My Investment Process
In my early investing days, my mission was to ‘find and buy cheap stocks’, obsessed with sometimes short-term returns, quantitative factors and never paying above a fixed price (15 P/E or 10x EV/EBITDA) for anything. That’s probably true for a lot of early value investors. We equate value with cheap. I know I was anchored to that idea. I view that mentality now as hurtful to performance, given that I totally ignored the future prospects of a company. I was paying more attention to price paid and much less attention to the characteristics that made up a quality business, such as high returns on incremental invested capital, long runways for growth, dominant market position, cash flow generation, and solid management teams that know how to allocate capital.
Thankfully I’m a fast learner. Awhile ago I made the shift away from deep value investing or Ben Graham style of ‘getting excited to buy super cheap assets and just sitting on them for years waiting for the market to catch up’, to more of a Buffett style of investing where I’d like to get a great price but also a great company. There are differences of course, being that since I don’t own these companies like Warren Buffett can and don’t have complete control, it’s important to have a path to a visible upside, and a catalyst in place to realize that upside.
Today, Greystone Capital’s strategy is to buy great businesses at favorable prices. I follow a research-intensive, value-oriented investment process that results in my typical portfolio comprising 6 – 15 high-quality companies that I have studied for an extensive period of time.
Although there is more than one way to define a great business, I’ve typically found a high quality business to be an asset-light company with some form of pricing power and/or recurring revenue, a long runway for growth, shareholder friendly management with some ownership in the company, a clean balance sheet, and the ability to earn incrementally higher returns on invested capital.
My aim is to build a portfolio of these quality companies with excellent management teams that should reflect higher levels of intrinsic business value years into the future. It is within this framework I turn over a lot of rocks, read a ton of fund manager letters, speak to plenty of other investors and analysts, comb through SEC filings, and read everything I can get my hands on in the search for new investments. My goal is to try and find 1-2 companies per quarter and size the positions appropriately based on risk/reward.
Although we will look anywhere in our search for value, Greystone Capital’s investment strategy is centered around small and microcap securities. I’ve found some success searching in areas of the market that tend to be under-followed, illiquid, not included in any of the indexes, and in places where many (or any) analysts aren’t looking. My reasons for investing in companies that are under-analyzed or off the beaten path are many, but primarily because stocks heavily owned by institutions have often been among the most inappropriately valued. Companies with limited analyst coverage, high insider ownership, and high growth potential have outperformed the broader market, particularly when selected with a value focus.
In the search for new investment ideas that fit this criteria, I’d say that idea generation is a haphazard process. To date, I haven’t found one particular place to go (other than reading about every small and microcap company I can) in order to consistently generate ideas. I start with a pretty broad research or screening process, by reading a lot, which includes annual reports, investor presentations, newspapers, SEC filings, fund manager letters, investing blogs, and plenty of investment write-ups/analysis. I frequent Value Investor’s Club, SumZero, fund manager letters, and occasionally Seeking Alpha.
My best (and favorite) sources of ideas are reading company write-ups, fund manager letters, and speaking to other investors about individual companies. It’s exciting when I come across a new idea or company that appears to match my investment criteria, and I can start to dig into the filings more deeply or start to learn about the industry more in depth. Given the number of publicly traded companies, including over-the-counter, I enjoy letting other smart analysts and investors help find ideas for the partnership.
When I started out as an investor, I put an incredible amount of weight on originality of an idea. I used to think it was a sin for another fund manager to have led me in the direction of a quality business trading at a cheap valuation if I weren’t the one to see it first. This idea and behavior turned out to be harmful as I missed on a lot of companies that upon studying, I’d be thrilled to have in the portfolio. The reality is, there are tens of thousands of public companies out there, and one of me. I simply won’t be able to cover them all over time, so part of being successful as your portfolio manager is opening my mind up to new ideas and making sure I’m always collaborating with smart and talented investors. That idea to me makes nothing but sense.
In one of the best articles I’ve read about investing, Graham Duncan, professional allocator and co-founder of East Rock Capital, outlines his opinion of the five levels of the ‘game’ of investing based on decades of experience and interviews with thousands of fund managers.
He describes Level 2 as Expert – playing the game you were taught – as the stage when an analyst moves from processing other people’s research agendas to generating their own ideas. It’s within this stage, he describes, that most investors plateau, where they develop a static sense of identity (such as, I am a value investor like Buffett). Duncan says that by constructing their identity as an ‘expert’ in certain sectors or companies, they limit their ability to observe change in those areas.
