Invest Like an Investigative Reporter: Stories From the Qualitative Side

Don't focus on finding an informational edge. Forget 'tips.' Instead, just try to put customers, suppliers, store managers and ex-employees at ease. Fit what they know with what you know

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Sep 25, 2017
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In a previous article, I discussed the importance of thinking like an investigative reporter. I used several examples – a couple of Chinese frauds, a company that was quickly depreciating its assets, etc. – but I did not talk much about what kind of research you can do outside of accounting. In some ways, the examples used in that article could have been titled “invest like a forensic accountant” instead of “invest like an investigative reporter.” Here, we will explore the Philip Fisher side instead of the Benjamin Graham side. What kind of “scuttlebutt” have I turned up when researching stocks, and how can you do the same?

First of all, I want to make the point that qualitative scuttlebutt is anecdotal. It comes from stories store managers, suppliers, customers, ex-employees, competitors and executives tell you. You really do have to think like an investigative reporter when hearing these stories because some of these people have an axe to grind. They are human, so most of what they are going to tell you is about how important their job is, how smart they are, how dumb the people they report to are and how everything would be better if they ran the place. A lot of anecdotes will also be overly personal and somewhat gossipy. I have been told – without asking about it in the slightest – which executives had substance abuse problems, which companies someone thought was going to be taken private and so on.

When talking with other people about the scuttlebutt, I have noticed a problematic pattern. If you have read “The Snowball,” you know Warren Buffett (Trades, Portfolio) was once told: “If you’re hunting in a golden haystack, you don’t need to find a golden needle.” Meaning, just because some idea is obscure or it took a lot of work to dig up, does not make it more valuable. Most unknown information is not useful information. Likewise, a ton of useful information is widely known but misunderstood.

Most of the really useful scuttlebutt I have gotten was not hard to dig up. It was very close to being public knowledge. More importantly, all the terribly dangerous scuttlebutt I have found had the allure of being “insider knowledge” that was hard to get. Luckily, I have never found myself falling victim to the idea information is more useful just because fewer people have it. Take the substance abuse example for instance. I did not really care who was running that company, so it did not matter much to me if the guy at the top was sober or not. If he stopped being able to function, someone else would take over – and it was the kind of company where I thought whoever took over would do fine. But a couple sources we – my newsletter co-writer Quan and I – talked to acted like this was information we would be terribly interested in. Knowledge about the basic product economics of a business is so much more useful than knowledge about how great or awful the current CEO is.

So when looking for qualitative scuttlebutt, you are still looking for what I call the 3 C’s: what is “constant”, what is “consequential” and what is “calculable.”

A bit of information that drives some quarterly result but will even out by next year does not matter to me; it is not constant. Information about whether a price increase will be 4% this year or 2% like in most years also is not going to matter much. Unless you can put that into some pattern, it is not consequential. Maybe it matters if the price increase is for the one and only product the company sells.

Calculable means information like the company usually raises prices faster than inflation or traffic usually rises less than the local population. Those are numbers you can plug into back-of-the-envelope type math.

The first level of qualitative scuttlebutt is – of course – a site visit. I have eaten at Cheesecake Factory (CAKE, Financial). I have been inside a Tractor Supply Co. (TSCO, Financial) store. I have pulled into a Murphy USA (MUSA, Financial) station. In each case, I went for research purposes. I brought along some other people for their input. I was trying to get some context for the business.

I once researched a company called DreamWorks Animation (now owned by Universal). When talking with some other people who researched the company – and, in fact, put thousands of dollars into the stock – I was absolutely floored to learn theyh had never seen a DreamWorks Animation movie in theaters. When I was talking to these people, there was a DreamWorks movie out. You could pay $10 at night or about $6 for a matinee to go sit in a comfy chair for 90 minutes and see the product this company sunk $150 million or so into. I mean, if you are thinking about putting a lot of money into Boeing (BA) and a letter comes in the mail inviting you to the unveiling of their new model – I think you would go. But somehow the idea of going to your local movie theater to see a kids’ movie seems odd.

