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The Science of Hitting
The Science of Hitting
Articles (534) 

Which Companies Should I Research?

Observations play a critical role in selecting investments

January 18, 2017 | About:

In my most recent article, I laid out the framework I use to analyze potential investments.

I hope that article can help the new investor hit the ground running.

In the comment section, one reader shared the following thought:

“Maybe to complete the circle you could do a post about what would make you want to gather all this info on a company in the first place? Building 15 years of financial data, doing the reading, asking the questions, etc., is exhaustive not to mention exhausting. You need to have some kind of hunch that it's worth the exercise. What generally gets you to that point for a company?”

I will try to answer that question with two examples.

Costco

I specifically picked Costco (COST) in my last article because the company has a special connection with its customers. Simply put, the shopping experience is better than what’s offered at competitors like Sam’s Club or BJ's (that’s partly why Costco reports membership renewal rates of roughly 90%).

A quick Internet search shows that employees think highly of the company as well (for example, see this Bloomberg article); you get a clear sense of this as a shopper. A company with happy customers and employees is a good starting point. In addition, Costco’s business model doesn't seem difficult to understand (it sells beer, socks and TVs). Those insights suggest to me that Costco is the type of business that a beginner should look at.

If you follow the outline I laid out in the last article, you’ll notice a few additional items early in your research. On the first page of the fiscal 2016 annual report, management shows financial data for a few key measures (the number of warehouses, net sales, net income and so on). One of the metrics shown is “comparable sales growth,” with the company reporting 4% to 7% growth in each of the past five years. Is that good? This requires pulling competitors' data to see how they stack up on comparable metrics (the answer, in this case, is a resounding yes). We can now draw a relevant conclusion: Costco is selling more to its existing shoppers, adding new cardholders to its legacy warehouses or both; either way, it suggests customers continue to flock to Costco in droves. Apparently people enjoy shopping at Costco (personally, I'm a big fan of the rotisserie chicken). This is incremental data that supports what we’ve experienced as customers.

After this limited amount of work, there’s enough evidence to suggest Costco is worth a closer look. It's worthwhile to spend a few hours on a deep dive into the company's history and financials. Coming to this conclusion required very little in terms of “true” research.

PepsiCo

PepsiCo (PEP) is another company that the aspiring investor may stumble across. My interest in the company was derived from another consumer insight: I looked at the potato chips on the shelves at gas stations and grocery stores. I discovered that most major brands – Doritos, Tostitos, Lay’s, Rold Gold and others were produced by Frito-Lay, a subsidiary of PepsiCo. Dominant shelf space suggests dominant market share, a fact later confirmed through a quick Internet search (what a world!).

This only matters if the business is financially relevant to PepsiCo as a whole; if it only accounted for 5% to 10% of Pepsi’s profits, I would’ve been disappointed. This is where pulling old financial data becomes relevant. Flipping through the 10-K, we can see that “Frito-Lay North America” accounted for nearly 25% of PepsiCo's sales in fiscal 2015 and an even larger percentage of its profits. Clearly Frito-Lay will have a meaningful impact on PepsiCo’s long-term success. As you work backward and plot the segment results for 10-plus years, you’ll see that the track record has been impressive as well. Based on these two conclusions, that’s a compelling case for further analysis. Again, I was able to reach this answer while doing little “true” research.

Conclusion

In each of these examples, I approached the idea through the eyes of a consumer. These conclusions don’t require any understanding of financial statements or how to value a company.

The insights I have as a consumer are relevant to my thinking as an investor. Simple questions can have meaningful answers: Which companies do I enjoy dealing with? Which brands stand out? These questions may point to unique businesses that are worth examining.

This is how I found companies to analyze when I first started. It’s a process I still find relevant today. I’m looking at companies I’m intimately familiar with that have business models that are easy to understand. If I was starting anew, this is the approach I would use to source new ideas.

Disclosure: Long PepsiCo.

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About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 5.0/5 (8 votes)

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Comments

jtdaniel
Jtdaniel premium member - 2 years ago

Hi Science,

I really enjoyed your two articles on this topic. My perspective is that the best stock to research is often one that we already own. I was recently reminded of this while studying several health care-related stocks. While I found a few strong prospects (ESRX, CVS, DVA and Q), a side-by-side comparison process gave me a fresh appreciation for what I already have -- Abbott Labs, Abb Vie and Waters. I entered the process thinking that all three were over-priced, but eventually concluded that I should buy more Abbott and continue to hold Waters and Abb Vie. Best, dj

The Science of Hitting
The Science of Hitting - 2 years ago    Report SPAM

Jtdaniel,

Thanks for the kind words on the articles; hopefully new investors can use them as a framework to hit the ground running. It's hard to go wrong starting with a great company like COST.

For people like us (with a bit more experience), I agree with what you said: there's a lot of value in intimately understanding the companies you're already invested in (as well as their competitors and the industry as a whole). I'd recommend staying away from healthcare in the beginning, only because it's so difficult for the average investor to understand (that includes me), but I see your point.

Personally, the only hope I have of sticking with a name during times of crisis (temporary struggles in the business, stock down 20% or more, etc) is to intimately understand what I own - and why I own it.

Thanks again!

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