I had the pleasure to sit down and discuss my value investing journey with a group of friends earlier this month. During the conversation, one of them asked this great question: “So how do you know that you have generated differentiated and better insight?”
It was such a wonderful question that I had to pause a bit to think about how to answer it. Today’s article is an elaboration of the answer I provided.
First, for us to generate different and better insight, we have to know what the most popular and average opinion is. There are various ways to find out; we can read the news headlines, GuruFocus articles, sell-side reports, etc. Most of the time, you can find what I call the most common first-level information and opinions. It doesn’t take much time to generate first-level insight.
Second, we cannot generate better insight if we do not want to spend the time and effort. A question I have been asked several times before is: “How can I have better insight without spending much time and effort?” My answer is usually: “Well, do you deserve to have better insight with that mindset?” It is sort of like asking Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio), “How can I be as rich as you guys but only faster?”
Which leads to my third point. For us to generate better insight, we have to do at least two things: we have to know more about the business than most people, and we have to think deeper than most people. How can we know more about the business than the other, say, 80% to 90% of investors?
One approach is to study the whole ecosystem and see where the business stands in the value chain. For instance, with the drug distributors Amerisource Bergen (ABC, Financial), Cardinal Health (CAH, Financial) and McKesson (MCK, Financial), if you just study the three of them, you might think you know what’s going on in the industry. But it’s not until you study the pharmaceutical companies, the drug stores, the pharmacy benefit managers and the managed care companies that you can really appreciate the dynamics of the industry.
How can we think deeper than most people? Well, we have to keep asking why. With each answer to the “why” question, we get a level deeper. And there are many angles you can ask questions from. With the drug distributors, you can ask: “Why has Amerisource Bergan outperformed McKesson and Cardinal? Why have the margins declined over time? Why do they make more money from generic drugs and independent pharmacies?" Sometimes you may not find the perfect answers to those questions, but thinking about them will help you generate better insight.
Another point I made was how we know when we have generated better insight. First of all, you have to understand the business. And how do you know you understand the business? Well, a tell-tale sign you understand the business is when you listen to management talk or when you read sell-side report, you understand everything. Very often when we listen to conference calls or when we read research reports, we have very little idea about some of the key terms in the industry. I certainly experienced that many times with my journey in DaVita (DVA, Financial). Once we understand the business, we start again with the consensus. If we agree with the consensus or just state the consensus as our opinion, by default we do not have better insight. So we have to have supportive evidence that our opinion is different from the consensus. But being different is not enough, we have to have better opinions. If you can point out why the consensus is wrong and what evidence you have that makes you right, then you may be on the right track to generating better insight.
You can also generate better insight if you only focus on one sector, such as tech or health care. I have friends working in both fields. Because they are so focused and involved in all stages of investment from angel round to public markets, they know a lot more about the industry that non-sector-focused investors.
Last but not least, sometimes by exploring areas nobody else is, you can generate great insight. The microcap space, for instance, is full of companies that few investors follow. If you know a lot of under-discovered microcap gems, you can say you have better insight in that space. Ditto to spinoffs, reorganizations, recapitalizations and other types of special situations.
