“…the number of questions is not so much the important, but it’s just that the quality of the questions and then come to having that analytical judgement on which questions are important for a particular company.” —Michael Shearn
In this post you find the most recent interview from 5GQ with Michael Shearn, the author of The Investment Checklist: The Art of In-Depth Research.
I have transcribed the first two questions, question number one beeing about what part in a 10k to look at and the second question about how many checklist items there are in Michael’s own investment checklist.
For questions number three to five I have transcribed only the question, so you can see what they’re about and go to the video interview to hear Michael’s answers to these questions.
Q1: What part of the 10k do you spend the most time with? There’s so much information in there, what section do you think that investors maybe aren’t paying enough attention to you?
- A1: When I look at a 10-K, my goal is I wanna understand what the business does. I also want to know how how does it make money. So one of the first thing we look at is, we go to the income tax footnote, and what we wanna see is: Do they make money? Because under the income tax footnote, that’s usually about note 12 or around there, they have a line item called “Current taxes” and that’s the money that they send to the IRS. So if a company is not making money, they’re not gonna be, on a cash basis, they’re not gonna be sending any money to the IRS. So that’s kind of the first stop in the 10-K, to see if there even making money.Just to give you a historical example I remember looking at Enron, and looking at that footnote and it was negative. They were not making any money.
But after that you know the other section, this is something I’ve learned recently, is the risk section, because it’s really, if you think about pharmaceutical drugs, there’s funny commercials where they’re always talking about all the risks, the things that can happen to you. They are pretty much disclosing a full amount of things that can happen. The same thing happens in the 10k under the risk section, and what happens is that it’s very easy to gloss over those risks because they are written in very plain language, and so it’s very important that kind of spend a lot of time there because every company that has failed or had a problem, the problem has been in the risk section, it’s always in there. But what happen is that the language is written in such a way where it’s not alarming and it’s kind of innocuous language. So what we do is that we look at the risks and we read it and we try to understand; Has this company encountered any of these risks before, is there an historical example that we can look to, to see kind of how that risk affects the company or is this something we don’t know how it’s gonna affect the company?
So we where recently looking at a company called FXCM, it kind of hit our screen so to speak and as we were reading articles about what was going on at the company the stock dropped quite a bit. They talked about exactly an article reference one of the risks that they had to make up their clients equity accounts if they ever got negative. But when we went to go read the footnote it was very innocuous, it kind of was written in such a way that it was very difficult to catch. So I think, you know for me, how it works, I really pay attention to the risk section because it really gives you a good insight into what could go wrong and you can do your worst case scenarios and things like that. … The lawyers make sure you cover all of them. … So you kind of really have to weigh those things and what’s real real big risks and what’s not. But I take the first part not the second part about stock fluctuations or clustering and things like that. It’s more the business risk section.”
- Q2: How many checklist items do you have for your personal investment checklist?
- A2: I look at a checklist more as a research process. What it allows us to do is a series of questions that allows us to examine the business from a lot of different perspectives. So we’re not looking at in, you know, in the past I spent a lot of time just focusing on whether the company had a competitive advantage and I’d ignore things like the customer side or the management side. And just kind of on that one thing. So the questions really help you get a holistic view of a business. But really the goal of it and the goal of the questions is, you kind of want to understand the distribution of the cash flows for a business. Are they narrow? Or are they wide? So there’s questions in there like fixed cost base that would tell you that they had a wide range, so you would know the earnings would fluctuate quite a bit. So it’s kind of a far as a number of questions and it really becomes kind of a judgement call. So for certain companies for example, let’s think of FactSet, a service that I subscribe to. I’m not gonna be really asking a lot of questions about their suppliers. But if I was looking at a metals recycler, well suppliers are very important ’cause they’re recycling metals, so the supply of the metal is very important or where they can get aluminum and to turn into steel so the questions kind of way depending on the company. But I will say there’s two questions I think must be answered for every company, and I think they carry a lot of the weigh. And the first question is: How dependent are the customers on the product or the service? That let you know, let’s say a restaurant, we’re not all dependent up on it. But it allows you to understand the degree to which those cash flows are gonna vary. Because if the customers are stuck to your product the more narrow distribution cash flow and the less surprises. But if your customers are not as dependent, they could use other areas, and you know there’s gonna be a lot more variation so you can prepare in advance for that. Second question, we always like to know who we’re partners with. Is management that we’ve evolved in our investment strategy we have learned to us it’s really the most important component so we spend a lot of time answering that question as well. But, you know, the number of questions is not so much the important, but it’s just that the quality of the questions and then come to having that analytical judgement on which questions are important for a particular company. So if you’re worried about the CEO and that they’re very aggressive in their accounting, well you will spend a lot of time on the accounting side. We just generally pass on those kind of companies. But say you’re a value investor and look at all different kinds of companies, you would have to spend a lot of time on adjusting the financial statements to make sure, to see what they’re really earning, because you know they’ve been aggressive in their accounting. So it’s really, it kind of depends on the company.
The remaining questions (not transcribed in this post) are:
- A3: The subtitle of your book is the art of in-dept research and it really struck me while I was reading your book that the real art involved is a lot of these little adjustments that you can make to the numbers that you’re looking at when you’re performing you’re analysis to normalize things to get some kind of an idea of like how to approach what is happening in the real world, like economically versus the accounting. Other than just the obvious, you know, be conservative or find a margin of safety. Do you have any tips for us on have to make analytical adjustments?
- A4: I think this is one of the greatest problems to solve as an investor, in a person doing research. There’s forty thousand stocks roughly in the world. You don’t have the time to be an expert on every single one of them. How do you go about narrowing down your universe to screening for the ones we think they’re gonna give you the best bang for your research buck so to speak?
- A5: If you think about investing like a horse race, where it’s a para-mutual betting basically, so you don’t always have to know who’s the fastest horse necessarily, but it’s the odds of winning versus the payout. I feel like your book gave an amazing insight into picking the fastest horse, a great checklist of all the different things that make up for a great business to buy, but I’d like to hear a little about how the price factors in in that context of horse-betting where it’s not all about the fastest horse.
From having looked at the first two questions, let’s turn to the last one outside of the five ordinarily questions.
- Q6: What book would you like to recommend?
Hurricane Capital 