Sunday, June 29, 2014

When to Stop Researching a Stock

The above tweet from Amni Rusli (you can follow her on Twitter and I recommend doing so) struck a chord with me. In my eleven years of researching stocks, I have yet to come across a "perfect" one.

There's always something you won't like about the company you're researching. More to the point, if you can't find anything wrong with the company, you're not looking hard enough.

Some of the most common negative factors that I come across in my research are:
  • Concerns about the company's durable competitive advantage (if it has one)
  • Misaligned management incentives
  • A bad recent capital allocation decision (e.g. paying too much for an acquisition)
Sometimes these factors are enough for me to walk away from the research idea, yet if I like most everything else about the company, I'll keep researching. 

WD-40 Company (WDFC) is a good example of this -- I love the business, think management is doing a fine job, but really don't like that it uses EBITDA as a performance and bonus measure. Still, I wouldn't not buy WD-40 at the right price simply because it uses EBITDA. 

If the company you're researching meets at least 80% of the criteria you look for in a stock and is trading at a good to fair price, that's an attractive opportunity. Don't let perfect be the enemy of good, as the saying goes, and miss the opportunity because you're looking for that last 20%.

But watch out for these red flags

It's one thing if the negatives are fairly benign, but there are a few negatives that I consider massive red flags and will immediately stop researching the stock if I find one of them. 
  1. Untrustworthy management: If there's anything in management's background that is particularly off-putting to you, just walk away. A common exercise is to ask yourself if you'd trust them to watch your kids/dog/cat while you were away on vaction. 
  2. Blackbox revenue stream: To borrow a phrase from Peter Lynch, if you can't illustrate with a crayon how the business makes its money, you shouldn't own the stock. 
  3. Aggressive accounting: This can be tricky to detect. Here's a tip I picked up from my friends John DelVecchio and Tom Jacobs who wrote What's Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio -- focus on revenue recognition as it is crucial to confidence in everything below it on the income statement and, by extension, the cash flow statement. One simple test you can run is looking at Days Sales Outstanding (DSO), explained here
  4. Government entity as a major shareholder: Government owners have different motivations than regular shareholders.
  5. Unethical actions: Similar to the first point, but different in the sense that the unethical action could have been made by someone outside the executive suite. This speaks to a lack of risk management within the company and reflects poorly on management.
When do you stop researching a company? I'm curious to know. You can let me know in the comments section below or on Twitter.

Stay patient, stay focused.


@toddwenning on Twitter