How to improve your investment research process

“Data! Data! Data! I can’t make bricks without clay.”
– Sherlock Holmes, The Adventure of the Copper Beeches

A regular Monevator reader, G., recently wrote in with a question about how to properly organise the deluge of information he comes across in his investment research.

Indeed, all of the information available can easily produce, as G. called it, “paralysis by analysis” – that is, being so overwhelmed by data that you decide no decision is the best decision.

G. noted that this issue was starting to frustrate his active investing:

Whilst I am making progress on building a portfolio with ‘good’ dividend companies, I have created a problem with amassing a great deal of information during my research.

With this in mind I was wondering if there were any ‘tips’ on how best to organise this?

I have newspaper / magazine cutouts, information from various books written down on A4 pads, extracts from your website and many others.

The term paralysis by analysis springs to mind. I appreciate that this may not be a subject that you could provide a steer with. It’s just that it is starting to demotivate me on a subject that like.

Thank you for reading this message and keep up the excellent work.

I can certainly relate to the reader’s frustration, as I’m sure many of you can.

Even ten years ago, I would see my stock quotes just once a day in the morning newspaper. Sometimes I’d go to the local library to look up the by-then dated company information that was printed in a monthly shares magazine.

Today, by contrast, investors can have any piece of public information available with just a few keystrokes.

In some ways, this easy availability of financial data makes research less time-consuming.

However the amount of data can also unnecessarily obfuscate the process, and make investing decidedly less fun.

You call the shots

It’s important to start with the premise that investing is a decision-making business. As with most decisions you need to make, you’ll never have complete information nor will all of the data you compile necessarily lead to one conclusion.

Still, you must make a decision to either buy, sell, or do nothing.

What’s great about investing is that doing nothing is a valuable option for individual investors. As Warren Buffett said in 1999, “You don’t have to swing at everything (in the stock market) – you can wait for your pitch”.

In other words, when you’re managing your own money, you don’t need to buy or sell a share if you don’t want to.

This advantage for individual investors shouldn’t be underestimated.

Professional money managers don’t often have the luxury of doing nothing. Their clients usually insist they take action, any action, and falsely equate action with the manager earning his paycheck.

With that in mind, a key to good investing research is to relax.

There’s nothing wrong with saying, “I don’t understand this” or “this isn’t the right time to buy this share” and moving onto the next idea.

Keep the notes you’ve taken on that particular idea to review at a later date.

Go your own way

I believe the best way to reduce all the information you feel the need to keep track of is to focus your investment process.

Each investor’s research process is different. An investor taking a dividend-focused approach, for instance, will likely collect and process data differently than someone with a high-growth approach. That’s what makes a market.

What’s important is that you develop a process that’s repeatable and simple.

The start of a good, repeatable process is to establish some simple screening criteria that greatly reduce the thousands of available shares to a few dozen or so that more closely fit your objective.

To illustrate using a dividend-focused approach, I’ve previously outlined a few screening criteria. The next step in that process would be reviewing the screening results and identifying a few companies that are worthy of further research.

I suggest studying one company at a time, otherwise you’re likely to be overwhelmed.

Once you’ve found a company to research, read the last two or three annual reports and the most recent interim report to get a better feel for the company’s business. If you don’t understand how the company makes its money by that point, I’d pass on the idea.

If you still like the company at that point, take a closer look at the balance sheet, cash flow statement, management, and if you’re an income investor how the dividend has grown over time.

Another key to a good investing research is to focus on avoiding mistakes rather than seeking winners.

When you’re looking at the financial statements, you don’t need to get bogged down in the details (unless you’re an accountant by trade or really enjoy digging into the numbers).

You do, however, want to look closely enough to ensure that the company is profitable, that it generates solid cash flow, and has a balance sheet that’s appropriate for its line of business.

This should sound obvious, but it’s amazing how many messages I get from other investors suggesting I look into a company that has yet to generate a pound in profit.

How do they manage it?

I’d also suggest taking a closer look at the company’s management to see if the leaders of the company are properly incentivised and what major investment decisions (mergers, expansion plans, and so on) they’ve made in recent years.

Have a look through the board’s remuneration report found in the annual report (it’s found in the proxy filing in the U.S.).

Here are a few questions you’ll want to answer

• How is management compensated relative to its major peers?

• Upon which metrics are management’s annual bonuses based?

• Are these the right metrics for this business?

• Have management’s investment decisions made the company stronger or weaker compared to the competition?

Price is what you pay, value is what you get

If you still like the company at this point, I suggest getting a feel for the company’s valuation and comparing it to the market price.

Even the best company can make for a bad investment if you pay £1.50 for it when it’s really worth a pound.

Admittedly, valuation is part art and part science, but again, your aim should be avoiding mistakes – the purchase of overvalued shares – rather than seeking successes.

Anyone can make a share look cheap in a valuation model by changing a few assumptions. Err on the side of conservatism with your forecasts, and if the market seems to be assuming too much growth for now, consider waiting for a pullback in the share price.

The valuation phase is another area of the research process where I see too many investors being overwhelmed by the data or, alternatively, feeling that the more complex and detailed their models are the more likely they’ll be right.

In my experience, even simple models like the dividend discount model that use a few data points can tell you a lot about the market’s expectations and the company’s value.

Seek to follow the 80/20 rule – find the 20% of available data that explains 80% of the valuation.

Manage your time wisely

Finally, it’s important not to follow more companies than you can reasonably cover, given the time you have available for research.

It’s always fun buying new shares, but remember that each company requires what I call maintenance research – that is, reading the quarterly or half-year results, the annual reports, updating model assumptions, keeping up on management changes, and so on.

If you have only a few hours a month for research and you own 50 separate shares, you’ll certainly feel overwhelmed with all the data you need to analyse.

I’d much rather own five shares that I know very well and can reasonably manage than own shares in 50 companies but have little idea of what’s happening at each one.

You might ask, “But what about diversification?”

Well, that’s where index trackers can help even us active investors.

If you can only follow five companies, carve out a portion of your portfolio dedicated to active investments (say 40% of the total) that will contain those five companies. The balance can go into a broad-based tracker fund.

Back to basics

If you’re feeling overwhelmed by your investing process, remember to relax, focus on the parts that are repeatable (because your process should improve with each iteration), and seek to simplify rather than complicate it.

Please post any further thoughts or questions you have in the comments section below. It’d be great to hear from you.

It’s hard to believe it’s been a year since my previous post on Monevator! I promise not to make a habit of being away for so long.

Note: You can bookmark all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted.