I've often stressed how vital rigorous, detailed research is in the investment process, particularly if you are managing an extremely concentrated portfolio.
While I have mentioned several times the importance of research, I have never really outlined a good research plan.
The reason why is quite simple: There isn't one.
Every investor is different
In my experience, every single investor has a different way of conducting due diligence on opportunities. The research process is shaped by years of experience and learning. For example, when looking for companies to add to my portfolio, I tend to avoid businesses with high levels of debt. I also want management to have skin in the game as, in my experience, this reduces the risk that they will make risky acquisitions or put the business in a position where its future is jeopardized.
I was recently speaking to a fellow value investor who didn't have the same opinion of insider ownership and debt. In fact, they had precisely the opposite view. They were more than happy to buy companies with a small insider ownership and lots of leverage, something I wouldn't be comfortable with based on my experiences.
If you are looking for a shortcut, I'm sorry to say that there is not one. Building a strategy that you are comfortable with takes time and effort. It also takes losses. You learn a lot more from losing money than you do making money as it forces you to concentrate on what went wrong. Only then you can build this element into your strategy.
One point to consider in the research process is that you learn around 80% of your information in 20% of the time. The remaining 20% of the data takes 80% of the time, but it's this level of detail that separates good and bad investors. If you are willing to go the extra mile and search for the information the rest of the market is missing, you will have an advantage.
Time and effort
I would argue that today, with the internet providing as much information as it does, you can find out around 80% of the information you need to know on an opportunity in 5% of the time.
The best place to start is websites such as GuruFocus or Morningstar. Both of these sites will give you a broad overview of the company you are considering, as well as some rough valuation figures and other metrics such as leverage and profit margins. The next stage of the research process is to find out what the company actually does. The websites mentioned above will give you an idea, but if you are serious about investing, you need to take a look at the company's own website and supply chain. If the company is inside your circle of competence, this process will be much easier as you will already have a broad overview on the business (if it isn't, should you be investing?).
For me, the next stage, when I have a broad overview of the business, its valuation and products, is looking for red flags. I think it is essential to uncover red flags as early on in the process as possible because the longer you spend evaluating a potential investment, the higher the likelihood you will convince yourself it is worth buying.
The best way to avoid this psychological bias and avoid wasting time is to look for red flags early on and throughout the company before you have a chance to convince yourself otherwise.
Some red flags to consider are: Is the business at a cyclical peak? Is the level of debt on the balance sheet unsustainable? Are there any derivatives on the balance sheet; if so, why? What is the profit to cash conversion ratio? Is the company underspending on capital projects? Is management empire building (are sales increasing but return on capital falling)?
This is not an exhaustive list; it is only designed to give an idea of some of the red flags I look for.
The next stage of the process is finding the final 20% of the information. I read through the company's conference call transcripts and look at investor presentations to improve my understanding of the business, where profits are coming from and what it is doing to enhance future growth. Next up, Securities and Exchange Commission filings. I usually skim through these filings in the red flag stage of the research process, but this will be a more in-depth look at each business.
Throughout the research process, I will be taking notes on the company, building the investment case and highlighting key points to revisit. For example, in 2016 the company said it will do X by 2018, has it?
Finally, when I have learned as much about the business as possible, I will try and determine a valuation. By this stage, I will hopefully know enough about the company to be comfortable computing an intrinsic value. If not, and there's something I can't understand, even at this late stage, the investment idea could be thrown out.
Conclusion
So that's the process I use. It is shortened for the sake of brevity, though it does give a broad overview of the steps I take. As mentioned above, every investor will have a different approach.
