Following our short break last week in our IDS series to present our first guest post (A unique Japanese business – Nihon Trim (6788 JP)), we are now back with step #4! And now, it’s time to get down to the details, the nitty gritty. As selecting interesting investment targets is mostly an elimination process, which is what we are doing with the IDS, this fourth step will allow us to eliminate most potential targets and keep only the selected ones which are in line with our investment philosophy. It’s the typical funnel concept. Again, this is the natural way our brain works – we are building up on our findings and focusing our energy only on the bests. Of course, this step and the way you interpret it will depend largely on what you have found out going through step 1 to 3. However, there are a few principles which can be applied at large and which can be useful to keep in mind when applying step 4. The speed at which you can go through step 4 will vary depending on your experience and the knowledge you have accumulated about a certain sector or industry.
Following step 3, you should now have selected investment targets which are in line with a few very basic but crucially important factors in order for you to keep digging further. You’ve probably put these potential targets on a watchlist and now it’s time to decide if these really are attractive targets or not. So, in short, step 4 consists of developing and going through a detailed investment checklist to make sure you understand an investment target as much as possible. In the medical field, it’s been proven that checklists can seriously decrease fatal diagnostic errors. In investment terms, a detailed checklist will allow you to decrease your risk by getting a strong understanding of the target (we’re not doctors, just investors, so hopefully no fatalities involved). But, be smart! You do want to spend the necessary time and work on a target, however don’t forget the 80/20 rules. When going through your analysis, you’ll probably be able to gain an enormous amount of information and knowledge at the start of the process. However, the difference in insight you’ll get from your 31st hour of analysis will be much less than your 4th hour of analysis. So, spend your energy wisely. The way you find your information can also be made as efficient as possible and technology can be of great help. As investing is all about the future, you will never be able to know and predict everything. At some point, you just need to go for it.
From your initial review, you should have an idea of what to focus on for this 4th step. However, be careful and stay open minded as during your more in-depth analysis you might find out totally new and unexpected factors which are important and need to be seriously taken into consideration – you don’t want to miss something, which might lead you to make a major mistake later. Never forget that if you are considering buying the shares of a company, someone else is selling and thinks the opposite of you, and he/she might be right. There’s no space for ego here! In addition, the depth and breadth of your checklist will vary significantly depending on the target you’re reviewing. The emphasis you put on each factor in your checklist will also vary. For example, the factors of consideration for a Chinese insurance company will be quite different to the ones for an American high-end manufacturing firm. An easy way to deal with this is to start with a full list of factors and then decide which factors are important. As you gain in experience, you can group factors depending on the type of target you’re considering and its industry or sector. Your checklist should also be flexible and factors should be added as you discover them – don’t lock yourself within a rigid framework.
Unless you have an outstanding memory, which is not my case, for each target you review, you should write down your findings for every factor of analysis. Try to find the most efficient way to write down your findings. It can be in the form of a log or bullet points. Unless you’re writing for someone else, it doesn’t need to be pretty or read fluidly. It simply needs to be to the point and enough for you to remember what your key findings were so that you can refer to them in the future. Writing down your findings will serve two main purposes: 1) it will help you structure and clarify your thinking, and most importantly 2) it will allow you to keep a record which you can refer to in the future, whether you took the right decision or not at the end, and learn from your analysis and subsequent actions.
Starting to build a checklist can be challenging and you might not know where to start. I have recently found a book which can be extremely helpful in that sense titled “The Investment Checklist: The Art of In-Depth Research” by Michael Shearn. The author presents operational, financial, and strategic factors which should all be considered when looking into a company and he explains each factor in detail. I have found this book to be very useful as a reference and it’s an excellent starting point. It also presents the readers with different ways of considering specific factors, depending on the situation. Michael Shearn is a fund manager himself, which makes his work even more convincing and relevant. Keep in mind though that this book is especially useful considering my personal investment approach, which might not be as useful to you if you have a totally different investment philosophy.
Once you’ve gone through your checklist, weighted the different factors of analysis depending on the target you’re reviewing, and you’re satisfied with the work you’ve put in, you now have to decide what you want to do with the target. As mentioned, going through your IDS, you’re trying to eliminate options, so you have to take a decision. You can either: 1) decide to do more work in terms of valuation, 2) keep the idea on your watchlist as a low priority target, or 3) discard the idea. We will discuss #1 in more detail next week, however the reason why you might want to do more valuation work is based on the fact that, so far, we’ve only done a very basic valuation review and we now have a lot more information on the company, which might influence our valuation. As for option #2, if you believe a target does have some merit, but you’re not confident enough yet to take a decision, you might want to keep it on your watchlist and keep learning about it over time. Finally, if an investment idea is too hard to understand and you don’t believe that this is going to change in the future, just reject the idea and focus on other targets.
We are slowly getting there and hopefully your own IDS is taking shape. Let me know if you have any questions!
Next post, next week!
Keep growing your snowball!