The truth is, going to the movie theater with paying customers would be way more valuable than a press event for some jumbo jet. At the movies, you could see the film with the parents and kids who are the target audience. These people actually paid. They do not have poker faces. You can read what they think pretty well. It is like they have put a focus group together for you.

Buffett would have done that.

Around the time he invested in Walt Disney Co. (DIS, Financial), Buffett met Walt Disney, visited Disneyland and saw "Mary Poppins" in theaters. The beauty of researching something like DreamWorks is they put out so few movies you could learn so much about the overall company from watching just one. They were pretty much a one product company at the time.

Now, I actually screened every movie DreamWorks ever made as part of my research. But I did that at home. The really valuable opportunities are when you can see the movie in theaters along with paying customers.

This is not really even scuttlebutt, but it is research most people do not do. When I was researching cruise companies, I read all the books I could find about the cruise industry. When I was researching Babcock & Wilcox (BW, Financial) – I now own the spinoff, BWX Technologies (BWXT, Financial) – I read a book that gave a little narrative description of every nuclear disaster in the industry’s history.

It is just common sense to do that kind of research. If your boss assigned you the task of writing a report on the cruise industry, you would go online or to the library to see if there were any books you could read on the subject. But some investors act as if it is not sporting to read anything other investors might not be reading too. It is like the only approved written materials are the 10-K, articles in financial publications and GuruFocus for 30-year financials – but are you really supposed to read books on the history of the industry, specific companies in the industry, the founders and so on? If you can find them, you read them. I read everything I could find on Jeffrey Katzenberg and DreamWorks.

Here is the rule: any research you would do if you were preparing a bid for the whole company is research you should do before buying a stock. That is common sense. A bid for a company and a bid for a stock should have the same due diligence. They are the exact same investment, just on a different scale. You may not have the resources to do all the research you would want to do, but the first step is you should want to do all the research you would do if your job was to prepare a bid for this business in full.

OK. So you are “out in the wild” at this company’s place of business. Now what?

When you visit a location, you often get the chance to talk to a manager of that location. I am not a very gregarious person, so I usually enlist other people – often people I talk stocks with online – to go to stores in their area and chat with the manager if that is the sort of thing they like. You ask these people to help you out. You share what you know with them, and they share what they know with you.

Let’s talk about the temptation of truly “inside” information. Three times in my life I have been told a company was likely to get bought out very soon. So far, the universe is zero for three in actually delivering those buyouts. I would never invest in a stock because I heard a buyout rumor.

In one of these three cases, however, I actually was interested in the stock. What this person told me made me feel I had to “recuse myself” from ever considering the stock. He was preparing a possible bid for the whole company, so he wanted my opinion. Very few people had written about the company. He could see (through online searches) I had written more than anyone else. So he was basically doing his scuttlebutt by approaching me. That locked me out of the stock. By the way, he did not bid for the company in the end.

In two other cases, I was told by employees they believed their company was going to be bought out. In both cases, I dismissed this information as not being reliable in the sense it did not change the odds of a buyout in my view at all. Yes, the companies were both cheap enough for me to consider buying a share – so they were cheap enough for private equity to be interested in. But in both these cases, the story I was told had to do with the relationship between a top executive and a potential buyer. In other words, the employee always sees the CEO talking with an investment banker and assumes he knows what that means. I believe the CEO spoke with the investment banker. I just do not believe the employee is qualified to know what that means.

The more “inside” you think your information is – the less weight you should give it. This is to counteract the perverse bias investors seem to have where a “tip," which may or may not be true, is somehow worth less than the overall public picture of the company that “everyone knows.” Like I said, I feel I have been good at avoiding this mistake. But most people who have gotten involved in doing some scuttlebutt with me do get intoxicated with the idea they have turned up something the market does not know. Once they realize this is not public information, they start talking about options and other such nonsense. Scuttlebutt can fill in some facts, but the overall decision on how to frame an investment is always going to be based mostly on very, very public information combined with some other insights you bring from background knowledge of similar situations and maybe a bit of scuttlebutt.

Here is the truth: information alone is not important and not that valuable.

What matters is context. I have said before your “edge” is not knowing something the market does not know. That is silly. Human beings are not good at processing a ton of information and distilling it to the few key variables that should determine the stock price. Give everyone the same information and some are going to draw the right conclusions while others are not.

