In his book "Margin of Safety," value investor Seth Klarman (Trades, Portfolio) discusses how much research and analysis are sufficient before making an investment.
You might think that when it comes to researching stocks, the more you do the better. Some people will spend weeks studying their company’s sector, browsing interviews with analysts and former workers, trying to talk to management, listening in on quarterly earnings calls, reading every SEC filing cover to cover and maybe even looking at how the stock has historically traded.
However, while it is certainly very advantageous to read up on all of these things, Klarman believes that there are a number of problems with going to that much effor.
Remember the 80/20 rule
In "Margin of Safety," Klarman wrote:
“First, no matter how much research is performed, some information always remains elusive; investors have to live with less than complete information. Second, even if an investor could know all of 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 80/20 rule: 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.”
In other words, there are opportunity costs associated with doing more research than is efficient. The more time you spend dredging through that 80% of less useful information, the less time you have to focus on other, potentially more useful things.
Follow the insiders
To make matters worse, that 20% information is often difficult to obtain. It requires the analyst to engage in second level thinking, going beyond the cursory internet search. The best information is usually proprietary and available only to authorised insiders.
Klarman believes that analyzing the behaviour of well-informed insiders management or the board of directors can provide some of the best insights into what is really happening at a business. He writes that investors should look for signs that these insiders are buying stock with their own money (rather than stock options from company compensation plans). Such actions often signify that the business in question is undervalued.
Of course, insider buying is not an ironclad guarantee that a company is undervalued. In some instances, management may have overly rosy expectations. In others, unscrupulous executives may be trying to create the appearance of financial health. In these situations, it is the job of the analyst to think critically about the information that is being fed to them.
Disclosure: The author owns no stocks mentioned.
Read more here:
- The Value Investor's Handbook: Be Approximately Right, Not Precisely Wrong
- Warren Buffett: Why Long-Term Bonds Are a Bad Investment
- Seth Klarman: The Proper Way to Think About Investment Risk
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