🧗 10,000 hours of Scuttlebutt
OIJ (#7) Pros and cons of performing your own financial research (and buying an index fund)
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In Service to Yourself, In Service to Others
Most people overestimate their ability when it comes to executing certain activities. This is particularly true in finance for single men who have never undergone a major correction. In the words of legendary investor Peter Lynch:
A correction is nothing more than a Wall Street euphemism for losing a lot of money very rapidly. Behind all the smoke and noise on the market's surface, it's important to remember that companies - small, medium, and large - make up the market's backbone. And corporate earnings drive stock prices - Peter Lynch
People seem to compute probability erroneously. These calculations lead us to incorrect conclusions and, more distressingly, they inspire a false sense of security.
The lesson here is obvious… guys, please start dating. Jk.
On a more serious note, this is called the Dunning-Kruger effect in psychology. It’s a simple yet effective way of visualizing perceived competence (confidence) against real competence.
How and why do people get it so wrong? Let’s start by examining the foundational stage for every human being who’s ever been interested in finance and get-rich-quick schemes.
The Gambling Stage
Although most people will call this speculating, to me, speculating requires some skill, which we lack at this stage. Because we are generally blank slates, we tend to gravitate towards solutions that seem to take us to the promised land as soon as possible.
When you gamble, your brain releases a powerful chemical called dopamine. This is the feel-good neurotransmitter that makes you excited. One would expect to feel excited only when winning, but your body produces this neurological response even when you lose.
This effect is caused by the quick succession of wagering, acting, and receiving a reward (win/lose). Being high on these chemicals leads to acting irrationally, increasing the chance of losing sight of what the odds are and ignoring the probabilities of certain outcomes, especially those on the downside.
Michael Easter on the JRE presented a fascinating idea called Scarcity Loops. This three-factor combination leads to extremely addictive behaviors.
Opportunity. There must exist a chance of getting things of value. The probability of winning does not matter as much
Unpredictable results. Players must know they will win… eventually. However, they don’t know when or how much
Quick repeatability. The game must immediately be replayable. On average, players finish 16 games per minute on slot machines. On the stock market, you can potentially take part in limitless games running simultaneously
Before moving on, I want to point out that Michael mentions a casino operation that is not open to the public and is designed to study human behavior. It is allegedly financed by 73 companies, including large Fortune 500 tech, and will probably be the topic of study of a post in the future.
With all this in mind, I’m not advocating for people to start or stop gambling, but rather I’m pointing at the fact that you should acknowledge and accept that you are gambling when it comes to your first few bets on the stock market. It can be addictive, but the best way of dealing with it starts with understanding the symptoms.
Hopefully, your brain will remember this feeling when you’re dealing with a conundrum in the future. Used correctly, it’ll build up your investment instinct and serve as a warning whenever something resembles a gamble.
Most people stay in this phase forever. Some are by choice, and others are due to a lack of one or more key elements that make for a good investor.
Essentials for Investor
Anyone wanting to become a good investor should - humbly - assess whether they possess the following abilities. The description is non-exhaustive but focuses on describing the core aspects of each principle.
Technical. Deep understanding of accounting principles, applicable regulation, sector-specific information, intellectual property (IP), and competitive advantage
Intellectual. Capacity and willingness to work close to the edge of your circle of competence and continuously push to expand its boundaries
Temperamental. Innate ability to control your emotions, deriving neither great pain from failure nor great pleasure from success
You can work very hard to develop technical and intellectual aspects through a combination of theory and experience. Unfortunately, most of your temperament and the part that counts of your intellect is inherent to your personality, the way you were raised, and, let’s face it, your gene pool.
I believe the characteristics that make for a good investor are bestowed on you rather than earned. You can be terrific at puzzling out a mosaic of information from years of research, but it’s pointless if you can’t act on it.
Acting can be a very mundane task, similar to buying groceries, or, in times of crisis, it can be extreme, like jumping off a plane with no parachute.
