So we know how I don’t do research. I don’t talk to management. And I usually don’t even listen to management. At least not about the future. So what do I do?
I read the SEC reports for the company and for its competitors. I also read earnings call transcripts. And I love to look at company presentations. Old ones. Reading what a company said it was going to do in 2000 or 2005 now that it’s 2013 can tell you a lot.
I spend a lot more time with historical financials than most people. EDGAR now goes back about 15 years. So you can put together your own 15 year long Value Line-style sheets for any company just by entering EDGAR data from old 10-Ks into Excel. I always do this. And I like to do it both for the company I’m looking at and for competitors.
That worksheet will raise a lot of questions. And what you need more than anything when researching a stock is a good list of questions.
For some very well-known companies there will be books to read. In the last year, I looked at both DreamWorks (DWA) and Carnival (CCL).
So I read "The Men Who Would Be King," "Disney War," "Selling the Sea," "Devils on the Deep Blue Sea," etc. I also read books less directly connected with those companies themselves where I knew some parallels were present. For example, I read a couple books on Pixar. And a biography of Walt Disney. That was all background for analyzing DreamWorks.
That might sound like a lot of work. But it’s really not. I’m sure you read plenty of books each year. Replace some of your reading with books that will help you analyze some specific investments you’re looking at.
The key is to focus. Most people flit around. Once you have a possible investment in your sights – block out everything else. Don’t spend half a day thinking about Carnival or DreamWorks. Spend a whole month focused on just one stock.
Once you get into the mindset of a dedicated analyst, reporter, investigator – whatever analogy you want to use – it will become second nature. You will have a trail of common sense questions to follow. And they will take you to new and different sources.
Sticking with the DreamWorks and Carnival examples, there were plenty of conference call transcripts to read. And a few recorded calls to listen to. For those two companies the CEO is an owner/operator who goes on the conference calls himself. So they are particularly valuable.
For DreamWorks, there were also probably half a dozen good interviews with Jeffrey Katenberg online that I had to watch. Everything from Charlie Rose to industry events.
I also watched a couple DreamWorks movies in theaters. And I ordered all the past DreamWorks movies. I rented the DVDs instead of streaming the movies so I could also listen to the commentaries.
That’s all just background. And none of it is hard to do. It’s not exactly unpleasant reading books and watching movies. It’s true that for the interviews – and just about everything else – you’re taking notes. But no one is judging you on your notes. They just have to be clear to you.
It’s important to understand you don’t need to know everything. I did a lot of research on DreamWorks’ products. I talked to some parents and kids – since I’m neither – who see DreamWorks movies in theaters. I went to theaters so I could see the actual audiences.
That’s not necessary with most products. I can’t judge a lot of products. I use Windows 8. And Windows 8 is obviously important to Microsoft’s financial future. But if I was going to invest in Microsoft (MSFT) – I wouldn’t put any special stock in my impression of Windows 8. I have no reason to believe my view of a tech product is better than what analysts, etc., are saying. I’m not a good guide to what the public wants. And certainly not what large corporations want.
DreamWorks was different because the reception of their movies by the public is the key to investing in that business. Movie ticket prices are fixed. They aren’t set by DreamWorks. The distribution of the movie – done through a major distributor – is well understood. I know roughly how many screens DreamWorks can get on. I know the kind of marketing budget they have.
The key question is how many people will show up in each theater. For most companies, you worry about price and volume. Not with movies. With movies you just need to worry about volume.
If I was analyzing another studio, I wouldn’t have gone to see any of their movies. The only reason to see DreamWorks movies was because they are repeatable. All DreamWorks movies are big CG animated family movies. They try to build franchises out of them. There is an element of repeatability here. They are doing the same thing over and over. I needed to study that thing.
When analyzing any investment you want to focus on the things that are: constant, consequential and calculable.
The kind of movies DreamWorks makes is constant. Public reception is consequential. As we saw when Rise of the Guardians flopped. Is public reception calculable?
There are some numbers you can play around with. And I did. I looked at how big the CG animated market has been each year since Toy Story. How much of the overall box office does it claim? How much of that market segment does DreamWorks get? How much do new entrants, smaller movies, lower quality movies, etc., matter?
I was able to answer some of these questions. For example, it’s obvious the top CG animated movies tend to account for a huge part of the business regardless of how many CG animated movies come out. There is probably some built-in audience for any Pixar release and – to a lesser extent – any DreamWorks release.
