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Thoughts On Process
Some thoughts about my process for managing current investments and researching new ideas
A few people have asked me about my research process for learning about companies and industries so I figured it made sense to write up some thoughts about my process, with the intent of being helpful to readers and also to hopefully codify what I’m doing currently and evaluate which aspects I can improve.
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At a high level, there are three buckets of work one might be doing at any given time:
Monitoring and Reviewing Longs
Finding New Ideas
Monitoring and Reviewing Longs
These are companies you already own so ideally you have a good sense of the story and the key drivers of the business and the stock. This bucket involve monitoring news, reviewing earnings report and transcripts from the quarterly management calls, as well as transcripts from any conferences that management attends. In terms of the decision tree for a core long (and this is different for every investor as everyone has different time horizons) it boils down to:
1. The story is pretty much the same, I’m comfortable with the numbers and managements vision so doing nothing is the appropriate course of action at the present time.
2. The story is deteriorating, I’m not comfortable with the direction that management is taking the company or the guidance they’re providing for the future. Maybe the company’s moat is not as strong as evidenced by contracting margins or slower than guided revenue growth. Maybe management is demonstrating poor capital allocation decisions by spending recklessly on M&A, overpaying for non core assets or companies with little synergy to the existing business. Maybe growth or margins or some other KPI you measured in your initial work is just not going to hit your targets and this is the case where you need to take a sober look at the position and reassess how comfortable you are with the story as it stands today. A stock with a deteriorating underlying business or one that generally doesn’t match your initial assumptions for negative reasons is a good candidate to sell. Whether you sell out of the entire position or reduce the exposure depends on the specific company, but in the context of monitoring your longs, these are the sort of things you want to look out for in terms of making the decision to continue holding the stock.
3. The story is improving or exceeding expectations. This is usually good news because it means the company is outperforming the expectations in your original thesis. What will ultimately determine your actions is your reassessment of the story now that the market has had time to digest to the company’s outperformance. If the market is slow to react to the news, it may be the case that the stock remains undervalued even in the wake of the news.
An example might be a company that is experiencing accelerating revenue growth because of a secular trend. The company reports earnings and the stock goes up as a result of the market learning the positive news. The company rerates from a 10x multiple to a 20x multiple in a day. If you’re able to look at the results and say well it might not be as cheap as before, but i’m still confident this is 15x ntm earnings and maybe 9-10x in two years, it might be a position you want to add to.
This is psychologically difficult.
You’re averaging up. You’re increasing your cost basis and diminishing the return you’ve already earned. It is of the utmost importance to take a cold and sober look at the business’ trajectory and how it lines up with your initial thesis and assumptions. In my experience I have found it more difficult to average up winners than to cut losers, but it can often be the case that good companies tend to compound their competitive advantage and that is why it is so important to not let the psychological difficulty of adding to a position that’s going up get in the way of building a successful position in a great company by averaging up on a winner.
It’s not to say that every time a company exceeds expectations it is a time to buy more stock. The second possibility in this scenario is that while yes that the business exceeded expectations this quarter, on a normalized basis the performance is still just above the upper end of your assumptions and based on the market reaction, you believe the stock to be approximately fairly valued and so you’re comfortable holding the position as is, not adding or reducing.
The third possible case is the market drastically over reacts to the better than expected performance and possibly pulls forward a lot of your expected future returns in a much shorter time frame. I can choose to sell out of the entire position because of course there’s an opportunity cost to keeping money with any one company and now that I’ve achieved my expected return (albeit over a shorter time horizon) I need to find a better use for that capital. Or it can be the case that one can reduce the position to a smaller percentage of their portfolio and see the position as “house money” if it was able to return a portion or even all of your initial investment. One other possible variation of this scenario is that the market barely reacts to a company exceeding expectations. This may be the opportunity to continue building a position in a company I view as a winner but it may also be a sign that the market views the company as more cyclical and is assigning the stock a lower multiple because it believes eventually earnings will come back to a more normalized state.