If you can’t sleep like a baby because you’re concerned about some position in your portfolio, then you’re either taking on too much risk or you are not built for it.
In both cases, you should opt for delegating.
The above-mentioned attributes make for the necessary, but not sufficient, conditions to become a GREAT investor. Even though most people won’t acknowledge this, the difference between good and great is plain and simple luck.
One would assume there’s some additional factor in the equation, but if you think about it, that’s pretty much it. In the words of the late Munger:
Well, you’ll end up agreeing with me because you’re smart and I am right.
-Charlie T. Munger
So now that we know we don’t want to gamble, understand and possess the abilities that make for good investors, and want to take action, what are our options? We can choose to either do it ourselves or delegate it.
Delegating implies buying everything, usually in broad and indexed exchange-traded funds (ETFs), or trusting a professional money manager to do the job. Both options avoid getting into the topic, passing the buck to a third party who will spare us the time and - possibly - make us money.
Most people should delegate. This might sound like advice for beginners, but it isn’t. At this point, even professional money managers should take a step back and ask themselves:
Are you chewing more than you can eat?
Are you acting outside your circle of competence?
Are you deviating from your core strategy?
Are you diworsifying?
We will, however, explore the far more entertaining and probably less effective option of doing it ourselves. On the off chance that you’re the next Warren Buffett, this may yield extraordinary results and be tons of fun for you. Either way, I love doing it, so I might as well share it with the world.
What is Research?
Research is simply the means to understand what a company does to a certain extent. The idea is to interpret publicly available information (10-K, reports, news, presentations, podcasts, newsletters, etc.) and private information (scuttlebutt) to assemble a mosaic.
This mosaic of information should provide an edge, asymmetric information that can allow an investor to build conviction without exceeding legal limits. In the public market, this limit is called privileged or insider information.
There are many correct ways of going through this process, but the way I approach it is goal-oriented, meaning I’m looking for specific information that makes the case for the company extremely compelling.
My process leads to idea rejection. I’m looking for excuses to say no, so ideas that remain end up being very strong cases. Note that even when you think you’ve grasped the matter, you’re probably wrong. Once again, Dunning-Kruger steps in, and once you have an established base, the more you know, the more you will doubt your competence.
Some items, correlations, or events remain unknown even after several walkthroughs. However, with experience and the will to push through, even these can be unveiled.
In my experience, this mostly happens after you purchase the share, which is not ideal, for lack of a better word. With that in mind, and contrary to my previous beliefs, once you know about 50% of the story, you’re probably ready to jump in at the right time.
My process is simple: You must verify and be okay with the first step before proceeding to the next one (A→B→C→D). The way you test for each can vary significantly, but by having a concrete target, you can discard companies based on fit.
e.g., you are offered to invest in a listed Tier 1 automotive enterprise.
(A) → You have an analogous understanding of the Tier 2 automotive parts segment because you worked as a machinist for 5 years, got along with suppliers, and understood the value chain.
(B) → Revenue growth is around 10%, margins are constant at 5%, and debt looks in check. Looking at their financial,s you spot an abnormally high CAPEX for the last 2 years, meaning FCF should be higher in theory.
(C) → You start interviewing clients, suppliers, former employees, and competitors. They all mention that the company is run by incompetent managers who overspend on trivial marketing and bad quality parts that they must replace frequently. The replacement rate matches the extra CAPEX you spotted when looking at the financials.
(C*) → Your process ends here. You might want to save the company on a watchlist if management changes, but you can’t invest in the company. On the bright side, you learned a few lessons that will make future research efforts more effective.
What is Scuttlebutt?
Scuttlebutt generally refers to rumors or gossip. The term originates from sailing, where drinking water was stored in a "scuttled butt", a cask with a hole for accessing the water. Sailors would gather around this cask and exchange gossip, leading to "scuttlebutt" becoming slang for rumors, similar to modern "watercooler talk" in offices.
