Thursday, March 22, 2012

How much research is enough?

Nate Tobik wrote an excellent piece on his Oddball Stocks blog about scuttlebutt. Scuttlebutt is important. That's what Phil Fisher advocated. And that's what gives Warren Buffett the confidence to put a quarter of his partnership money into American Express in 1960's in the middle of the salad oil scandal (he sat at restaurant tables and counted how many people were still using Amex card) and invest in IBM last year (he talked to his managers who used IBM's services and products).

This leads to an important question: how much scuttlebutt is enough? Or more generally, beyond analysing the financial statements, how much extra research is enough?

Financial statements tell us a lot. The quality of the products, the operation and the management will eventually be reflected in the numbers. But many times, there are delays. The impacts are not immediately visible in the financial performance. Getting the information firsthand before the impact finally surfaces in the numbers gives us an edge. Surely more information is better. So, where do we stop?

I think this all comes down to what Bill Ackman half-jokingly called "Return on invested brain damage":
“One of the things I learned a lot earlier in my career is to do a calculation which I call return on invested brain damage, which is before I make an investment which requires brain damage, or a lot of work and energy, I figure out how much money I can make.  The higher the brain damage, the higher the profit has to be to justify it.”
In short, it's a judgement of "cost vs. benefit" of the your research effort.

As Nate has already mentioned, the bigger your stake is, the more effort you want to put in. Your stake can be big because you have a large pool of money to manage. Your stake can also be big because you run a concentrated portfolio.

Besides, I also believe scuttlebutt is more important in investing in quality businesses than in net-nets. Why? The value of a net-net comes from its current assets, which are (usually) concretely shown in the balance sheet. You don't need to talk to a customer to find out. On the other hand, the value of a quality business comes from things like brand loyalty, quality of services and excellence in execution etc. These are intangibles. You won't find them in the balance sheet. To know you are getting what you pay for, you need to verify the company's brand loyalty, its quality of services, its execution, etc. How? Scuttlebutt.

If you look at it this way, it becomes clear why people like Benjamin Graham and Walter Schloss didn't emphasize scuttlebutt as much as people like Warren Buffett and Phil Fisher. Investors in the first group tended to hold a hundred positions, each taking up only 1-2% of the portfolio; investors in the second group took large stakes in their positions. Investors in the first group invested mainly in net-nets; investors in the second group invested in quality businesses.

One more thought. Early on I said more information was surely better. But is that always the case? Michael Mauboussin in his excellent More More Than You Know argues, with the support of researches, that beyond certain point, acquiring more information doesn't improve the quality of your decision-making. Instead, it will only increase your confidence which may turn out to be wrongly placed. I think this is a form of confirmation bias.

At the end of the day, I agree with Nate. I definitely think I have to do more scuttlebutt than I was. 

p.s. If you want to find out some "think outside the box" scuttlebutt techniques, check out hedged fund manager John Hempton's blog. For example, how to find out a supermarket's supply chain is more efficient than the others? You can do an apple freshness test. How to find out a hi-tech company is likely a lie? Check out what kind of car the CEO's son is driving.


  1. John,

    Really like the post, agree with you that at a certain point research hits diminishing returns.

    Oh, my last name is Tobik, not Nobik..

    Thanks for the post and the thoughts.