This is an overly simplistic description of managing core longs and every portfolio manager will have different approaches to constructing their portfolio. Some favor a more concentrated approach (8-10 stocks, even 15 is pretty concentrated) while others will be more diversified. Some may have less constraints around position sizing while others may have a strict 5% or 10% of nav limit meaning that any time a position exceeds that limit they’ll reduce it to be in line with their risk management protocol. Tax considerations are of course relevant when thinking of selling a position as short term gains are taxed differently than long term gains.
In summary, it’s important to stay on top of the longs in your portfolio and be monitoring for inflection points where you may want to add to the position, reduce your exposure or sell out if it entirely. Although it’s painful to watch a stock you sold continue to go up, one is likely to regret averaging down on a loser more than selling out of a future winner. As always, investing is as much about the in the moment psychology of making decisions with limited information as it is doing the research and modeling to inform the decision making process.
Reviewing Watchlist and Starter Positions
This part varies from fund to fund and from pm to pm but at a high level it is about monitoring and reviewing the companies on your watchlist, which you may or may not have built a “starter position” in (a position that is probably significantly smaller than a core long, bought because of your interest during the research process but sized smaller perhaps because of reservations about short term performance or current valuation. Or because you want to be Druck and you’re following his “invest first, research after” approach.)
Whatever the reason for starting a position in a company, the decision tree is somewhat similar to monitoring and reviewing your core longs. If you only did a bit of research before buying a starter it may make sense to spend some time really digging in and getting to know the company. Again, everyone will have different parameters for what would constitute the appropriate conditions for adding to a starter so it becomes a core long or selling the position but what is important is that you understand yourself and you know when you know enough to make that decision one way or another.
In the second case, where you have added a company to your watchlist but haven’t started a position, the work to be done will vary depending on why you added the stock to your watchlist. If you are someone who only builds a watchlist when you have done a reasonable amount of work on a company, you might have a price target on the stock at which you’d be more comfortable buying. You might also be concerned about cyclicality or seasonality in the business and want to get more clarity around their trajectory by waiting to hear their next earnings call.
This is another thing that can be psychologically challenging.
It can be tempting to watch a stock on your watchlist go up and say “well I missed that one” but as previously discussed, it’s important to remain detached psychologically and assess the situation from a sober point of view. It may be the case that the underlying business is inflecting and the recent run up is only the start of a secular acceleration for the company. And if that’s the case, you want to do the work to try to understand that so you can get comfortable buying something on your watchlist after it’s already ran up.
This is definitely not easy in practice as for some reason the mind seems to anchor to the price at which you added the stock to your watchlist.
At the same time, if you have not done any real work on a company, seeing a stock go up in the short term isn’t necessarily a reason to just ape into it without any real work. This brings me to perhaps one of the most important points of this piece: it’s important to have your own criteria for decision making. You have to know yourself, your biases and how you operate and understand the criteria by which you’ll feel comfortable making a decision one way or another. Because at the end of the day, your process is one of your most important assets and building one that is repeatable (and one you can trust) is essential to longevity in investing. That’s why it’s crucial to understand what works best for you and what information you need in order to make the decision. Doing post mortems can be helpful to assess if you stayed true to your process. For instance, say you sold meta after their high capex guide, massive headcount ramp through covid and stated metaverse ambitions. Seeing Meta’s run up in 2023 can be hard to stomach but ultimately it comes down to did you make the decision for the right reasons? If so, you can trust your process moving forward and understand that there’s going to be times where you have losers. Ultimately limiting them is your long term goal and understanding yourself well enough to have a repeatable process that you trust is as well. If the findings of your post mortem is “well I sold Meta because everyone on Twitter was saying Zuck lost the plot” that’s maybe not as strong a reason in terms of developing your own unique process.
What works for some people might not work for you and that’s fine, I think the most important thing is iterating and understating the core tenets of your decision making process to set yourself up for success in the future. Some people can spend a few days to a week looking at a company and get comfortable enough to add it to their watchlist and buy it after good results. Others will need more time after the initial decision to add it to your watchlist. Personally, I have 3 sections of my watchlist:
1. I have done the work, like the company but want to see the next quarter or two results before making it a core long. This is when I’ll buy a starter position.