Imagine “the market” knows the CEO has a substance abuse problem. Imagine the market knows what I just told you – that a man with enough money to buy a company talked to some blogger (me) about whether he should make a bid.

How do you incorporate that into the stock price? What is the market supposed to do with that?

Interpretation is key. Interpretation matters more than information. My newsletter co-writer, Quan, knows I repeat a sort of personal mantra a lot in the research process.

I say, “There is no such thing as theory independent data.” Meaning, if we do not have a hypothesis – if we have not made some guess about what we are going to find and what it means – we would not even know what is a clue and what is not. You cannot really find the facts first and come up with a theory later. The human brain is incapable of working that way. You need to have a theory, test a theory, discard a theory, form a new theory, etc. as you work your way through the facts. But until you have a theory – you do not know what facts you need.

Take Buffett and American Express Co. (AXP, Financial). During the salad oil scandal, Buffett only needed to know one really important bit of information: did the corporate scandal at American Express shake consumer confidence in American Express card (and travelers cheques)? So that is what he set out to learn through scuttlebutt. If he and his associates checked out what was going on in local restaurants, they would probably have an excellent idea of what was going on all over America. If people were using the card in Omaha – American Express’ brand would survive the scandal just fine.

Scuttlebutt is very useful in situations like this. For example, someone was talking to me about Under Armour (UA, Financial) and said the stock was down because teens do not think it is cool anymore.

That is a problem you can easily solve with scuttlebutt. Talk to them. You know teens or you know people who know teens. Talk to them.

Why is it important to do this?

Because if you read what a Morgan Stanley analyst or a Barron’s writer or a blogger like me says about whether teens think Under Armour is cool or not – you are just sticking your head in an echo chamber. It is very possible the analyst, the journalist and the blogger have not spoken to any teenagers at all. It is very possible no one in this chain is relying on a primary source of any kind.

As an investor, you want to severely limit your use of secondary sources. That is what I was saying about the two buyout rumors I mentioned. That stuff was worse than hearsay. If I had relied on that information, I would be relying not on what really happened – the CEO meeting more than once with the same investment banker – but with what the employee (who is not an expert on CEOs or investment bankers) inferred was the reason for those meetings.

Usually, the information someone gives you in terms of qualitative scuttlebutt is information they do not know the value of. Employees have a very narrow view of a company. In some companies, there are only three to five people at the top who have as wide a view of the company as an investor would. Everyone else is more narrowly focused on their specific function, some metric they think is important or this one product or business unit. They cannot tell you about the company as a money-making machine. They have never looked at it that way. You have a broader view than they do. But what little they do know about the company they know very, very well.

I will cheat and give you a classic example of scuttlebutt that is not actually scuttlebutt. Before investing in George Risk (RSKIA, Financial), I read an interview (not widely circulated, but public) where the then-CEO said the input costs of the material the company was buying were higher than the price some competitors could sell at.

What we are going to talk about here is interpretation.

On the surface, what that CEO said sounds very, very bad. But I had more context. I already knew George Risk had not lost a lot of market share. So now I knew some customers were staying with the company despite there being competitors with much lower cost structures.

As a result, I started thinking: what matters in this business? Is it just price? Or is it on time delivery? Is it customization?

And that gave me enough confidence in George Risk’s ability to raise prices if it needed to (because volumes dropped) that I bought the stock.

This is why you do not want to think purely in black and white terms of “good” or “bad.” In fact, in both cases where the scuttlebutt I heard most convinced me the company I was looking at was a good business – the person who gave me the information was actually complaining. What they were complaining about was their powerlessness to do anything if the company raised prices. Essentially, they were telling me if the company raised prices even faster than they had been – they would still buy just as much from them. So they were calling the company and its people all sorts of bad names, but they were telling me there was no substitute for what the company was giving me.

I will give you an example of a stock right now where scuttlebutt would be useful. I have not researched Games Workshop Group PLC (LSE:GAW, Financial), but based on what little I know of the company, I think the key question is: what if Games Workshop keeps raising prices on "Warhammer?" How long can the loyal fans of this game keep buying?

