Advice on Doing Research for Industry Specific Investing

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From a reader:

Hi David,

I’ve been a classic “bottom-up” investment advisor for a few years now, but I agree with your assessment that industries, in general, are under-analyzed by the masses.

Here’s a round up of hedge funds’ May returns

InvestTyro Absolute Return Fund was down 1.5% for May. The fund's main contributors in May were Super Micro Computer, which gained 1.6%, Shyft Group, which was up 1%, and GCI Liberty, which gained 1%. Detractors in May include Recro Pharma, which fell 2.6%, index shorts and hedges, which declined 2%, and DXC Technology, which was Read More


What is the best way to learn about a particular industry? Are you aware of any comprehensive publication that sheds light on both the qualitative characteristics of an industry and the appropriate valuation methods?

Thanks!

There are several ways to learn industries.  I’ll try to explain:

1) You can choose a bunch of companies in an industry, email the investor relations area, and ask for packet equivalent to what they send buy-side analysts.  I’ve done that at various points in time for industries I wanted to learn.  Compare and contrast.  Who is doing well, badly and why?  In the mid-90s, I did this for the trucking industry, and learned a ton of information.  I also talked with some trucker friends of mine who gave me on the ground data.

2) You can read industry publications.  When I was a buy-side analyst for the insurance industry, I read those regularly.  They exist for almost every significant industry.

3) You can go to industry meetings.  Almost every industry has meetings where they discuss industry conditions.  Just don’t be too pushy in trying to get information.  Be interested in the industry as a whole, and don’t try to gain material nonpublic information.

4) Value Line & Morningstar both provide industry analyses.  So do most major investment banks.  You can review those and compare and contrast.

5) You can use the quality screen to look at what industries have a rising ratio of gross profits from operations, versus a falling ratio of gross profits from operations.  Here is a chart from the last seven years:

PRICINGPOWER_8574_image002 industry

The colored field reading “Chg” is the difference between the average of years 1-3 and years 5-7.  Profits are noisy, that’s why I did an average.

Gross profits from operations as a fraction of assets [GP/A] is a good measure of the quality of an industry, and whether their sustainable competitive advantage is is improving or declining.

Now, when I look at a measure like that, I do one of two things:

  1. I buy cheap companies with strong balance sheets among those industries where GP/A has fallen hard, and buy them, knowing that they are survivors, and will rebound.
  2. I buy moderately strong companies in industries where GP/A has been improving, and after research, the trend is not well understood.  It helps if the industry is dull, and few people follow it.

That’s what I do.  Whatever you do, size it to your own abilities, or the abilities of your firm.  Beyond that, look at cheapness of a company relative to normalized earnings, i.e., average earnings over a full market cycle.

By David Merkel, CFA of Aleph Blog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.