The Investment Checklist

by Michael Shearn

  For example, if you are studying the television industry, then attending the National Association of Television Program Executives (NATPE) conference will give you valuable insights because most attendees are involved in the creating, developing, and distributing of television programming. You can walk from booth to booth talking to representatives from each company, asking them why their product or service is better than competitors. You will very quickly understand the pros and cons of a product and service by doing this. It would take you a long time to obtain this information otherwise, but you can do this in a few days by attending the conference.

  In my visits to conferences, I also like to watch how top management and employees interact. How comfortable are the employees when the top managers are around? Do they change their behavior? I like to ask the employees at the booths what hotel they are staying at and what hotel the managers are staying at. If the managers are staying at a luxury hotel such as the Four Seasons and the employees are staying at a budget motel, this may mean that the business does not value its employees, or at least that management sees itself as different or above the frontline employees.

  Other Industry Insiders or Associates

  You should also search for tangential sources, not just customers, competitors, employees, and suppliers. Think of other industry insiders or associates, such as those people concerned with manufacturing data, trading data, or people who operate social and professional centers. For example, when my firm was analyzing Western Union, we spoke with individuals who worked at the World Bank whose job was to collect remittance data (when migrant workers send money home, it is called a remittance). We wanted to understand if Western Union’s growth potential was high or low based on existing data and whether the existing data underreported the true size of the market. People who work closely with the data were able to give us more detail about market estimates.

  For example, we learned that Banco de Mexico, who reports its figures to international groups and the U.S. government, gathered much of its data from Western Union itself. Because they only accumulated data from a few commercial sources, we knew the market size was larger than estimated. This led us to learn more about how the larger market functioned, and eventually gave us greater insight into how remittances work. It also helped us understand that Western Union had more market growth opportunity than was first apparent.

  Talk to Professors at Nearby Business Schools

  Another great tangential source is college professors and deans of the business school in the area where the business is located, because they probably interact with the local business in some capacity. Also, many prior students of these professors may be working at the business. What is the reputation of the business in the community? Is it a good place to work? Does the university want its students to work there? For example, I sold an investment in one company after I learned from a university dean that the company’s management team took advantage of its customers and that many former students complained about an unethical culture.

  Talk to Headhunters

  Talk to headhunters who work in a particular industry and ask them what businesses they believe are the best places to recruit management from and why. Headhunters are an extremely valuable resource because their job is to find skilled management for a business. You can find headhunters by locating the local office of the larger recruiting firms where the business is located. For example, if a business is located in Atlanta, Georgia, you would search for articles that listed the top 10 headhunters in Atlanta. Then, you can begin to look for individuals in these firms or those who are cited in articles.

  How to Contact Human Sources—and Get the Information You Want

  One way to start building your human intelligence network is to contact those sources that are quoted in articles written about a business or industry. One of the hardest things to do is to pick up a phone and call someone you have never met. It is called the cold-caller’s curse. The stress you feel is produced by a fear of rejection. However, because these people have already spoken to the press, they will likely speak with you, which will increase your confidence in reaching out to other sources. This does not mean that you should talk only to readily available sources, but it is a strong start in locating and contacting the best sources.

  Try to learn as much as you can about your sources before speaking with them, and then write a letter referencing the article where they were quoted. Ask if they can give you a couple of minutes of their time to further elaborate on their comments. In the letter, let them know why you are calling them and how you will use the information they give you. Sending a letter, instead of an e-mail, will stand out, and you will dramatically improve your chances of speaking with a source.

  Also, offer to share your conclusions from your research. This serves two purposes: First, it gives you an opening to maintain a regular contact with a source; second, you will engender goodwill. Be sure to keep in contact with your most valuable sources regularly so that you are not calling them out of the blue when you need them most. You will find that it is tedious to begin this process, but the more you do it, the more momentum you will build, and the easier it will become.

  When you contact a source, your goal is to get information on why things are happening. The best questions are broad questions rather than direct questions. For example, a direct question is, “What time is it?” because you get just one answer: “It is 8:00 pm.” In contrast, a broad question is, “How do you think this business compares to its competitors, from the customers’ point of view?” You will find that one of the biggest benefits to asking broad questions is that you will uncover many things that you did not know about the business and even things that you didn’t realize you needed to know.

