As investors, we commonly face the dilemma of assigning time to different tasks, however, given that our time is limited, we need not only to prioritise, but also be very efficient in our research. How much time should we spend on researching companies, and how deep should our research be? In "Margin of Safety,"Â Seth Klarman (Trades, Portfolio) comments upon this and provides us great insights on how to move faster as we do research.
"Some investors insist on trying to obtain perfect knowledge about their impending investments, researching companies until they think they know everything there is to know about them. They study the industry and the competition, contact former employees, contact former employees, industry consultants, and analysts, and become personally acquainted with top management. They analyze financial statements for the last decade and stock price trends for even longer. This diligence is admirable, but it has two shortcomings. First, no matter how much research is performed some information always remains elusive; investors have to learn to live with less than complete information. Second, even if an investor could know all the facts about an investment, he or she would not necessarily profit.
This is not to say that fundamental analysis is not useful. It certainly is. But information generally follows the well-known 80/20 rules: the first 80 percent of the available information is gathered in the first 20 percent of the time spent. The value of in-depth fundamental analysis is subject to diminishing marginal returns. Moreover, business information is highly perishable. Economic conditions change, industries are transformed, and business results are volatile. The effort to acquire current, let alone complete information is never-ending. Meanwhile, other market participants are also gathering and updating information, thereby diminishing any investor's informational advantage."
Here, there are some very important points.
1) Information follows the Pareto rule: Most of the relevant information that we will be able to gather stems from the first 20% of the information we read. That is to say, it is critical to be selective on the information that we read. I would suggest the latest 10-K report to get a good idea of the business and determine if the story is understandable and interesting. After that, we could spend some time on quarterly filings, but generally, the 10-K is a great place to start.
2) Information is subject to diminishing marginal returns: The more we investigate, the less benefit we obtain from the new information. There is also an information saturation, which provokes us to get confused and indecisive, since our brain can only handle a certain number of options and ideas at once.
3) Informational advantages are constantly disappearing: We could debate whether the market is efficient and the degree of that efficiency, but we all recognise that the market is somewhat efficient, and it eventually reflects all available information. That is to say, that an informational edge has an expiration date, and, if not used, will provide no value to our investments, given the constant movements of companies.
4) The way to compensate uncertainty is with low prices: While we must gather and take decisions with imperfect information, the way to compensate for this is with a margin of safety. The bigger it is, the more uncertainty it will protect us against.
Do you have any other recommendations in conducting research?
