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Thomas Macpherson
Thomas Macpherson
Articles (193)  | Author's Website |

Asking the Right Questions

Having access to great data is only half the battle. Asking the right questions is critical to outperformance.

The battleground is no longer having access to information. That was yesteryear’s investing. Today’s investing in the 21st century is about asking the right question. You’re no longer going to be a good database. You’re going to be a good search engine. The answers are there to be found. It’s the right questions to ask. That’s how we differentiate ourselves as well. We’re not looking for information. We’re looking for insights. “ – Rupal Bhansali[1], CIO, Ariel Investment International Equities

In the original British version of "House of Cards," the Chief Whip Francis Urquhart tells a reporter, “Perhaps we should start by asking some questions.” While things didn't work out so well for the reporter Mattie Storin (you can find the original series here), Urquhart went on to become prime minister.

I bring this up because over the years I’ve realized having access to good data is only half the battle. The ability to ask not only good questions – but also the right questions – makes all the difference in your investment performance. I wish there was any easy way to develop these questions, but there isn’t. An enormous amount of work is required to obtain the data, devise the right criteria, understand what you are looking for and obtain insights valuable to your investment process.

An example of asking the wrong questions was the performance of privately held Spoonrocket – a meal delivery vendor in California. According to a recent Bloomberg article, investors in the company never thought to ask the company about its last financial statements that were creative (and I’m being generous here) to the point of nonsensical. As an example, the company "failed to achieve profitability by conventional definitions" but was "contribution margin positive." This latter statement simply meant they made money if they excluded "costs of customer service, central employees, office rent and marketing to drivers.[2]" While the company showed remarkable growth and customer service, it might have been helpful if someone had simply asked, “Can you make money with this business?”

Spoonrocket shut down in March and sold some assets to a food delivery company in Brazil. Profitable indeed.

While it may be hard to develop industry- or company-specific questions, I’ve found there are some broader questions that are simple go/no-go in the decision to further investigate. These questions may not require a lot of technical ability, but common sense and intellectual curiosity are a prerequisite. More money has been lost by emotional failures and intellectual laziness than by any other means. Here’s my list of essential questions as you begin to evaluate a potential investment.

What is the company worth?

It is so easy to lose sight of this as a northern star, but it’s probably the single most important question you can ask as you get started. No matter how you come up with it – price/book, price/earnings, dividend discount or discounted free cash flow – estimate a value for your investment. We avoid companies that have business models that we can’t estimate profitability (ever wondered why it’s so hard to estimate the value of a company with no earnings or free cash flow?), financials so obtuse it’s impossible to understand (Enron comes to mind here) or proprietary technology and operations that can’t be shared (I’m looking at you, Theranos). If you don’t know how to value a company, then it clearly doesn't fit inside your portfolio.

Do I fully understand how the company makes money?

It seems like a relatively easy question, but it’s surprising how few investors can answer this question about their holdings. For instance, many investors will tell you pharmaceuticals’ main customer is a physician. Actually, pharmaceuticals have no business or financial relationship with a physician beyond providing free samples or paying thought leaders to speak on their behalf. Pharmaceuticals manage the actual distribution of drugs from manufacturing facilities to drug wholesalers – and in some cases directly to retail pharmacy chains, mail-order and specialty pharmacies, hospital chains and some health plans. They have no relationship with managed care companies, patients or almost all employers. If you don’t understand how your potential investment makes money, then don't make it an actual investment.

Will the company be as successful 20 years from today?

The concept of having a wide moat means it will take considerable time and treasure for a competitor to make inroads against your investment’s products and services. We are all relatively clear on what Coca-Cola (NYSE:KO) will be doing for business 20 years from now (though there were moments when clarity was lacking – like the time it acquired a shrimp farm), but how clear are we when it comes to Building 19[3] (“Good stuff ... cheap”)? The latter isn't really an option (it filed for bankruptcy several years ago), but what about a company like Lexmark (NYSE:LXK)? Could you really – with a real sense of security – predict what Lexmark will be doing in 2036? If you can’t come up with a concise and confident answer within 30 seconds, it doesn't belong in your portfolio.

Are my data inputs valid and well reasoned?

This is a relatively subjective question but still critical. The easiest person to fool in investing is yourself. The ability to obtain multiple data sets, understand their sources, work out any assumptions and assure yourself of their accuracy is essential to building great valuation models. Nothing pleases me more than when I can get two completely opposing viewpoints supported by a great deal of data. Rather than seeing that as a problem, I like to see it as a tremendous learning tool.

For instance, I was recently reading two diametrically opposed viewpoints on Nintai Charitable Trust holding Expeditors International (NASDAQ:EXPD). One writer believed the international supply chain was near collapse based on the China slowdown, crash in commodities, increasing competition and pricing pressure. The other highlighted EXPD’s operational strength, deep industrial relationships, outstanding management and slow (but upward) international growth. Who was correct? I think they both were in some ways. In both articles the data was well founded/researched, and the arguments provided a tremendous resource in my investment education.

How do I break my investment case?

In a recent article (you can read it here) I discussed the importance of getting to zero or “breaking” your investment case. In most cases when I calculate an estimated intrinsic value through my discounted free cash flow model, I will halve the companies one-, five- and 10-year free cash flow growth estimates. After reviewing the impact on valuation, financial strength, etc., I halve it again.