2. I have done the work but can’t get comfortable with valuation or some other aspect of the story but the company is interesting, so add it to watchlist A. In some cases this may also merit a starter position, as there is always the possibility that even though a stock appears “expensive” on current valuation metrics, it’s actually relatively fairly valued or even cheap based on its projected growth and margins over the next few years.
3. I haven’t done enough work but for whatever reason came across the company and something about the story sounds intriguing. These get added to watchlist B where I still need to ramp up on the name in order to have any sense if I’d ever want to own it in some capacity.
This is of course different for every fund, but having sections of your watchlist like this can help when you’re looking to prioritize work for the day or when you have some free time because you know the next company you need to look into.
Finding New Ideas
This is probably the most vast and open ended of the three, as inevitably the companies you own and have on your watchlist are the result of your idea generation process. There are a number of ways to go about this and as is true with investing, it will be different for every fund and may even differ from person to person at the same fund.
In some cases, your scope may be narrowed by your investment mandate. For instance, a growth fund may screen based on sales or earnings growth and derive their investable universe that way or a fund with a specific sector focus such as tech may limit its coverage universe to tech stocks. In cases such as these, it makes sense to follow Druck’s wisdom of “the best way to learn about an industry is to study every company in it.” This might not be quite as possible for those who are more generalist investors but it still isn’t a bad strategy, even if you examine each company at a relatively high level. This is also where having a strong network can be beneficial as talking to someone with experience covering the industry can be helpful during the process of ramping up.
But let’s say you’re not sure where to start finding new companies, where are places you can look for potential ideas? One that is viable if you already have a portfolio of longs and a watchlist is to look into the supply chain of some of your best longs. The simple reason being that companies focused on growth are going to be investing in the future, whether through the income statement or the balance sheet, and the companies that supply them are going to be downstream beneficiaries of their increased investment.
For instance, if you owned AMD or Nvidia and were interested in exploring who puts together servers from their chips and then ultimately sells it to data center customers, this process might have led you to Super Micro Computer. Or if you owned Taiwan Semiconductor and were interested in what equipment they buy in order to make semiconductors, this process may have led you to ASML or other providers of semiconductor capital equipment.
This isn’t to say it’s a sure thing to find companies that are downstream of ones you are already long and it’s often the case that a supplier or vendor has economics that vary to different degrees from the company they are working with, but it’s at least somewhere to start. Companies are required to disclose if one customer is 10% or more of their revenue so this can make an interesting place for research, and while they often won’t disclose who their big customers are, with some additional research there is a possibility that one can narrow it down.
One of the main takeaways here is to spend a lot of time reading and keeping notes. In my own process, I start a google doc for a company or a trend that I’m researching and add notes from what I find as I’m doing the research. This allows me to come back to the doc to review things and also can serve as inspiration when Im looking for a new idea. Again, management won’t always give away exactly who their big customers or suppliers are, but between 10ks, earnings calls, investor presentations and conference talks one can get a decent sense of who it might be. I once tweeted something that was along the lines of “one person’s capex is another person’s revenue” in reference to Mark Zuckerberg increasing Meta’s capex and buying GPUs with the capital, and this idea is along those lines. There’s really no substitute to doing the work yourself and reading 10Ks, earnings call transcripts and investor presentations released by the company and though it might sound surprising, there can be alpha found in taking the time to actually read all the relevant documents and materials.
The essence here is that there’s often breadcrumbs that are worth following when a company is growing and investing in the future, and diligent research here can be a fruitful source of idea generation.
The next suggestion is not necessarily easy to navigate because of the complexity and potential difficulties in determining the real from the hype, but doing your best to understand near to mid term thematic trends can be profitable if you are indeed able to parse the companies that are truly structural beneficiaries of whatever the trend is from the companies that attempt to build hype when they don’t benefit or may even be a loser as their industry undergoes a secular shift in the future. Longer term trends are great too but by their nature will take more time to play out and it is more difficult to determine who will benefit and how the market will price the likelihood of certain companies being winners or losers.