  At the end of the conversation, ask your source who else you should be talking to or who are considered some of the most knowledgeable sources in an industry. You should also tell your sources that you will not quote them in any research reports and that you will protect their identities, even if they give you permission to quote them. There should not be any risks for your source to talk to you, and it is important that you build trust with them.

  Don’t despair if a source is unwilling to speak with you. I have found that sources who are less willing to speak are the worst sources anyway, as they are often less engaged. People who are open to speaking with you are generally passionate about their subject area, and they will talk at great lengths about it to others who show genuine interest in their knowledge. The more passionate the person, the more open he or she usually is to sharing information.

  Create a Database of Your Interviews for Future Reference

  Be sure to record all the details from your conversations without adding your own commentary or ideas about what you think a source meant. If you are unsure, note this. This way you will not fall into the trap of rationalizing the answers of your source with your assumptions. Remember, great investors see things as they are, rather than as they want them to be. You also want to note whether your source is stating assumptions, a theory, a fact, a question, an idea, or a related point. Do not be in a hurry to write a summary of your conversation, and write down all responses. This way, you can create a collection of interviews that you can turn to later. Many of the answers you receive from your interviews will seem innocuous or unimportant, but this information can be valuable later.

  Write a brief synopsis describing your source. Was this person friendly, passionate, and engaged? Or did he or she answer questions quickly and want to get you off the phone? If you include this information in your notes, it may help to provide a context for the source’s comments.

  You will find that by piecing together a great number of ordinary observations, you end up with unexpected and meaningful insights. As you interview more and more people, you will start to see patterns that help you understand the larger picture.

  You want to cultivate your sources and stay in contact with them at least two to three times a year. The ma
in advantage of staying in contact with your sources is that you can turn to them whenever there is a negative news report that causes the stock price to drop. These are the people who can help you interpret the true severity of the news. These sources can also alert you to negative developments and inform you of changes in the business. My firm invested a lot of time over many years identifying reliable people in the industries we were invested in. We have learned that you need to do in-depth work on identifying sources and establishing their credibility in advance, because it is difficult, if not impossible, to do this in a short period of time.

  Knowing we could speak to credible, reliable people paid off for us. When the price of our investment holdings suddenly dropped during the economic downturn in 2008, rather than relying on newspapers and other secondary sources for information, we called our customer, supplier, and management contacts to better understand what was going on at the business level at each of our holdings. After speaking with these sources, we learned that things were not as bad as the more sensational news reports suggested. This helped my firm maintain rationality and be opportunistic, because most general news stories were reporting that the U.S. economy was potentially headed into a depression.

  APPENDIX B

  How to Interview the Management Team

  I regard interviewing managers as something of an art, and I admire those who do it well. When you think of the best interviews you have read or watched, you may remember how you were drawn into the conversation. Part of what drew you in was probably the fact that the interview had, at some point, turned into an engaged and meaningful conversation. At their best, management interviews can provide deep personal insight into how managers think.

  If you have an opportunity to meet with members of the management team, use your time learning how they got to where they are and ask what lessons they learned along the way. This will put most managers at ease, as you are talking about their favorite subject: themselves! You will also find that the answers you receive are more revealing, and you will gain better insight into their character. Most Wall Street analysts don’t ask these questions, so the manager’s responses are less likely to be scripted.

  The conversation you want to have will be focused on management’s view of how the business is run. Ask questions that are open-ended rather than closed-ended:

  An open-ended question is, “How did you make the decision to hire the senior vice-president of development?” This type of question requires a detailed, conversational answer.

  A closed-ended question is, “What is the tax rate for this quarter?” This type of question can be answered with only a one-word answer, which won’t reveal anything about how a manager thinks or makes decisions.

  As interviewer, your job is to listen, and then continue to ask questions to clarify what a manager is saying.

  Do not ask hypothetical questions, such as, “What would you do if you were confronted with a certain problem?” The answers to these questions do not yield many insights because what managers think they will do is often different than what they will actually do. Instead, ask questions that will help you learn how the manager thinks and how he or she plans to execute.

  Ask Open-Ended Questions

  The following are a few open-ended questions you might ask (in no particular sequence). You should focus on the questions that you think will be most revealing to you:

  Why did you join the business?

  How did you rise at the business?

  What skills made you chief executive officer (CEO)?