However, the possibility for total failure when you move away from these two companies was much higher.
All of this information was easy to gather using websites like Box Office Mojo, the-numbers, etc.
Once you have an industry you are interested in – follow it. For example, I read Variety. Entertainment companies can make good investments. I can understand some of them. It’s a fine place to fish for good stocks. They aren’t always cheap. And in most years I know I won’t find any entertainment stock worth buying. But it won’t hurt to have the background knowledge that reading Variety every day provides.
I highlight anything that interests me and then I go look up those companies. Or I look into the economics of that kind of venture.
You never know when this will come in handy. For example, DreamWorks was originally just a movie company. It has since gotten involved in a musical (Shrek), TV shows, etc. It also bought a TV show library with some character rights involved. It licenses rights. It has considered – in a couple different forms – getting involved in theme parks. And there has been speculation about a DreamWorks-branded cable channel.
So it helps if you have some background knowledge of all these things.
How is that possible? Isn’t that way too much work?
For one stock – it is. But business knowledge is an investment in itself.
Right now, I’m looking at Mediaset (GETVF). I’ve looked at News Corp before (NWS). So I’ve looked at Sky Italia before. That gives you some free context for understanding Mediaset. If you’ve already looked at Sky Italia, you already know more about the competitive landscape in Italian TV than you would if you were coming to Mediaset fresh.
Even knowing something about DreamWorks can help you understand Mediaset. A huge investment – around 1 billion euros a year – for Mediaset is TV rights. These are often rights to football (soccer) and movies. A lot of the movie rights come from American majors. DreamWorks is not considered a major in terms of its overall film production. But it is in the business of selling the TV rights to big movies. So part of learning about DreamWorks involves learning about why HBO or Netflix wants the movies, how much they are willing to pay, how long a deal runs, how it works, etc.
This kind of knowledge is transferable. In fact, a lot of what we’d consider “expertise” on a subject is really just the ability to transfer knowledge from stuff you learned in the past and apply it to a new situation you are facing now.
Knowledge accumulates. And knowledge of public companies – especially of slow-changing companies – doesn’t go stale very fast. If I had a great grasp of Mediaset as it was in 2006 – which I didn’t – I wouldn’t need to do much work on the stock today. There have been changes in Sky Italia’s position. And the condition of the Italian advertising industry is totally different. It’s at a low point right now. It wasn’t back then.
But most of the key points about Mediaset don’t change in just a few years. The same is true of most businesses. If you look at the kind of businesses Warren Buffett favors – knowledge has a long shelf life. He understood Coke in 1989. He doesn’t need to do a lot of work to understand Coke today. It doesn’t change much. Once you know Coke you always know Coke. So when the stock price drops you just need a quick referesher. You don’t need to start from scratch.
You don’t need to answer that many questions about a stock. The key concerns are:
2. Product Economics
3. Competitive Position
If you think about it, those are the assumptions that make up your DCF and your buy decisions. I never actually do discounted cash flow calculations. They aren’t helpful in practice. But they are nice in theory. So you want to apply the principle of a DCF to your analysis.
For example, you can look at Mediaset’s past cash flows – I paid special attention to the last 15 years – and compare them to today’s price. It’s obvious if you do that (using either average dividends paid, average free cash flow, average EBITDA, etc.) that it’s worth buying the stock even if it doesn’t turn a profit for the next 5 years (because of a lousy advertising market in Italy).
That’s because dividends have averaged 330 million Euros a year over the last 15 years. And the company’s market cap is just 2 billion Euros today. A yield of 16% starting in 2018 would more than make up for the lack of any cash flows before then.
So, you see I don’t need to know everything about Mediaset to decide whether or not to buy the stock. Using a common sense approach of counting the last 15 years of dividends I then drew a totally arbitrary line in the sand to help me make a decision.
I assumed the Italian advertising industry would be hopeless for the next five years. And it would be back to normal by 2018.
You can argue with those assumptions. I won’t defend them as logical. I will defend them as a reasonable and simple way of ballparking whether Mediaset might offer a high enough return to offset the risk.
And what is that risk?
Here is where we can focus on what the key questions are. We know that if Italy “reverts to the mean” around 2018 or so in terms of advertising spending – we’d be fine if Mediaset were in the same sort of position then that it is now (and has been in the recent past).
