Someone emailed me this question:
“One thing I was wondering about was how you conduct industry research? Do you study industries in a general sense (if so, where do you find the info) or do you just accumulate industry knowledge by reading a ton of 10-K’s and Annual Reports across a given industry group?”
When I research companies, I do it in groups. For example, say I’m only interested in American Express (AXP, Financial) and Discover (DFS, Financial) right now, because they are the only credit card stocks that look cheap. MasterCard (MA, Financial) and Visa (V, Financial) look too expensive. I’m not saying that’s true. This is a hypothetical. But, it illustrates my point well. Some investors would just read about American Express if they knew American Express was the only stock in the group they might buy. I don’t do that. I’d research American Express, Discover, MasterCard, Visa, and maybe one other peer at the same time. In big industries, I can’t research everything out there at once. But when Quan and I were writing the newsletter, our standard routine was to pick five peers for every company we analyzed. Doing that required us to always come up with the five public companies that were most similar to the one we were interested in. This provides a list of future candidates for investment. It also gives you a way of learning about the industry.
We picked two different MRO distributors – Grainger (GWW, Financial) and MSC Industrial (MSM, Financial). We also looked at Fastenal (FAST, Financial) about as seriously as those two. So, what I know about the MRO industry really just comes from reading the 10-Ks, investor presentations, etc. of those three companies. We researched each of the three as serious stock ideas. We only picked two of the three. We never picked Fastenal. But, looking at Fastenal helped us understand Grainger and MSC.
This approach was very useful in looking at banks. It was difficult for Quan and I to start picking banks, because these stocks were different from other stocks we’d looked at in the past. We needed a whole different way of estimating the earning power of these companies. It became easier to analyze banks as we went, because a lot of these banks are a lot like each other. One of the first banks we wrote about was Frost (CFR, Financial). One of the last banks we wrote about was Bank of Hawaii (BOH, Financial). Frost and Bank of Hawaii are pretty similar. I like Frost a lot more than Bank of Hawaii. But they both make money in much the same way. Most of the Excel sheets, ways of appraising the company and possible risks were really the same at the two banks. It was easier to write about Bank of Hawaii because we’d already written about Frost. Now, Bank of Hawaii is in Hawaii and Frost is in Texas. So, Bank of Hawaii and Frost aren’t competitors; they’re peers.
The easiest way to motivate yourself to do serious industry research is to actually believe you might buy these other stocks one day. So, if there’s a decent chance you might one day buy MasterCard or Visa at the right price, it’s going to be easy to do great research on American Express’s peers. But, if you don’t see any way you’d ever buy any credit card stock except American Express, then it’s harder to motivate yourself to put in the work. So, it was easy for us to do industry research in banks. I knew I might actually one day buy Frost, Prosperity, BOK Financial, Commerce, UMB Financial and Bank of Hawaii. It was easy to put in the time to learn about those companies. Likewise, it was easy to put in time researching MSC Industrial and Fastenal when we were writing an issue about Grainger. Knowing I might, at the right price, be willing to invest in either MSC or Fastenal made that research easy to do.
It’s harder when you are researching peers you know you will never get the chance to buy. For example, we wrote an issue about Progressive (PGR, Financial). In the direct channel, Progressive’s closest peer is GEICO. The company’s second closest peer in the direct channel is USAA. These aren’t standalone publicly traded companies. So, I was never going to get the chance to buy either GEICO (a Berkshire Hathaway company) or USAA. I also knew that I wasn’t going to buy stock in other insurers that had a very different business model like Allstate or State Farm. Researching Progressive’s peers was more of a slog compared to researching Grainger’s peers. When researching Grainger, I knew I might turn up another good stock idea or two in MSC and Fastenal. When researching Progressive, I knew this was impossible. My research would either convince me to buy Progressive or not. It wouldn’t lead me to any other great stock ideas. So, I’ll admit it’s tougher to motivate yourself to do the same level of industry research when the other companies in the industry aren’t viable potential investment opportunities.
I still try to do it, though. Quan and I wrote about Village Supermarket (VLGEA, Financial), which operates Shop-Rite supermarkets in New Jersey. The stores are pretty big, averaging more than 60,000 square feet. And almost all of them are located in New Jersey, the most densely populated state in the U.S. The closest peers for Village were other Shop-Rite operators (which aren’t public), Wegman’s (which isn’t public) and maybe Kroger (KR, Financial), which is public. Quan and I also tried to learn as much as possible about Publix. That company isn’t publicly traded either. There were a few previously publicly traded supermarkets that might have been decent peers. We usually didn’t include a lot of information about companies that were no longer publicly traded in the actual issues of the newsletter we did. But, it’s something we looked at.
