How much research and analysis is sufficient before buying a stock? This is a problem that every investor has to grapple with, but unfortunately, there's no clear answer. It varies from investor to investor.
On the one hand, before investing in Coca-Cola KO, Warren Buffett (Trades, Portfolio) reportedly read 100 years of the company's annual reports.
On the other hand, Mohnish Pabrai (Trades, Portfolio) has said that he could spend a few hours looking at a business before deciding to buy. Pabrai prefers "no-brainer" value style investments.
How much is too much?
According to Seth Klarman (Trades, Portfolio), the anser lies somewhere in the middle. In his book, "Margin of Safety," Klarman opines that while the level of extensive due diligence performed by some investors is "admirable," it has two fundamental 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."
He went on to explain that while fundamental analysis is a critically important part of the investment process, information gathering "generally follows the well-known 80/20 rule." This rule suggests that 80% of the available information about any investment is gathered in the first 20% of the time spent researching.
Klarman also listed some other reasons why excessive information gathering is subject to diminishing returns. For example, information is not always easy to obtain. Some companies even "impede its flow," Klarman stated. He noted that some information is proprietary and must be kept confidential.
Further, Klarman noted that "business information is highly perishable." Investors are always looking through the rear-view mirror when analyzing a company's financial information. We only have historical statements to analyze, and these are published several weeks after the end of every accounting period.
Not only do investors have the challenges above to consider, but they also have to contend with other market participants:
"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."
It's all about the journey
These are some of the problems investors face when it comes to researching opportunities. Unforatunly, there's no one-size-fits-all solution to the question of how much research is too much or too little. Investors need to make their own decision on this front. Klarman concluded the discussion on the topic in his book with the following statement:
"The research process itself, like the factory of a manufacturing company, produces no profits. The profits materialize later, often much later, when the undervaluation identified during the research process is first translated into portfolio decisions and then eventually recognized by the market.
In fact, often, there is no immediate buying opportunity; today's research may be advance preparation for tomorrow's opportunities. In any event, just as a superior sales force cannot succeed if the factory does not produce quality goods, an investment program will not long succeed if high-quality research is not performed on a continuing basis."
To me, Klarman seemed to be suggesting that it's not the initial volume of research that matters, but the duration. The initial research may identify an undervalued opportunity. However, this may change over time. The business world is fluid and ever-changing. What was true today may not necessarily be true tomorrow.
The only way to keep up with the fast-moving market is to remain vigilant and spend time updating your figures and forecasts based on the information available at the time.
Disclosure: The author owns no share mentioned.
Read more here:
- Seth Klarman on Ebitda and Why Investors Shouldn't Use it
- Mohnish Pabrai Sells Stocks That Are 'Too Hard to Analyze'
- Warren Buffett's 4-Step Investment Checklist
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