That requires three things. One, Mediaset’s equity must survive the Italian crisis of business confidence (business confidence is what we care about because Mediaset is advertiser supported). Two, Mediaset’s competitive position must be maintained long enough to enjoy an Italian ad recovery. Three, Mediaset would need to remain as unregulated as it is today.
Now we can start asking specific questions about those risks. We can talk about how many ratings points Sky Italia can take from the former Mediaset/RAI duopoly over the next five years. We can talk about possible political restrictions on Mediaset (Silvio Berlusconi is the largest shareholder) like reducing the ad time allowed per hour of programming. Or increasing the amount of ad time allowed at RAI. We can also ask how important the digital television frequency auctions might be.
Then we try to use what we know to answer those questions. In some cases, we may be able to measure how much of a margin of safety there is. For example, Mediaset could survive a 10% decline in advertising revenue from today forward. A 15% decline would not be fun. A 20% decline would require some sort of restructuring. That’s bad. Mediaset’s costs are very fixed. That’s how TV networks tend to be. So you either need to borrow more money or you need to issue stock or you need to cut back on your TV rights spending.
To answer the question of whether it would be easy to borrow money we flip to the info on debts and net financial position. It’s in the annual report. And it’s not pretty. It shows they are using a lot of bank debt rather than carefully spaced long-term bonds. They are not positioned the way you would want to be in an economic crisis. And obviously that is our biggest fear. Because if advertising and liquidity both plunged at the same time in Italy, Mediaset would have problems. So that answers the debt question. It’s a real concern.
The option of issuing equity is easy to answer. We don’t want them to do that. Mediaset’s equity is incredibly cheap – on a price-to-sales, price-to-cash flow, etc., basis – compared to TV companies around the world. In fact, Mediaset’s own Spanish subsidiary (which is publicly traded) trades at a much higher price.
Therefore, the issuing of shares – even if it were possible – would be terrible for investors. We wouldn’t want to see that.
I’m not concerned about the spectrum auction idea. Plenty of failed Italian TV businesses had spectrum. Sky Italia succeeded because it had content. It’s important to have movie rights, football rights, and the willingness to lose a lot of money for the first couple years to enter the Italian TV market. Spectrum is not the barrier I’d be most concerned about. I can’t speculate on whether Mediaset might be harmed through political actions because of its association with Berlusconi.
The process I just walked you through is specific to Mediaset. I followed that process – and asked those questions – based on what the key questions were that would determine my views on Mediaset’s
2. Product Economics
3. Competitive Position
In this case, the key issues are – I believe – just #1 and #4. If you buy Mediaset common stock and the company is later reorganized in some way – through bankruptcy, dilution, etc. – you obviously paid too high a price. Likewise, if Mediaset’s competitive position (versus Sky Italia) deteriorates horribly within just five years you have a problem. And if Mediaset fails to survive the next five years you have a problem.
I think it passes the product economics and competitive position tests easily. And, obviously, if Mediaset doesn’t have to raise capital then today’s price for the common stock is definitely low enough. As I mentioned, it’s trading at just six times the average past dividend. Even when you consider the amount of debt – enterprise to average past cash flow is fine.
So all the questions revolve around whether Italian advertising will recover and whether Mediaset will survive to see that recovery. The fixed nature of Mediaset’s costs were a key part of that concern.
So you do need to know things like what state the Italian advertising market is in, whether that is cyclical or permanent, how fixed a TV network’s costs are, etc.
All of these things are easy to find out once you know what questions to ask. So the problem isn’t finding the information you need. The problem is knowing which questions to ask. That is always the hardest part.
The best way to fix this problem is to be completely focused on one stock at a time. Once you find a stock you think has promise you should devote all your investing time to understanding that business.
Most investors don’t do that. They look at a lot of stocks for short amounts of time. They pay attention to what the market is doing. They follow a lot of investing news. They worry about where the euro is headed, etc.
All you need is a good system for finding promising stocks. And then the determination to focus exclusively on a promising stock once you find it.
It’s impossible to learn everything you need to know about a stock unless you have a single-minded focus on that one business. If you can maintain that focus, it’s really easy.
I know it still sounds hard. But it’s really no harder than what reporters, biographers, etc., do every day. Once you have a topic to focus on you can come up with questions, follow leads, etc.
There is no standard format for doing this. Each stock is unique. So the research process you end up following is also unique.
Ask Geoff a Question!