  What do you believe the job of the CEO is?

  What do you want to be known for?

  How do you measure whether you are successful?

  If you were sitting down with some potential long-term investors, what two or three reasons would you give them to take a look at the business at this time?

  Is there a possibility this business is going to be two to four times as big as it is today, five, or seven years down the road?

  If you were a private business, how would you operate differently?

  What do you like about working here?

  Who are your current and past mentors, and what impact did they have on your life?

  What character traits are needed for your job?

  What character traits do you look for in a successor?

  What three things would you do to destroy the business as quickly as possible? Give yourself a one-year time frame.

  What type of people are you looking to hire?

  How do you find quality candidates?

  How are you developing future leaders?

  What is the culture you are trying to instill at your business?

  If we were meeting three years from today, what would need to have happened during that time for you to feel happy about your progress?

  How do you keep the big picture in perspective and not get too bogged down in the everyday details?

  What factors do you consider before you expand into a new market?

  What are the biggest opportunities the business has?

  How many people do you need to hire to grow?

  How do you stay close to your customers?

  What type of information do you need on a weekly basis?

  If you were away for one year, which key metrics would best tell you how the business was doing?

  Why can’t other people do what you are doing?

  Be Aware of the Danger of Face-to-Face Assessments of Managers

  Most investors overestimate their ability to judge a management team based on a face-to-face meeting. They believe they have the ability to judge a person’s character by looking him or her in the eye or watching body language. However, there are many problems associated with relying on your gut instincts.

  First, you may be unduly influenced by the personality or personal beliefs of the manager. We all like people who are like us, and we tend to dislike people who are not like us or who don’t share our beliefs. Perhaps the CEO does not have the same political views as you do, and you therefore dismiss his or her ability. We all overestimate our abilities to be rational, and how much we like someone often affects our judgment.

  Another stumbling block is looking at the world through your own perspective rather than through the other person’s perspective. Let’s say you are a hedge fund manager who likes to push your subordinates to work 20 hour days, 6 days a week. What types of management teams do you think you will admire? You will admire those businesses that push their employees to work long hours. The problem is that this type of culture may not work at certain businesses (or many businesses, for that matter).

  Second, managers will tend to share with you the things they think you want to hear. You might sit down with a CEO and listen to what appears to be a well-laid-out plan to create value that increases your confidence in the business. There may be other negative elements that you don’t hear about, and in fact, the plan may fail miserably. Part of this is just human nature or optimism and not that the managers intend to deceive you. Adding to this problem is the fact that many managers are simply overconfident in their own abilities.

  A third error in assessing management is ignoring situation and context. We often attribute behavior to a person’s character rather than to the situation or context. For example, if a person is going through a divorce, this situation may make the person appear to be unstable even though he or she may not be that way on a normal basis.

  Fourth, we all have different backgrounds and experiences, which affect how we assess people. If you have spent most of your time in an office, it is likely you will resonate with a manager who has worked in the corporate suite his or her whole life instead of one who spends time in the field.

  Fifth, our ability to evaluate people is affected by the company we keep. The more we associate with people with good character, the easier it is for us to recognize those who do not possess good character. Early in my career, I mixed closely with some people with serious character flaws. I
found myself constantly making excuses for them. I would say things such as, “I know they have certain flaws, but I am learning a lot from them.” Over time, I began to spend less time with these people in both my business and personal life. I found that my ability to make distinctions quickly improved. The more I associated with good people, the quicker I was able to identify those who had serious character flaws that might affect their business.

  APPENDIX C

  Your Investment Checklist

  Understanding the Business—The Basics

  Do I want to spend a lot of time learning about this business?

  How would you evaluate this business if you were to become its CEO?

  Can you describe how the business operates, in your own words?

  How does the business make money?

  How has the business evolved over time?

  In what foreign markets does the business operate, and what are the risks of operating in these countries?

  Understanding the Business—from the Customer Perspective

  Who is the core customer of the business?

  Is the customer base concentrated or diversified?

  Is it easy or difficult to convince customers to buy the products or services?

  What is the customer retention rate for the business?

  What are the signs a business is customer oriented?

  What pain does the business alleviate for the customer?

  To what degree is the customer dependent on the products or services from the business?

  If the business disappeared tomorrow, what impact would this have on the customer base?