A lot of supermarkets get acquired by bigger chains. Therefore, it can be helpful to see what multiples different buyers paid for the chains they acquired. This wasn’t directly applicable to Village, because Village is part of a co-op (Wakefern) that controls the Shop-Rite name. An acquirer couldn’t really buy one Shop-Rite operator and integrate it into their operations in the same way they could acquire other chains. So, the value Village would have to an acquirer like Kroger could be less than you’d think. Of course, the value to a financial buyer who didn’t want to change the way the business was run wouldn’t be different than you’d expect. It might still matter what different buyers had paid for supermarkets with strong positions in other parts of the country. We certainly looked at all the deals that had been done in the supermarket industry in the last 10 years or so.
Let’s assume you want to take this same approach to industry research. First, you find a stock you might be interested in, and then you do your best to seriously research all the publicly traded peers you can find. If you’re interested in Omnicom (OMC, Financial), you’d also research Interpublic (IPG), Publicis (a French company), WPP (a U.K. company) and Dentsu (a Japanese company) at the same time. There are other companies you might want to look at, too. It would depend on how interested you were in different parts of the business. But there are companies out there like Havas, Saatchi and Brainjuicer, too. Some of these are a lot less comparable to Omnicom. But the best way to learn about some specific part of a big, complicated business is often to read everything you can about a smaller, simpler business doing the same thing.
Let’s go back to that American Express example. In some ways, American Express is actually pretty complicated. The company has more of a fully integrated approach than some of its competitors. Although MasterCard and Visa are huge, they aren’t doing as much in each transaction as American Express is. MasterCard and Visa have a different focus than American Express. Discover also has a different focus. This will come out clearly in the investor presentations and the earnings calls. Analysts will zero in on those parts of the business they think will most influence the earnings estimates they will come up with for the company. The downside to this is that earnings call transcripts often aren’t that useful. Using the American Express example, analysts may be really interested in co-branded deals like the Costco deal that American Express lost. This won’t be of much interest to a long-term investor.
I remember this issue when I was looking at Omnicom (OMC, Financial). Analysts were very interested in whether (and when) Omnicom would lose the Chrysler account. At the time, this might have been Omnicom’s single biggest account. I don’t remember exactly. But, it’s not important. Because I can definitely tell you that Omnicom’s single biggest account wasn’t actually that big when compared to the entire company. Omnicom was never going to lose 30% to 50% of its business by losing a single client. It might lose 3% or 5%. But then it might be in a better position to win business in that same industry. And, of course, the overall increase or decrease across all clients is often 3% to 5% in a year anyway. Just the cyclical nature of the business could disguise the loss of a big client.
This is why I don’t find earnings calls as useful as investor presentations. 10-Ks are great. Earnings call transcripts are sometimes useful. But, if you’re only going to read one document from each company, read an investor presentation from each of them. If the companies in the industry are all large and publicly traded, they may all have done an investor presentation at some time. I strongly recommend you download an investor presentation – the most recent one is fine – from each of the publicly traded companies in the industry. They are short. They are easy to read (they’ll be in slide form). And they’ll often have some data about the company’s own market share and the market share of competitors. They’ll also have data on sales by geography and sales by product categories. This can help you get an overview of what each company in the industry does. How are their business models different? What are their relative strengths and weaknesses? What do they each focus on?
Of course, the most important information is what the management of all the companies agree on. If they all agree price is important or delivery speed is important or something like that – you can bet that’s true. They will all try to paint a rosy picture of the industry. And they will usually try to paint an especially rosy picture of their company relative to competitors. That kind of information isn’t going to help you much. But, the more you read about all the companies in the industry – the less you’ll fall into the trap of only focusing on what management is telling you. You’ll be able to see the other side of what they’re doing and why they might be doing it.
This is especially true when you are looking at companies who have different business models. If you just look at Visa or MasterCard, you won’t have a very full picture of the industry. But, if you pick either Visa or MasterCard and then American Express and Discover to look at - now you’re going to be reading a lot of talk about which business model is better and why. This will help you get a complete picture of what each business model is really all about. The important thing is understanding the different business models. It’s not about deciding which is best and which is worst.
For example, Quan and I researched Fastenal, MSC Industrial Direct and Grainger. We never came to a conclusion about which of those three business models is best and which is worst. But we came away with a much better understanding of each of the three companies because we studied the other two peers at the same time.
My advice on industry research is not to do it. Always think of an industry as a group of individual companies that you can study. Don’t think of the industry as this big, amorphous blob. Instead of trying to research the credit card industry – research Discover, Visa, MasterCard and American Express all at the same time. You can learn about an industry without ever having to do research apart from a specific stock. That will keep you motivated. It will keep you engaged. And it will keep you focused – not just on a specific industry, but always on a specific stock you might one day buy if it gets down to the right price.
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