Why do this? To me it’s a simple – and ruthlessly effective – tool in creating a scenario that tests the financial limits of a potential holding. As an example, CBOE Holdings (CBOE) – an NCT holding – has grown free cash flow by 14.3% annually over the past five years. What would the impact be on my valuation if growth was halved to 7.1%? Or halved again to 3.5%? Does the company have the financial strength to handle such a catastrophic event? As you run such models you find there aren’t that many companies that can take such an event in stride. Those that do qualify for further research at the Nintai Charitable Trust.

Conclusions

Asking questions that give you out-of-the-ordinary insights is far more art than science. Much like trying to figure out the best query on Google (how many times have you heard someone say “I’m a terrible searcher”?), investors need to really think about what they are trying to solve and then develop the best questions to obtain helpful insights. In the last 20 years the world has flattened considerably when it comes to finding investment research. GuruFocus is something Warren Buffett (Trades, Portfolio) would never have dreamed possible starting out in his father’s brokerage house.

But data is slowly becoming a commodity. Insights – ones that give an investor a true advantage – are much harder to come by even with all of today’s technology. If you can create a handful of core questions that provide insights into a value-based investing model, then you are half way home already.

As always I look forward to your thoughts and comments.


[1] Her full interview can be found at www.latticework.com

[2]Tech Startups Come Up With Some Creative Definitions for ‘Profitable”, Bloomberg, Ellen Huet, May 15th, 2016

[3] Anybody who grew up in New England will realize this is an actual example along with Building 19¼ and 19½.

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About the author:

Thomas Macpherson
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chairman of the Board at the Hayashi Foundation, a Japanese-based charity serving special needs children and service pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

Visit Thomas Macpherson's Website


Rating: 5.0/5 (11 votes)

Voters:

Comments

Dr. Paul Price
Dr. Paul Price - 4 years ago    Report SPAM

You've got to have a feeling about 'worth' to know if a stock is a buy, sell or hold.

Many articles fail to even mention an assessment of where their recommendations should be trading.

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Thanks for your comment Paul. It never ceases to amaze me how few people actually think of price and value when it comes to investing. Though we shouldn't complain I guess! Thanks again for your comment. Best. - Tom

batbeer2
Batbeer2 premium member - 4 years ago

Hi Thomas,

You say:

>> Asking questions that give you out-of-the-ordinary insights is far more art than science. Much like trying to figure out the best query on Google (how many times have you heard someone say “I’m a terrible searcher”?), investors need to really think about what they are trying to solve and then develop the best questions to obtain helpful insights.

I say:

Yes!

I would add that thinking about the right questions beforehand is enormously helpful in making the actual research proces much more effective. With specific/smart questions in mind for a given company, it becomes much easier to read a stack of 10-ks.

I would argue that it becomes fun to read a 10-k if you are asking the right questions. But that's me :o)

Thanks for sharing.

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago
Hi Batbeer. Thanks for your comment. I am ashamed to admit it, but I too find it fun to read 10-Ks
jasonfrey33
Jasonfrey33 premium member - 4 years ago

I appreciate all your articles. Expeditor's International is one of my favorite picks in the current market. Their ability to focus on long term results is appealing and I find the valuation attractive, especially in this elevated market.

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Hi Jason. Thanks for your comment. We have owned EXPD since 2004 and will likely own it far into the future. I completely agree with you comment about management keeping a long term focus. We consider them one of our top capital allocators in the portfolio. Thanks again for your kind note. Best - Tom

rherion7
Rherion7 - 4 years ago    Report SPAM

Hello Thomas, It was great meeting you at the GF value conference. Great article, so much of the success in investing is just keeping to the basics.

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Hi Randall. It was a pleasure to meet you as well. Hope you enjoyed the presentations. Happily the demands for successful value investing (as Thoreau said, "simplify, simplify, simplify") align with my relatively limited intellectual capabilities! Thanks again for your comment. Best. - Tom

rherion7
Rherion7 - 4 years ago    Report SPAM

I enjoyed your presentation immensely, although healthcare and biotech are not in my circle of competence. The "simiplify, simplify, simply" thesis is what has made me think I could continue to succeed at investing.:)

snowballbuilder
Snowballbuilder - 4 years ago    Report SPAM

"Happily the demands for successful value investing (as Thoreau said, "simplify, simplify, simplify") align with my relatively limited intellectual capabilities!"

Great quote Tom ;) you are smart umble and funny

Making the right questions , keeping it simple, staying in our circle of confidence, have the stomach to be unpopular and the stomach and mental stability of doing nothing until something is really worth doing .

Let the champions compound for years to take the full benefit when a business is growing soundly (a 2x can became a 10x) and the umility to cut the losses when you have made a business error .

The big money are in sitting on. Have a good day. Best Snow

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Hi Randall. Glad you found the presentation interesting. My next article will be about Wall Street's expectations on pharmaceutical sales versus market realities. I hope you find it interesting. Thanks again for your comments. Best. - Tom

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Hi Snow. Thanks for your comment. The older I get the more I agree with your assessment - patience, emotional fortitude, and simplicity are 90% of the battle. Having the humility to acknowledge your mistakes is also vital to acquiring new knowledge. Thanks again for your comment. Best - Tom

Zejia
Zejia - 4 years ago    Report SPAM

Hi Tom,

Great article as always. What comes into my mind is how to ask insightful questions to the management team. To me, asking the questions about the company' long-term prospects are the "right" questions. But it's easier to say than done. I would be very interested to see whether you can elaborate this with some real-life examples,e.g. How Nintai ask questions to the management team of your investment. Thanks, Zejia

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Hi Zejia. Thanks so much for your comment. I will write an article on how we approach management and what questions we ask. Hopefully I can write it this week and get it out on GF. To answer your question will take more than a simple comment. Thanks again. Best - Tom

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