Investment Research

While knowing how to value businesses is essential for investment success, the first and perhaps most important step in the investment process is knowing where to look for opportunities. Investors are in the business of processing information, but while studying the current financial statements of the thousands of publicly held companies, the monthly, weekly, and even daily research reports of hundreds of Wall Street analysts, and the market behavior of scores of stocks and bonds, they will spend virtually all their time reviewing fairly priced securities that are of no special interest. Good investment ideas are rare and valuable things, which must be ferreted out assiduously. They do not fly in over the transom or materialize out of thin air. Investors cannot assume that good ideas will come effortlessly from scanning the recommendations of Wall Street analysts, no matter how highly regarded, or from punching up computers, no matter how cleverly programmed, although both can sometimes indicate interesting places to hunt. Upon occasion attractive opportunities are so numerous that the only limiting factor is the availability of funds to invest; typically the number of attractive opportunities is much more limited. By identifying where the most attractive opportunities are likely to arise before starting one’s quest for the exciting handful of specific investments, investors can spare themselves an often fruitless survey of the humdrum majority of available investments.

Value investing encompasses a number of specialized investment niches that can be divided into three categories: securities selling at a discount to breakup or liquidation value, rate-of-return situations, and asset-conversion opportunities. Where to look for opportunities varies from one of these categories to the next.

Computer-screening techniques, for example, can be helpful in identifying stocks of the first category: those selling at a discount from liquidation value. Because databases can be out of date or inaccurate, however, it is essential that investors verify that the computer output is correct. Risk arbitrage and complex securities comprise a second category of attractive value investments with known exit prices and approximate time frames, which, taken together, enable investors to calculate expected rates of return at the time the investments are made. Mergers, tender offers, and other risk-arbitrage transactions are widely reported in the daily financial press as well as in specialized newsletters and periodicals. Locating information on complex securities is more difficult, but as they often come into existence as byproducts of risk arbitrage transactions, investors who follow the latter may become aware of the former.

Financially distressed and bankrupt securities, corporate recapitalizations, and exchange offers all fall into the category of asset conversions, in which investors’ existing holdings are exchanged for one or more new securities. Distressed and bankrupt businesses are often identified in the financial press; specialized publications and research services also provide information on such companies and their securities. Fundamental information on troubled companies can be gleaned from published financial statements and in the case of bankruptcies, from court documents. Price quotations may only be available from dealers sicne many of these securities are not listed on any exchange. Corporate recapitalizations and exchange offers can usually be identified from a close reading of the daily financial press. Publicly available filings with the SEC provide extensive detail on these extraordinary corporate transactions.

Many undervalued securities do not fall into any of these specialized categories and are best identified through old-fashioned hard work, yet there are widely available means of improving the likelihood of finding mispriced securities. Looking at stocks on the Wall Street Journal’s leading percentage-decline and new-lows lists, for example, occasionally turns up an out-of-favor investment idea. Similarly, when a company eliminates its dividend, its shares often fall to unduly depressed levels. Of course, all companies of requisite size produce annual and quarterly reports, which they will send upon request.

Sometimes an attractive investment niche emerges in which numerous opportunities develop over time. One such area was the large number of thrift institutions that converted from mutual to stock ownership in the 1990s. Investors should consider analyzing all companies within such a category in order to identify those that are undervalued. Specialized newsletters and industry periodicals can be excellent sources of information on such niche opportunities.

However, the research task does not end with the discovery of an apparent bargain. It is incumbent on investors to try to find out why the bargain has become available. If in 1990 you were looking for an ordinary, four-bedroom colonial home on a quarter acre in the Boston suburbs, you should have been prepared to pay at least $300,000. If you learned of one available for $150,000, your first reaction would not have been, “What a great bargain!” but, “What’s wrong with it?”

The same healthy skepticism applies to the stock market. A bargain should be inspected and reinspected for possible flaws. Irrational or indifferent selling alone may have made it cheap, but there may be more fundamental reasons for the depressed price. Perhaps there are contingent liabilities or pending litigation that you are unaware of. Maybe a competitor is preparing to introduce a superior product.

When the reason for the undervaluation can be clearly identified, it becomes an even better investment because the outcome is more predictable. By way of example, the legal constraint that prevents some institutional investors from purchasing low-priced spinoffs is one possible explanation for undervaluation. Such reasons give investors some comfort that the price is not depressed for an undisclosed fundamental business reason. Other institutional constraints can also create opportunities for value investors. For example, many institutional investors become major sellers of securities involved in risk-arbitrage transactions on the grounds that their mission is to invest in ongoing businesses, not speculate on takeovers. The resultant selling pressure can depress prices, increasing the returns available to arbitrage investors.

Institutional investors are commonly unwilling to buy or hold low-priced securities. Since any company can exercise a degree of control over its share price through splitting or reverse-splitting its outstanding shares, the financial rationale for this constraint is hard to understand. Why would a company’s shares be a good buy at $15 but not at $3 after a five-for-one stock split or vice versa?

Many attractive investment opportunities result from market inefficiencies, that is, areas of the security markets in which information is not fully disseminated or in which supply and demand are temporarily out of balance. Almost no one on Wall Street, for example, follows, let alone recommends, small companies whose shares are closely held and infrequently traded; there are at most a handful of market makers in such stocks. Depending on the number of shareholders, such companies may not even be required by the SEC to file quarterly or annual reports. Obscurity and a very thin market can cause stocks to sell at depressed levels.

Year-end tax selling also creates market inefficiencies. The Internal Revenue Code makes. It attractive for investors to realize capital losses before the end of each year. Selling driven by the calendar rather than by investment fundamentals frequently causes stocks that declined significantly during the year to decline still further. This generates opportunities for value investors.