The most obvious examples from recent memory are AI and GLP-1 drugs. Both of these themes are still in the early stages of actually playing out in reality but based on moves in the market, investors feel these will inevitably create new winners and losers in their respective industries. In information technology more specifically, investors are familiar with the disruption caused by secular trends such as cloud and mobile and even the internet in general. While it’s become a bit of a meme, “secular tailwinds” can truly create new business models and even new industries entirely. I think there’s some hindsight bias in the sense that investors look back and think “wow all you had to do was get mobile right and you would’ve massively outperformed.” Which is not exactly true, companies such as Ericsson and Nokia may have looked like promising beneficiaries but have lagged indices in recent years and Blackberry and Palm Pilot, once industry leaders, are pivoting and out of business respectively. Microsoft missed mobile but now cloud is a major aspect of their business.
It is not enough to be early in noticing a trend, you have to really dig in and understand the businesses within the industry to get a sense of who may emerge as the winners and losers. There is of course the meta game of trying to predict who the rest of the market will crown the winners or losers over the next 6-18/24 months but since this piece is written from the perspective of someone looking to invest in quality businesses I’ll stay mostly focused on that.
Being able to parse reality from hype is certainly a crucial skill for any investor but it is especially relevant when you’re looking at a larger thematic trend and trying to find companies poised to benefit. An example of this research process can be found in these two pieces from(I helped with the AI losers piece and wrote a small part about luxury retail being a potential beneficiary in the GLP-1 piece.)
These were useful exercises in trying to understand a thematic trend and the companies poised to benefit from the potential secular tailwinds . There are countless other ways of finding new ideas and investing is a practice that rewards the diligent and curious mind. An investor who truly loves the game will enjoy the opportunity to learn about new ideas, regardless of if it leads to an actionable investment. Also, the benefit of constantly remaining curious is building a larger mental library of analogies from which to analyze future investments.
The more ideas and stories you’ve looked at, the better positioned you’ll be to evaluate future investments because you have a larger repository from which to draw analogies.
You can look at something and quickly understand ok that’s an accelerating revenue story or that’s an incremental margin story, similar to the ones you’ve looked at in the past. While no two companies will ever be exactly alike, the larger your bag of experiences the better equipped you’ll be to evaluate the next one you find.
Two other ways of potentially finding new ideas are through stock screeners and reading quarterly letters of funds whom you respect. Stock screeners are a great way to look for companies who fit some criteria but you may have not come across otherwise and fund letter ideas have the advantage of being vetted by someone whom you already respect, though it is of course not sufficient to buy something because someone wrote about it in their quarterly letter, it’s of vital importance that you do your own work and to reiterate an earlier point, you develop and firmly understand the criteria that is necessary for your own decision making process. But with the main goal of the idea generation work being to generate new ideas (lol) these are both good places to start and may occasionally lead you to venture outside of your comfortable universe and learn about something new. This is also something that investors can do well to varying degrees and it’s important to know yourself when approaching this kind of idea generation. Warren Buffett is on record numerous times recommending that investors stick within their “circle of competence” which is perhaps ironic because when one looks at the variety of investments the Berkshire chairman has made over his storied career it’s hard to fit them all within a niche, but the advice is certainly sound as a good precaution. Every industry has its own nuances and while it may be possible for a tech investor to get up to speed on a consumer or retail idea, wading into territories like energy or financials may prove exceptionally difficult for someone who is more of a generalist. That’s not to say one shouldn’t be open to ideas in any industry, there would be no way of learning about them if you kept a close mind, it’s only to continue to reiterate the point of knowing yourself and reinforce the idea that’s central to this piece: understand your own decision making criteria and when you are comfortable making a decision. Over the long run, you are only going to be as good as your repeatable process.
My Own Examples
I have tried to create somewhat of a formal process for my idea write ups by way of a simple template, I am still working on a similar template for my thematic write ups.
An example of a single name write up that follows this template can be found here with my piece about Nintendo.
