In this series, we’ve asked Covestor managers: “What is the single most important lesson you’ve learned about being a successful investor, and how do you try to apply that today?”
Author: Cheng Yuan
Covestor model: Value with Catalyst
The single most important lesson I’ve learned is that knowledge reinforces conviction. And research begets knowledge. I find the most effective investors possess an advantage over average investors because they are more resourceful. Their research skills and tools can help develop crucial insights that ultimately plant the seed of conviction towards a position.
Research is not as simple as poring over SEC filings. It’s also reading between the lines to glean the telltale signs of the progress or deterioration of a business. It’s identifying the key risks that would determine whether a business will survive a bad patch or head for the morgue. It’s finding the catalysts that will eventually unlock the value currently shrouded by distractions. The 10-Ks don’t tell you this.
10-Ks report the past. But investors need to look into the future. Therefore, you need to look for information that is not present in regulatory filings to get an idea of how the future’s going to look.
There is no one source that provides such information for all industries. Each industry will have its own source for statistics. Each business will have its own group of competitors.
For example, if you are investing in a bank, you’d want to look at Call Reports that banks must file with the Federal Financial Institutions Examination Council [FFIEC]. These reports will tell you the detailed breakdown of loans, deposits, allowance for loan losses and non-accrual loans. The Uniform Bank Performance Reports [UBPR] tell you how the bank compares to its peers. If the bank is under cease and desist written orders, you may want to read the written orders to understand the material that regulators are concerned about, and what the bank can and cannot do.
If you are considering investing in a biotech stock, you may be more concerned about the efficacy studies in past phases and the track record of current management.
I don’t think I can attribute this lesson to any particular individual or event. I believe it’s simply the result from reading the works of other investors I respect. I don’t mean the gurus. I mean the anonymous individuals who are happy to share their research because they have conviction and are therefore prepared to defend their ideas. The wealth of information their analysis contains can be enormous.
Such curiosity prompted me to figure it out on my own. This eventually led to the eureka moment. Since then, I’ve mustered the courage to venture into research on my own where research by others is not readily available. It all boils down to finding the answers to your appropriate questions.
What are the challenges to applying this lesson in your current investing?
Oftentimes it’s helpful to admit inferiority when it comes to investing. I acknowledge that on my own I’m not the best stock picker, nor am I a top researcher. On top of that, I’m not a full time investor. Fund managers often have a team of analysts to identify potential investments the manager can decide on. I can’t afford that luxury.
Fortunately, much like the open source community in technology, the financial community is often very willing to share. So I start with publicly available, rigorous research. I verify the claims in their research then conduct additional research on my own to confirm or disprove a thesis. Like the 10-Ks, reading an analysis alone is insufficient to build conviction towards an investment idea.
I also source my ideas from 13D filings of well known investors. In cases like these, I often need to attempt to reverse engineer the reason those investors hold a position in the investment.
Regardless of how I sourced my ideas, I then read up on anything that relates to the prospective investment. The more I read, the more clues I find. I start with the latest 10-K to bring myself up to speed about the business. From there, I come up with several questions that I believe are key to establishing an investment thesis. This could range from the supply and demand of the product sold to the data that can help me assign a value to properties owned by the company. Company presentations often offer a quick summary of the value that management believes can be unlocked in the future, though one does have to take managements’ words with a grain of salt. Often, reading peers’ presentations can confirm whether management claims are indeed valid.
I like to read all the press releases and news articles I can find about the company. Sometimes these articles offer clues to other avenues for answers. I also enjoy reading biographical articles about management which can speak to management’s track record and occasionally their follies. Earnings call transcripts also provide some color on the candidness of management when they discuss their mistakes in the past. The spontaneity of tough questions can put them on the spot and hint at both trouble spots for the company.
For example, if I’m considering a natural gas producer I’d look for the future supply and demand characteristics for the geographical area the producer operates in. The overall depletion rate of the industry in that geographical area may yield some clues about the supply-demand imbalance. It is also important to understand that an investment in a commodity producer often translates to a macro call on the price of the commodity. Again, in such situations, I try to read expert opinion from the industry to gain insight.
The biggest challenge to apply such extensive research to a potential investment is the management of time. I’m a one-man show. I don’t have the time or energy to follow more than 15 companies at a time. This forces me to concentrate on just a handful of positions.
A concentrated portfolio demands high conviction towards every idea in the portfolio. Any error is bound to scar. Such an undesirable consequence helps me focus on the risk of loss before considering potential gains. Extensive research is of utmost importance. The amount of effort I put into the investment prompts me to demand greater conviction in my valuation analysis. But of course, downside potential always remains.