Value investing by its very nature is contrarian. Out-of-favor securities may be undervalued; popular securities almost never are. What the herd is buying is, by definition, in favor. Securities in favor have already been bid up in price on the basis of optimistic expectations and are unlikely to represent good value that has been overlooked.

If value is not likely to exist in what the herd is buying, where may it exist? In what they are selling, unaware of, or ignoring. When the herd is selling a security, the market price may fall well beyond reason. Ignored, obscure, or newly created securities may similarly be or become undervalued. Investors may find it difficult to act as contrarians for they can never be certain whether or when they will be proven correct. Since they are acting against the crowd, contrarians are almost always initially wrong and likely for a time to suffer paper losses. By contrast, members of the herd are nearly always right for a period. Not only are contrarians initially wrong, they may be wrong more often and for longer periods than others because market trends can continue long past any limits warranted by underlying value.

Holding a contrary opinion is not always useful to investors, however. When widely held opinions have no influence on the issue at hand, nothing is gained by swimming against the tide. It is always the consensus that the sun will rise tomorrow, but this view does not influence the outcome. By contrast, when majority opinion does affect the outcome or the odds, contrary opinion can be put to use. When the herd rushes into home health-care stocks, bidding up prices and thereby lowering available returns, the majority has altered the risk/reward ratio, allowing contrarians to bet against the crowd with the odds skewed in their favor. When investors in 1983 either ignored or panned the stock of Nabisco, causing it to trade at a discount to other food companies, the risk/reward ratio became more favorable, creating a buying opportunity for contrarians.

Some investors insist on trying to obtain perfect knowledge about their impending investments, researching companies until they think they know everything there is to know about them. They study the industry and the competition, contact former employees, industry consultants, and analysts, and become personally acquainted with top management. They analyze financial statements for the past decade and stock price trends for even longer. This diligence is admirable, but it has two shortcomings. First, no matter how much research is performed, some information always remains elusive; investors have to learn to live with less than complete information. Second, even if an investor could know all the facts about an investment, he or she would not necessarily profit.

This is not to say that fundamental analysis is not useful. It certainly is. But information generally follows the well-known 80/20 rule: the first 80% of the available information is gathered in the first 20% of time spent. The value of in-depth fundamental analysis is subject to diminishing marginal returns.

Information is not always easy to obtain. Some companies actually impede its flow. Understandably, proprietary information must be kept confidential. The requirement that all investors be kept on an equal footing is another reason for the limited dissemination of information; information limited to a privileged few might be construed as inside information. Restrictions on the dissemination of information can complicate investors’ quest for knowledge nevertheless.

Moreover, business information is highly perishable. Economic conditions change, industries are transformed, and business results are volatile. The effort to acquire current, let alone complete information is never-ending. Meanwhile, other market participants are also gathering and updating information, thereby diminishing any investor’s informational advantage.

David Dreman recounts “the story of an analyst so knowledgeable about Clorox that ‘he could recite bleach shares by brand in every small town in the Southwest and tell you the production levels of Clorox’s line number 2, plant number 3. But somehow, when the company began to develop massive problems, he missed the signs…”. The stock fell from a high of 53 to 11.

Although many Wall Street Analysts have excellent insight into industries and individual companies, the results of investors who follow their recommendations may be less than stellar. In part this is due to the pressure placed on these analysts to recommend frequently rather than wisely, but it also exemplifies the difficulty of translating information into profits. Industry analysts are not well positioned to evaluate the stocks they follow in the context of competing investment alternatives. Merrill Lynch’s pharmaceutical analyst may know everything there is to know about Merck and Pfizer, but he or she knows virtually nothing about General Motors, Treasury bond yields, and Jones & Laughlin Steel first-mortgage bonds.

Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain. Yet. High uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen. Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.

In their search for complete information on businesses, investors often overlook one very important clue. In most instances no one understands a business and its prospects better than management. Therefore, investors should be encouraged when corporate insiders invest. Their own money alongside that of shareholders by purchasing stock in the open market. It is often said on Wall Street that there are many reasons why an insider might sell a stock (need for cash to pay taxes, expenses, etc.), but there is only one reason for buying.

The motivation of corporate management can be a very important force in determining the outcome of an investment. Some companies provide incentives for their managements with stock-option plans and related vehicles. Usually these plans give management the specific incentive to do what they can to boost the company’s share price.

While management does not control a company’s stock price, it can greatly influence the gap between share price and underlying value and over time can have a significant influence on value itself. If the management of a company were compensated based on revenues, total assets, or even net income, it might ignore share price while focusing on those indicators of corporate performance. If, however, management were provided incentives to maximize share price, it would focus its attention differently. For example, the management of a company whose stock sold at $25 with an underlying value of $50 could almost certainly boost the market price by announcing a spinoff, recapitalization, or asset sale, with the result of narrowing the gap between share price and underlying value. The repurchase of shares on the open market at $25 would likely give a boost to the share price as well as causing the underlying value of remaining shares to increase above $50. Obviously investors need to be alert to the motivations of management at the companies in which they invest.

Overall, investment research is the process of reducing large piles of information to manageable ones, distilling the investment wheat from the chaff. There is, needless to say, a lot of chaff and very little wheat. The research process itself, like the factory of a manufacturing company, produces no profits. The profits materialize later, often much later, when the undervaluation identified during the research process is first translated into portfolio decisions and then eventually recognized by the market. In fact, often there is no immediate buying opportunity; today’s research may be advance preparation for tomorrow’s opportunities. In any event, just as a superior sales force cannot succeed if the factory does not produce quality goods, an investment program will not succeed if high-quality research is not performed on a continuing basis.