IP report excerpts, vol. 2: Research

In this second post looking back to memorable moments in IP’s own letters to its shareholders, we continue to discuss our company’s “inner workings”. Again, the idea is to reveal as much as we can about the processes that should, over time, generate favorable outcomes for our investment ideas.

Q2 2008 report excerpts on investment analysis

A GOOD INVESTMENT ANALYSIS IS NOT PRECISELY AN “ANALYSIS”. NOR “INVESTMENT-RELATED”

(…)

The widespread impression that persists is that even among value-oriented funds, to assess investments consists essentially of systematically applying a pre-defined set of routines and mechanisms, with special emphasis on building complex financial models which, mired in naïve scientism, confuse and disorient more than they reveal.

(…)

Many seem to believe that valuing a company diligently consists of setting young men who have recently graduated or concluded their MBAs to read prospectuses, half a dozen annual reports and the same amount of conference calls, to talk two or three times with the company’s management, ask about their “sustainable competitive advantages”, apply Porter’s 5 strengths model, and the grand finale: process a discounted cash-flow model, making a cut of 10 to 15% in the management’s projections in order to avoid, of course, potential “execution errors”. To lend an even more “professional” aspect to the process, one adds to this basic “conservative” scenario another more optimistic one and a pessimistic one, and – voilá, the cake is ready.

In our experience, evaluating investment opportunities is not limited to this type of mechanical proficiency. It does not assume training by means of analysis manuals and “kits” that, once learnt by heart, are applied on an industrial scale by anyone, as the occasion dictates. This “pasteurization” leads, in the best of cases, to consensus, to the average.

After all, “analysis” does indeed involve discipline, sweat and hard work, but it is more finesse and interdisciplinary integration than brute force.

Evaluating investments is a much broader, richer and more interesting process than the idea evoked by the word “analysis”.

“PASSIVE” ANALYSIS

In the first place, any “investment analysis” process starts well before we have even selected an asset as the object of evaluation: it happens every day, every second, in a “passive” manner, without our intervention. After all, every new stimulus or item of information we receive daily only makes sense when it fits into a pre-established network of beliefs, values, myths, and mental models, which we have built slowly in the course of time. When we encounter the “new”, our conceptual frameworks, truths and prejudices “arrive before us” and fit this marginal information into themselves.

This discovery brings important consequences: if we know a priori that we only succeed in giving meaning to the “new” when we fit it into the patchwork of values, frameworks and previous experiences that we gather throughout our lives, we have the obligation, the responsibility, to build and renew – pro-actively, day after day – this network of mental models and experiences, so that we are better prepared to know, at the proper time, how to give a practical meaning, rapidly and precisely, to the most varied business situations that may appear. Considering that, from the perceptive point of view, you only reap what you plant, the solution is to plant all the time.

In short, given that part of the “analysis” is carried out passively, we have the responsibility to turn the game around, playing an active and vigilant role in forming our perceptive and interpretative apparatus.

In this context, it is fundamental to be pro-active in seeking new and exclusive sources of information, in building and nourishing high-level relationships, travelling to see the evolution of the industry in other countries and to better understand the movements in the supply chains at global level, reading voraciously about many different subjects, and so on.

ANALYSIS AS A SYNTHESIS

The etymology of the word “analysis” leads us to the meaning “to separate a subject into pieces and understand the inter-relations between its parts” or, in a wider sense, “to examine with care”.

However, paradoxically, the desired output in an investment “analysis” process is in fact, a synthesis. What is sought is an ingenious, clear and well- structured re-combination of a collection of information and judgments gathered from different sources, into a “whole” that enlightens with clarity the process of deciding whether to buy or sell an asset.

That means identifying, after research that is often exhaustive, two or three key points that clearly define the reasons for a distortion between the price and the value of the asset under analysis.

Just as in traditional, empirical research, the process of conceiving and formulating the key hypotheses to be verified requires perspicacity, imagination and creativity.

ANALYSIS AS A NARRATIVE, INTERPRETATIVE ACTIVITY

To “analyze” is to manipulate concepts, to reason in an abstract manner. To produce meanings, build stories, raise hypotheses. A good investment case is, in general, only a simple story, with a plot. And a clear conflict as its focus point: the market’s consensus view against the analyst’s alternative view, that is, the distortion between the price and the perceived value of the asset.

ANALYSIS AS AN ACTIVITY OF AN ADVERSARIAL AND INVESTIGATIVE NATURE

Investment analysis is, from beginning to end, an eminently investigative process. A good analyst starts from a hypothesis – or from a set of them – and pro- actively seeks both confirmatory and disconfirmatory evidence to assess the strength of his “thesis”. With the same impetus. He is not satisfied with easy answers: he pursues the necessary information wherever it is. Provided it addresses a key point of the analysis, the more difficult it is to obtain, the more valuable and exclusive the information.

Analyzing an asset in a diligent manner sometimes involves interviewing shareholders, managers, clients, suppliers and employees of the company in question.

Obviously, each of the persons involved – especially the managers – is not exactly in line with us. It seems obvious that this should be considered in an “analysis”, but it is not. Even experienced analysts let themselves be influenced by the contagious optimism of an articulate and well-prepared CEO, by the enthusiastic statement of a good CFO.

In our experience, it is a crucial part of an analysis process to profess skepticism when one is presented with any information, regardless of the origin. There is no neutral information.

But it is one thing to make contact with these agents in order to meet a schedule and tick off the items on the due diligence worksheet. It is quite another to see these interactions as opportunities to test hypotheses, confirm or discard evidence, raise new questions. And to an experienced analyst, the key questions are those picked up on the spur of the moment.

More senior analysts not only make this kind of visit after preparing well, in advance, but also know that each interaction represents an opportunity to produce an important, decisive insight.

As Ken Fisher says regarding his legendary father, Phil, in the excellent foreword to the classic work “Common Stocks and Uncommon Profits”:

“In looking at companies, he always prepared himself in advance before meeting the management (…). He always wanted to be prepared and he wanted the company to know he was well prepared so they would appreciate him”.

“But his very best questions always popped out of his mind, unprepared, never having been written in advance, because they were the angle he picked up on the fly, as he heard the answer to a lesser question. Those creative questions were the art. It is what, in my mind, made his querying great.”

“The art is to get more questions – and the right questions – flowing from the answers you receive to prior questions. I’ve seen people who rigidly run down a standard question list, regardless of the answers they get. What question best flows from the answer is key. And so on. When you can do that on a real-time basis, you are a composer, an artist, a creative and investigative investor”.

CONCLUSION

The “investment analysis” process, as we see it and try to put it into effect at IP, is more complex, far-reaching and stimulating than may seem at first sight. Strictly speaking, it is not even just “analysis”, nor just “investment- related”. And it starts clearly with a choice: to adopt, a priori, an active, skeptical and vigilant posture in relation to information and knowledge throughout the process.

And the cost of this constant vigilance and continuous preparation, which is paid well before reaping the benefits, is quite high. But in respect of “investment analysis”, this is the path we have chosen to follow.

Tags: analysis, foodforthought, investmentanalysis, ipreports, mentalmodels, quotes, research, synthesis