Research process

Many investors, when asked to define their research process, say something along the line of, Oh, I just read through the SEC filings, earnings transcripts, listen to other investors, and so forth, and then I just try to make sense of it.

Aspiring analysts deserve more than that.

Of course, there’s a process. Perhaps it changes in each case and it may be hard to define, but every analyst generally follows a definable road to insight even as they may not recognize it. Especially when the company is outside their circle of competence and they’re trying to expand that circle of competence.

A well-defined process can push through that point when you’re at the frightening gate of making sense of something new and the imposter syndrome whispers in your ear that you should just give up.

There’s nothing wrong with being the dumbest guy in the room full of specialists. Enjoy stepping into the things you don’t know about since that’s where you’ll find the steepest learning curve. Knowing the most details on any subject isn’t even necessary in investing. The analysis paralysis you get from swimming into minutiae may hinder your ability to make intelligent decisions.

But you must pursue intellectual honesty; the ability to recognize when you haven’t collected enough of the puzzle to do something about it. Charlie Munger has said: “I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do.” >97% of what you study likely shouldn’t lead to a decision. Picking stocks may be the end goal but increasing your knowledge about a variety of businesses and industries, or collecting case studies, should be your focus.

A recommended process

Step 1: Assess whether this stock is something you are willing to dive into

Think about studying stocks like reading books. The best book-reading strategy is to skim a lot, read a few, and re-read the best ones. The stock market is an ocean and getting to an investing decision likely requires you to read through hundreds, maybe thousands, of pages about a company through legal filings, transcripts, interviews, articles, and so forth. Make sure that your time and interest in the subject is worthwhile.

Step 2: Read the latest annual report

Skim the annual report and assess whether it’s worth more attention. Then read the full report. The annual report should contain enough information for you to understand the business and what makes it tick. This comes down to whether management has chosen to communicate as a partner or as a salesman. When the latter is the case, try to see through it and continue reading to learn more. Sometimes, however, you won’t understand something because management doesn’t want you to understand it, and they hide it behind gibberish or jargon as if it was mass-manufactured by a consultant. Then you should move on.

Step 3: Mark the turning points in the company’s history

Once finishing the annual report, pick up the prior years’ reports and skim through them. Look for defining events in the company’s history, whether that is a change of strategy, a restructuring, a big write-down, and so forth. Then study how these events relate to what happened to the company’s financials.

Step 4: Mark management changes and tenure time frames

Equally important to the company’s defining events is who ran the company at the time they happened. Relate the given management to the company’s financial history. Look closely at the incentive structure and how management has been compensated, either rightfully or unfairly.

Step 5: Write down questions

You’ll now have a bunch of questions in your head that weren’t covered in the reports. Write them down and let them form the groundwork of your analysis.

Step 6: Build a narrative and add nuance

Take the turning points and questions and flip through articles, earnings transcripts, or anything else on the Internet, perhaps reach out to investor relations, and so forth, to build a coherent narrative around how the company evolved and arrived at its current position.

Step 7: List the entities in the company’s ecosystem

Write down a list of competitors, stakeholders in the value chain, and other entities that are either affected by the company or affect the company in some way. Write down all you can think of to 1) make sure you don’t miss anything and 2) get a bird’s eye view which may help you as I think through the competitive advantages and value creation.

Step 8: Mix the narratives and build a story

Skim or closely read the competitors’ or stakeholders’ annual reports and then shuffle the cards around to see how these fit into the story. The idea here is to gauge what type of market it is, if competition is rational, if profits are abundant for everyone, and so forth.

Step 9: Tell the story in light of mental models

Doing hard work counteracts the natural desire to only seek out information that confirms what you believe. Mental models help you make sure that what you think is coherent with how the world works. Go through a list of mental models to see how the narrative fits with reality.

Step 10: Think hard about competitive advantages

Or, more importantly, think about what advantages they can build up to. You should now know enough about the company to give a qualified opinion on how it can continue or discontinue to create value.

Step 11: Decompose the company into different activities

Think through how each of the company’s activities creates value, either financially or externally in the ecosystem. This is important to do a proper valuation.

Step 12: Read the latest report again

Heraclitus once said, No man ever steps into the same book twice, for it’s not the same book and he’s not the same man. The second time you pick up the annual report, you’ll understand the business on a different level, and reading it again is a different experience. Read just the parts that caught your attention in the first place that you either didn’t understand or that somehow looked important.

Step 13: Go through your investing checklist

Make sure you haven’t glanced over any important issues.

Step 14: Value the company

This step is the easiest. Building a valuation is not hard work; Everything that preceded it was. Whether the valuation model is simple or complex doesn’t matter either. You could build a simple growing owner earnings projection or Gordon Growth-like model, you could build a 3-stage DCF, or you could build a complete unit economics model. The type of model depends on the type of business and they should all yield the same value. What matters is whether the valuation is roughly right and whether you’re confident in your research.

If the company ticks all boxes—it’s a great business, it’s within your circle of competence, it’s one of your best opportunities given your universe of options, and the price is right—you’re free to buy it. If the price isn’t right, place it your my watchlist so that you’re ready to pounce when approaching something reasonable.