Now, I know what the fans are going to say. They will say the company is treating them badly with these price increases and if it does not stop, everyone will evenutally abandon this game.

Of course they are going to say that; and, of course, you should ignore it.

When doing scuttlebutt, you never ask a hypothetical questions like “at what price would you stop buying this?” Everyone lies when you ask that. They do not know they are lying, but they still do.

I am sure Americans believe that if the price of gas goes to $6 a gallon, they will do everything they can to cut back. They will buy a Tesla. Maybe they will, but the truth is they will be very busy worrying about a lot of things in life at that moment. They will try to think long term. But in the short term – they will have to fill up and pay whatever the commodity costs. They need to get to work. They cannot afford a new car just yet – they still owe quite a bit on the one they are driving.

So back to Games Workshop. What can you really ask?

When doing scuttlebutt, what you want to ask about is always behavior rather than opinion. Never ask for someone’s opinion. Always ask about how they behaved in the past, why they think they behaved that way and what might change their behavior in the future.

Always try to frame things in terms of preferences. People are more honest if you do not simply ask if they like the color blue. Instead, say: “Quick, blue or orange? You have to pick one now.”

So for Games Workshop’s customers, you could try questions like: What other tabletop games have you tried out? What games might you try out? If Warhammer is as expensive as you say, why do you keep playing it?

Actually, you never ask the last question I just asked. You use a dirty trick instead.

If you have to ask predictive questions – here is a tip. When polling people, it is natural to ask questions in the form of: “Which candidate do you expect to vote for in the presidential election?” and “How much less gas do you think you would buy if it cost $6 a gallon?”

Do not do that.

Instead, ask: “Who do you expect your neighbor will vote for in the presidential election?” and “How much less gas do you think your adult son would buy if it cost $6 a gallon?”

See, people do not think quite as highly of the consistent rationality of their neighbors and adult children.

Everyone thinks they are rational. No one is quite sure the rest of the world is.

People have self-images that need to be protected. It is an automatic reflex. So if you have to ask a question where someone might express an opinion that seems emotional, irrational or not the “right” answer, you need to let them save face and distance themselves from such a decision.

As investors – we are most interested in the irrational. I can see rationally whether you should buy product A or product B if the only difference is price.

The questions that really matter are ones like: “Why aren’t you switching bank accounts even though the place across the street would pay you $100 more a year in interest on your account?”

No one is going to give you a good answer. But, “Why do you think your brother-in-law sticks with that bank that gives him such crummy service…”

That is a question they will answer.

So here are a few tips.

One, do not get excited by some “informational advantage.” Do not even think in terms of an informational edge. Your edge is always your interpretation. It is how all the facts fit together. It is never the one fact you know  that the market does not.

Two, always ask about specific behavior. Questions like: do you call your broker or does your broker call you? Is there a meeting where that budget gets decided on? When you cancelled that one time, what made you do that? And how did you come up with that list of possible vendors?

Three, make it easy for someone to tell you hard truths. So depersonalize the situation. If you suspect a loan officer would make poor decisions at some point in the cycle – talk to him about what he thinks the average loan officer in the organization would do, not what he would do.

As a final tip, the first thing I tell anyone I am talking to for scuttlebutt is I do not short stocks and I would never put their name in print even if they ordered me to. I do not ask if they would like to be anonymous. I tell them they are going to be anonymous whether they like it or not.

As an individual investor – it will be easier for you. People are very suspicious of anyone who writes stuff. Other investors, analysts and bloggers are very happy to talk to me because they think I am a peer they can talk to using the same jargon.

The bad news is people inside an organization think I am a reporter because I write  on companies and stocks. So it is always easier to get them to talk to someone who is not a writer than to talk to me. They will talk to you sooner than they will talk to me.

My best piece of advice is to just re-read two books: Fisher’s “Common Stocks and Uncommon Profits” and Alice Schroeder’s “The Snowball.” Read those books closely looking for examples of how to do scuttlebutt. When you read them the first time, you probably were not thinking of how you could apply what you read in there directly to finding scuttlebutt of your own.

Buffett and Fisher knew how to get scuttlebutt and how to use scuttlebutt. Ape them.

Disclosures: Long BWXT.