HOW TO RESEARCH A BUSINESS:
I begin my research into an industry with a prominent company 10K. The Annual Report, or 10K, is filed with the SEC and is signed off by the CEO and CFO as truthful and compete. In effect, they are signing that the information in the 10K is all you will need to understand this company including its business, marketing, competitors, risks, market position (Moat) and its financials. If the information is incomplete in some material way ... that is if a missing piece of info might have misled me as to the quality of the company ... or if information is wrong, the CEO can go to jail.
Read the ‘Business’ section of the 10K; its only a page or two and it should give you a good idea about what this business is all about. Now, before you even get going on digging into the 10K, reflect for a bit on whether this business is right for you to own. You now know something about it so decide if you think you’d love owning this business. Do you love the products or services? Would you be proud to own the company? Would your family be proud to have their names associated with this business? Would you be happy to change the company name to your name? Does it fit your values? Do you want these products in the world in twenty years?
Those are tough questions for some people when it comes to some industries. Let’s take the oil industry for example; people who believe burning oil and gas is a detriment to the environment and that oil should be replaced at all costs with renewable, clean energy may not be interested in owning an oil company. That’s a values question and only they can answer it. For me, owning an oil company is something I’m proud of. I love flying in jets, driving my car, hauling my horses, heating and air conditioning the house, turning on the lights, using the internet, watching TV, living in a nation with no real poverty and none of that would be possible without oil. Yes, I’d love it even more if I could do all those things using electric engines or solar engines or hydro engines or whatever other clean energy source we can evolve into but for now and the foreseeable future, if the world didn’t have oil, not only would my cushy life be a lot less cushy but its highly likely we’d be in a world war so fast we wouldn’t know what hit us and last time I checked, the last world war was worse for the health of about 80 million people than smog. Those are my values and I’m voting with my money. You should vote your values with your money and you start figuring out how to do that by reading 10Ks.
Start with any prominent company but immediately try to get to the best company in the industry. Most 10Ks will have a section on Competition. Use that to figure out who else to read about. Or just go to ruleoneinveseting.com, put in the symbol of the company you’re starting with, click on the drop down menu and click on Peers. The Peers page will show you all the companies in that sub-industry and give you a quick look at the Rule #1 Scores for the top companies. Pick who you think is best and then dig in.
Read the 10k’s from most recent back to the oldest. You start with the last fiscal year’s 10k because you want to learn the business, as it is today, not how it was 10 years ago. Once you’ve read it and you dug into the numbers and understand them, at least to a degree of competence, then, before you go back to the previous year’s 10K, go over to the company’s website and listen to the last quarter’s analyst report. Between the two, you’re looking to get an overview of the business and a sense of who the CEO is and how he communicates with you about this company.
Here’s the key thing about the 10K and the live quarterly analyst report; they should make it easy to understand the business. If they make it hard to understand either they don’t understand it or it’s too complicated to invest in or they are intentionally making it hard so they can cover up problems. All three of those are good reasons to move on. Don’t mess with ‘complicated’; find a business run by people who understand it and who are honest about explaining what’s going on. And never feel like not getting it is your problem. It isn’t. Investing is never about being a lot smarter than other people. If that were the case, all those fund managers who can’t beat the market would be killing it and many of my students would still be broke.
Investing (as opposed to speculating) starts with understanding a few things well and sticking to those things. Warren Buffett calls that notion his ‘circle of competence’. Part of this process of reading and listening is about figuring out the industries in the market that you’re going to become an expert in. I tell my students I want them to be an inch wide and a mile deep when they first start out.
What you’re looking for is a simple business to understand and one that doesn’t have to change its product much. Is Apple is going to have the best phone in 10 years? Who knows if we’ll even be using iPhones? But is Exxon going to be producing oil in 10 years? Yes, they will be. Oil is a good product to research because it’s not going to change in the next decade.
We’re also looking for the Moat. A Moat is how this business keeps its profit margins with the other similar businesses trying to take over the market; this is critical in the oil patch because oil is a commodity, i.e., nobody cares whose oil it is. Brand means nothing much to a consumer or refinery. So what’s the Moat? What makes one company more durable than some other company?
The right Moat for a commodity business is Secrets and/or Price. Do they know how to find oil better than anyone? Can they get it to market cheaper than anyone? You’re reading to determine that. Here’s a clue what to look for: Higher profit margins than their competitors. Look at CF Industries, for example. They produce nitrogen fertilizer, a commodity, but they are number one in their world because they produce it far cheaper than anyone else. Look at Whole Foods; they sell groceries, a commodity. But they sell twice as many dollars per square foot of store than their competitors and their profit margins reflect that sales power.
Now that you’ve decided you like the business, its something you can understand, it matches your values, has a moat and you like the CEO, you start reading the previous year’s 10k and work your way back as far as the 10Ks go. Read’m all. I put Melissa to sleep at night reading the 10Ks out loud. I should record myself and sell the CD as a sleep-aid.
From the 10Ks I go to Seeking Alpha, put in the symbol and start reading all of the analysis; good, bad, mediocre. I read the quarterly report transcripts; again reading for Moat support as well as ideas about what can go wrong.
Through all this reading I’m out to figure out a good Story that says ‘this is why this is a wonderful business’ and I keep reminding myself that a wonderful business is one that I can understand and matches my values (Meaning), has a durable competitive advantage (Moat) and a CEO I trust (Management).
An important part of my Story will be an inversion of the data. Once I get it all together I’m going to try to prove that this investment is a bad idea. Only if I can’t prove that, only after I’ve inverted the Story to no avail, am I going to be really excited that this might be a great company to own.
From the Seeking Alpha I go to the library (Amazon.com) and try to find books on companies in the industry. Then to Fool.com for more commentary. And of course I just google the company and read everything that looks interesting.
Once through that, its time to do something similar for the major competitors. Read it all. You won’t be sorry and you only have to do it once. After reading all this you’re going to know more about this industry than most analysts. You’ll be an inch wide and a mile deep. That’s where you want to be.