An example where I looked at an overall industry through the lens of some of the best companies can be found here with my piece about luxury retail
I am always working to improve my process. For single name idea write ups, I’m always trying my best to understand the story and be able to distill in as few words and numbers as possible. Understanding narrative is crucial in the idea generation process and being able to understand how the numbers match up to the story (and vice versa) is one of the most important intangible skills for an investor to build and something I am always actively working on.
The basic template (found in the Nintendo piece and below) centers around the story and all the work being done is an attempt of finding the “inevitable” underlying objective reality through available information.
TLDR on the Story (Bull and Bear cases)
Key Metrics & KPIs
Commentary from Management
How numbers are key drivers of the story
This is the TLDR from the Nintendo piece, to give an example of what I’m talking about
Nintendo appears cheap on valuation metrics because the market views them as having a hit-driven, cyclical business model where they need to reestablish their user base every time they launch new hardware. The market seems to think we’ve reached “peak Switch” meaning that sales of the popular gaming console, the Nintendo Switch, have peaked and revenue is likely to decline in coming years, which will put pressure on margins and depress earnings. The market also doesn’t place much value on the ~$13B of cash & short term investments on their balance sheet, as management has conveyed their intent to build a cash buffer as a potential safeguard against things going wrong in the future (a failed hardware launch, for instance, could be expensive and hurt the company economically, which is why - in management’s opinion, it is prudent to hold a large amount of cash). If you had to pay a multiple of earnings for a given earnings stream, would you prefer one that is stable and experiences low but steady growth? Or one that is dependent on major product launches, and will have rather “lumpy” sales cycles where the first few years after a successful launch see dramatic revenue growth, only for that growth to taper off as everyone who wants a device eventually wants one? The market, as it stands today, does not seem willing to award Nintendo a high multiple of earnings, which seems to reflect a view that the company will always be chasing their next hardware launch and it’s financial success will depend it’s ability to reestablish its user base with the next “hit console”. The bull case is that Nintendo is evolving as a company (and Japan is simultaneously evolving its corporate governance laws to be more aligned with shareholders) and shifting towards a stabler revenue mix where a greater percentage of their sales comes from higher margin opportunities like software games (selling the games digitally through their eshop vs a physical retailer) and subscription revenue from their online service offering, Nintendo Store Online.
I also wrote a piece about Arista Networks and did a piece withabout Celestica and an earnings review where I looked at the earnings reports of some companies in my coverage universe.
I’m always trying to get a sense of the story behind the current numbers and valuation and how to best interpret management’s commentary and guidance as it relates to their vision for the company. As a great account once pointed out on Twitter, business analysis and modeling are table stakes, your job is ultimately to synthesize the story in a way that makes you money. This is of course obvious to some of my readers but hopefully helpful in the overall context of this piece about process, understanding the story and building a somewhat repeatable process that you can trust to make money in the long run
I hope this piece was helpful as it pertains to your own process for monitoring the companies you already own and finding new ideas. In summary, this piece covered some core ideas related to -
Monitoring and Reviewing Longs: This involves continuous assessment of existing investments, evaluating whether the company's story is consistent, and deciding to hold, reduce, or sell based on the evolving situation. This process includes analyzing earnings reports, management calls, and market reactions to performance. As well as updating your model to reflect new information.
Reviewing Watchlist and Starter Positions: There are various challenges in managing a watchlist, especially when stocks on the list start performing well. I wanted to emphasize the importance of understanding your own personal decision-making criteria, being patient, and avoiding impulsive decisions.
Finding New Ideas: There are many different ways to generate new investment ideas, including exploring supply chains of current holdings, understanding thematic trends, reading fund letters, and utilizing stock screeners. I wanted to again stress the importance of staying curious, building a mental library of analogies, and continuously learning. There is no perfect way to generate new ideas, so keeping an open mind and following your curiosity can lead you to ideas in places you may have never looked otherwise.
Hopefully the examples of my own research process provided some insight into how I put these ideas into practice and highlighted the significance of distilling complex narratives, understanding key metrics, and assessing management commentary and guidance but above all else, knowing yourself well and building your own (at least somewhat) repeatable process based on individual decision-making criteria.
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