It is through this lens, that some investors then come to see that filtering other people’s ideas represents an ability to identify key drivers of the game. It may be easier to build a portfolio by owning ideas through analysts, as opposed to doing an investor’s own deep research on each investment idea.
While I’m certainly not an expert as described above, when it comes to idea generation, I am happy to let others point out under-valuations of certain companies or asymmetric risk/reward profils, and will always take a look under the hood, as long as the companies strictly fit my investment criteria, I am capable of understanding the businesses, and they provide an adequate margin of safety or downside protection.
With that said, I will never purchase a security without running it through my criteria, research process, valuation tests, and checklists, but where exactly the idea for that security came from is less important to me than spotting the key drivers of a situation and seeing the underlying reality. In a universe where most companies issue millions of shares to the public, I find it odd to withhold from investing in a quality business at a favorable price just because I didn’t ‘find it first’.
As Duncan says: “Pride of authorship is an obstacle when it comes to making money.”
In line with that, I wanted to share some elements of my research process below. While none of this is unique or original, the structure serves as a nice guidepost for me when working my way through a company.
Greystone Capital Research Process
I usually start with a company’s investor presentation
Usually a good view of what the company does, their market position, historical financials, projections for the future, their competitive positioning. A lot of marketing materials here so the company is presented in a favorable light, take with a grain of salt
Next I read the most recent Annual Report, including the letter from the CEO to the shareholders, if there is one. I like to read a collection of the letters in order to get a sense of the following:
How does the CEO communicate in general? Does he/she only talk about positives of the business?
What challenges is the business facing, and how have they been addressed over the years?
Has the CEO lived up to his goals, promises or projections? Why or why not?
Is he/she saying one thing, but doing another?
Track key metrics and how the company has done over time
I’ll read a few annual reports in order to get a historical sense of the company, and try to cement what they do, and in order to start getting familiar with the financials
Then I’ll read 4-8 quarters worth of 10qs (Quarterly Reports) to get more of a sense of the financials and quarterly progress
I’ll then move on to the quarterly conference call transcripts which usually provide excellent commentary by management on their business results, the state of the industry, their competitive position, as well as responses to the questions asked by analysts who cover the company. I spend an inordinate amount of time reading and re-reading these transcripts to get a sense of how management responds to negativity, competition, questions, as well as how candid they are in answering difficult questions. A good management team will spend time talking about the industry in general, and I’ve found this to be one of the greatest sources of learning material available to investors.
I’ll usually supplement this reading with calls to IR as well as the management team, and work through a series of questions I’ve come up with
Next, I try to locate industry specific information such as trade journals, research reports, competition analysis. Learning about the industry is key, in order to determine what are the drivers of business success and how macro issues can affect a particular company. Is the industry growing? Secular decline? What do the future prospects look like, and what will be the demand drivers for the business I am researching?
Books are helpful here – usually an informative, well-written book about an industry. If it’s by the CEO or founder himself, even better.
From there, I move on to the internet
Product/service reviews paying special attention to criticism and negativity
Articles with management or about the company in general
Case studies involving similar types of businesses that have been successful in the past or not successful
Any and every piece of information I can find about the business – what don’t I like, and what are the risks here?
Following internet searches, I move on to finding additional ‘scuttlebutt’, which is a term value investor Phil Fisher used to describe gossip, rumors or chatter surrounding a given company. I try to get a holistic view of the company by speaking to customers, employees, suppliers, and competitors. This part of the research process is overlooked by some, but critically important. Traveling to trade shows, getting on the phone to call competitors, and understanding the key value drivers for customers is critical.
Once I have a solid understanding of the business itself, I focus on things like insider ownership, recurring revenue, expanding margins, what the competitive landscape looks like, and what the value proposition for customer’s might be.
If I’ve made it this far, I clearly believe the company is undervalued for some reason or another, so it then becomes incredibly important to address that. Why does the valuation gap exist? What am I seeing that the market is missing?
It’s so incredibly important to dig deep into this step, it should be placed at the top. Too many investors place emphasis on future valuation and fail to address why the company trades at the current price level.
Before considering entering into a position, or after initiating a small position, I’ll make it a priority to schedule a company visit. It’s here I’ll be able to meet management in person, get any remaining questions I have answered, and hopefully get a look at the operation itself, depending on the type of business
Based on my experiences with site visits, I find them to be invaluable, and trying to learn about things that aren’t in the company filings is incredibly beneficial
Lastly checklists are incredibly important throughout this process, and before making an investment, I have a 50-100 point checklist I go through to address any last concerns