Last month I wrote two articles on blind spots in investing – the origin of blind spots and how to deal with them. Since then I’ve received some very good feedback. One of the readers brought up a great point:
“There is no shortage of information about public companies and industries. Too much, in fact. I don’t think the goal should be to connect with anyone until you know which questions to ask. Blind spots don’t come from the lack of available information, but from not knowing what information to look for.
A good follow-up article would be to outline what information you’d look for, if it weren’t already available to the public.”
Here I’ll detail my approach in terms of seeking relative information when researching a company, which is far from ideal. Thomas Macpherson has written some fabulous articles on how he conducts his research, which I recommend again to all. Macpherson’s approach might sound daunting to non-professional investors who don’t have access to the valuable network within a specific industry, but the idea of first-principle thinking is generally applicable.
My view on this topic has definitely evolved over time. At present, I apply a mental model that I call "multiple layers of information" in my research. This mental model was inspired by Charlie Munger (Trades, Portfolio), Li Lu and Howard Marks (Trades, Portfolio).
The first layer of information is somewhat akin to Howard Marks' idea of first-level thinking – it’s very basic and widely available, accessible and retrievable. The non-footnote sections of annual reports, information available on the company’s website, articles about a company, earnings call transcripts, interviews of management team and so forth. These are all important sources of information, but they don’t produce differentiated insights. I try to get a general sense of the business and evaluate the business model from a big-picture point of view.
The next layer of information requires a bit more work but not necessarily access to the right people. This layer might include the following: all the footnotes of the financial reports; annual reports from decades ago if available; articles from magazines or newspapers; industry conference notes and transcripts; Glassdoor reviews; and books on the company, management team or industry.
Here I’m looking to piece together how the company got to where it is today, how management is compensated and motivated, what culture has been instilled throughout the organization and whether management is conservative or aggressive in their accounting. For example, one of the companies on my watch list recently started to make reserves for possible inventory write-downs, which they disclosed in the footnotes. But the management team has been optimistic about the downstream demand. This tells me the management team is either lying about the demand, or fooling themselves. Neither is good.
Details like this sometimes can make me remove a company from my watch list and help me form a preliminary impression about the company and the management team. For instance, I recently read a book about the founder of a snack food company and learned that the founder has failed in many previous careers, like Jack Ma of Alibaba (BABA, Financial). But he persisted and through these failures, he learned much about marketing, sales and human nature. This book was helpful for me to understand why the company became a multi-billion sales snack food company in less than a decade.
The next level of information most likely will require getting access to industry experts and company employees because we have to verify information we read, and seek additional information that’s not available from free public resources, but may be critical in generating different and better insights. I argue that one can know who the right people are to talk to and what questions need to be asked only when one has gathered and processed the first two layers of information.
For instance, an IBM (IBM, Financial) investor might want to speak to multiple IT department senior managers from various Fortune 500 companies, or Amazon (AMZN, Financial) and Microsoft (MSFT, Financial) engineers, to ask whether IBM’s products are competitive. If you are an IPG Photonics (IPGP, Financial) investor, you might want to speak to the downstream customers and find out whether there is pricing pressure and whether the Chinese competitor is taking shares. Thomas Macpherson’s article detailing his research on iRadimad (IRMD, Financial) is a masterpiece in this arena, representing the top level of research in the industry. Here is the list of people Macpherson spoke to (from his article):
- iRadimed management.
- Former competitors like Baxter product associate vice president, executive director, sales directors, technology leads, business managers, research and development, market access, etc.
- Hospital administrators: vice president of imaging, data vice president, MRI ops team, safety council.
- Ambulatory MRI private center: executive director, technical lead, ops manager, technicians, safety coordinator.
- Regulatory: FDA imaging lead, research coordinator, consulting MDs.
- Managed care: senior vice president of imaging strategies, executive director, reimbursement, director, image resources and clinical outcomes.
- Medical research facility: executive director, senior vice president of technology, senior director, image services.
- GE Health: Vice president of research, director of image services.
- Canon Health: senior vice president of market strategies and product development, associate vice president of new technologies.
- Thought leaders: Harvard Medical School, “The Whole Brain Atlas,” Keith A. Johnson, MD, Professor, Harvard Medical School.
- Thought leaders: Greg Freiherr of the Freiherr Group.
- Thought leaders: Eliot Siegel, MD, professor of diagnostic radiology and nuclear medicine, University of Maryland School of Medicine.
- Thought leader: Ezequiel Silva, MD, FACR, chair, American College of Radiology Commission on Economics.
If one has gathered the first three levels of information, they have probably already spent hundreds of hours. Ted Weschler has a “500-hour rule,” which is a good estimate of the least amount of time that is needed to generate any insights on a specific industry. In Macpherson’s IRMD research, after the gathering the first two layers of information,Â “It took approximately 400 hours to talk to a host of individuals and gather any follow up research, including trade journals and professional studies, conferences and peer-reviewed papers.”
In total, I wouldn’t be surprised if Nintai spent 600 to 800 hours on IRMD.
The next level of information is seeking answers to what I call the “really big questions.” Who has failed in the industry before and why? How’s the industry positioned in terms of the dynamics of the changing competitive advantages and comparative advantages of a nation? How does the ecosystem in which the company operates work and what are the reinforcing and balancing feedback loops? How does the company cope with Murphy’s law and the second law of thermodynamics?
Very often there are no definitive answers to these big-picture questions, but it helps to ask them and seek any information that be relevant.
- What threats has Facebook brought to governments all around the world?
- Has Facebook brought dramatic changes to how democracy works?
- Is Facebook incentivized to mishandle users' privacy data?
- How does Facebook handle fake news on its platform? What is management's view of Facebook’s editing responsibility?
- What psychological tricks have Facebook engineers deployed to make Facebook and Instagram behaviorally addictive? What is the underlying design framework of how the “like” button works and how status updates work?
- Is it moral to induce digital addiction?
In the process of trying to answer the above questions, I became increasingly uncomfortable with the company even though advertisers love the platform and the company has generated strong financial results.
Gathering and processing different layers of information is a skillset that might be developed over many years. A value investor in the early stage of evolution using the Ben Graham approach may think only about the first level of information. Over time as one evolves to higher levels of value investing, one would inevitably seek higher levels of information as well. As Warren Buffett (Trades, Portfolio) once suggested, value investors should follow the approach of journalists when researching companies. As I evolve, I resonate more and more with Buffett’s advice. The whole process should be rigorous and sometimes painstaking. But at the same time there’s tremendous joy in reasoning from first principles and finding out why and how things work.
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