In investing, the Scuttlebutt Method, introduced by Phil Fisher in his book "Common Stocks and Uncommon Profits," involves gathering insights about a company by talking to people connected to it, such as customers, vendors, trade associations, competitors, and employees.
Why is Scuttlebutt Research Important?
Scuttlebutt research is crucial for two main reasons:
Deeper Insights. It provides a deeper understanding of a company that can't be obtained just through reading. Insights from employees and customers can reveal valuable information about employee morale, customer loyalty, and potential switching costs.
Primary Research. This method is a form of primary rather than secondary research, such as reading financial statements. Conducting direct research builds confidence and conviction in an investment, especially during market downturns.
Practicing Scuttlebutt
Practicing the Scuttlebutt Method effectively is akin to method acting, where you immerse yourself in a subject to understand it thoroughly. Over time, this approach becomes second nature, making you a perpetual researcher. Here are a few tips on how to embrace the methodology through practice:
Combine Anecdotal and Empirical Evidence. Avoid relying solely on anecdotes. First, empirical research will be conducted by reading financial statements and company presentations. This foundation allows for informed conversations with knowledgeable individuals.
Seek Disproving Information. Guard against confirmation bias by seeking information that contradicts your hypothesis. Engage with both supporters and critics of the company to form an unbiased judgment.
Talk to a Diverse Group of People. Avoid echo chambers by talking to people outside your usual circles. Conversations with strangers, such as taxi drivers or store employees, can provide fresh perspectives.
Empathize with End Customers. Understand why customers use a product or service and what they like about it. Engage with users directly, whether through social media or personal product use, to gain firsthand insights. (Google/Amazon) Reviews can help, but they lack depth. Talk to people instead.
Think Broadly About Potential Sources. Leverage your network to find knowledgeable individuals. People in specific industries often enjoy discussing their work. For instance, ask professionals like dentists or car salespeople about industry-specific companies.
Maintain Confidentiality. Ensure sources that their information will remain confidential. This trust encourages openness and provides richer, more candid insights.
I hope these provide a more complete idea of the art of Scuttlebutt. This methodology, in combination with fundamental analysis, should lead to a more comprehensive understanding of any potential investments.
Fanatics
On a last note regarding my process, I usually leave management for last. Professional managers are great salespersons, so you don’t want to get trapped in their webs too soon. I think you should approach them at the end of the process because execution is crucial for most investment cases.
On the management front, two factors account for 90% of performance.
Integrity. Ethical standards and honesty of management. It encompasses the commitment of managers to uphold ethical principles, transparency, and fairness in their decision-making and interactions with employees, stakeholders, and the public.
Competency. Skills, knowledge, and abilities to effectively lead and manage an organization. This includes strategic planning, problem-solving, decision-making, communication, and leadership skills.
The best managers are obsessed with improving their enterprises. These fanatics constantly seek alternatives and use every opportunity to push their organizations forward.
Some may derive satisfaction from working 24/7 and having total control over every detail. Others may completely decentralize each department’s decision-making and push for superspecialization.
In either case, great managers will never take their eyes off the ball.
Scuttlebutt vs Indexing
The original question remains:
What should you do? Should you index? Should you do the research yourself?
Beyond understanding where you land in terms of investing know-how, there is only one major factor to consider: time
All of this takes inordinate amounts of time. Even if you can do it, you might be better off dedicating time to other things. This is, of course, a very personal choice. To me, it’s a matter of what makes me happy.
On that cheerful note, I’ll wrap up with a modified version of a quote from the Dào Dé King. The original quote reads:
When the student is ready the teacher will appear. When the student is truly ready... The teacher will disappear - Lao-Tse
Well, in investing, when the student is truly ready, they will acknowledge that they should probably index 😂
🙏 Feel free to ❤️ and comment so that more people can discover and enjoy this Substack 😇
I've tried conducting this type of research several times, but I often hit a roadblock when it comes to contacting the key individuals involved. Could you share your approach for reaching out to the C-suite?