I begin by taking a "macro" view of the economy, encompassing both the medium (1-2 years) and long-term (3-5 years). Having a macro view helps me maintain focus when evaluating investment opportunities because it forces me to think twice about investing in a company whose underlying thesis is inconsistent with my overall view. I think of the macro view as the foundation of the house - something that the other parts can hold onto. However, I'm also aware that my initial views can change, and that there is nothing wrong with revising an opinion if new information presents itself and rejects the facts and/or assumptions that I previously relied on.
Armed with a particular view, I think about what sectors will be impacted (directly and indirectly), and the companies that could benefit (or suffer, on the short side). With the global economy being so intertwined, chances are high that a particular event will affect several industries - like a set of dominoes. In fact, it takes time for valuations to adjust in companies within the second or third derivative industries because the market is so focused on what's in front.
I learn about companies mostly from reading periodicals such as Financial Times, Wall Street Journal, Barrons; magazines such as Businessweek, Fortune, The Economist; news sources such as Bloomberg, CNBC, New York Times; and sell-side equity research reports. I also use the internet as a source for ideas. For example, I can run a search on a particular function (e.g., "medical waste recycling"), and see what kind of companies come up from the search result (e.g., "Stericycle").
From the list of companies that fall under the industry (or industries) that I want to invest in, I narrow it down to one or two companies. There is no iron clad rule that I follow, but generally I try to keep the following factors in mind as I go through their annual and/or quarterly reports (i.e., 10K and 10Q):
- Does the company have a sustainable competitive advantage? This is what Buffett refers to as the "moats". The larger the moat, the harder it will be for competitors to try and take market share away. A competitive moat comes in many forms: intellectual property, monopoly, significant cost advantage, regulatory environment, brand loyalty, AAA credit rating, etc.
- Do I understand how the company makes money? Is there visibility on the future earnings stream? If it is too complex to understand, I'd rather stay away. Companies whose revenues are contracted are the easiest to analyze because it minimizes uncertainty. Included here are commercial REITs (you are told the lease amounts and the average rent term), utilities (they disclose the rates charged), and shipping companies (the day rates and average contract terms are disclosed).
- How does the company's fundamentals look? This question can only be answered by digging deep into the company's financial statements and footnotes - which is done only by a few investors (according to several sources e.g., commodities investor Jim Rogers). Before I attempt to model, I first look at things that I can quickly calculate, such as: amount of leverage, proportion of equity supported by intangibles/goodwill, whether the operations generate sufficient cash flow to support the business, trend of margins, signs of accounting gimmicks (this is a red flag), etc.
- Does management have a stake in the company? It's easy enough to check Bloomberg for insider transactions, and I certainly am skeptical when I see management selling their shares (e.g., Anthony Mozillo of Countrywide - now BofA).
- Are the shares fairly valued? I look at various metrics to evaluate a company's valuation: P/E, P/B, P/Sales, EV/EBITDA, FCF Yield, PEG ratio, etc. Certain metrics are specific to particular industries, so I only focus on those that are relevant. For example, I wouldn't use P/Sales ratio to value banks.
I leave modelling to the very end because by now, there should only be one or two companies that remain on the list. I'd rather model one or two companies that I believe to be good investment opportunities, rather than model 10 companies that I don't know much about. There is no sense doing a deep dive if the company's high level fundamentals do not check out. Although I put modelling at the end, it does not mean that it's not important. I find lots of valuable information as I populate the model, and it allows me to gain a better understanding of the economics of a particular business. When modelling, I'm mindful of the industry and the macro outlook when projecting earnings into the future. This is when I tie-in the macro view/economic outlook to the company's strategy, competitive advantage, fundamentals, valuation, and growth prospects - forming the backbone of my investment thesis.
After going through the process above, I may or may not end up proceeding with my original investment idea. If I'm lucky enough to find an attractive investment opportunity, I at least document the thesis and some points about the company so that I can remember (down the road) why I bought the shares in the first place. On the other hand, if nothing good turns out, I go back to the drawing board, re-think my idea, and come up with new companies to evaluate.
An analyst who I previously worked for taught me a valuable lesson, "Investing requires a great deal of patience because you will encounter several "dead-ends" before finding the right opportunity". Very true.