Rupal BhansaliCIO, Ariel Investment International Equities
In the original British version of House of Cards, the Chief Whip Francis Urquhart tells a reporter “perhaps we should start by asking some questions.” While things didn't work out so well for the reporter Mattie Storin (you can see the original series here), Mr. Urquhart went on to become Prime Minister.
I bring this up because over the years I’ve realized having access to good data is only half the battle. The ability to ask not only good questions - but also the right questions - makes all the difference in your investment performance. I wish there was any easy way to develop these questions, but there isn’t. An enormous amount of work is required to obtain the data, devise the right criteria, understand what you are looking for, and obtain insights valuable to your investment process.
An example of asking the wrong questions was the performance of privately held Spoonrocket – a meal delivery vendor in California. According to a recent Bloomberg article, investors in the company never thought to ask the company about its last financial statements that were creative (and I’m being generous here) to the point of nonsensical. As an example, the company "failed to achieve profitability by conventional definitions," but was "contribution margin positive." This latter statement simply meant they made money if they excluded "costs of customer service, central employees, office rent, and marketing to drivers." While the company showed remarkable growth and customer service, it might have been helpful if someone had simply asked, “can you make money with this business?”
Spoonrocket shut down in March and sold some assets to a food delivery company in Brazil. Profitable indeed.
While it may be hard to develop industry or company specific questions, I’ve found there are some broader questions that are simple go/no-go in the decision to further investigate. These questions may not require a lot of technical ability, but common sense and intellectual curiosity are a prerequisite. More money has been lost by emotional failures and intellectual laziness than by any other means. Here’s my list of essential questions as you begin to evaluate a potential investment.
What is the Company Worth?
It is so easy to lose sight of this as a northern star, but it’s probably the single most important question you can ask as you get started. No matter how you come up with it - price/book, price/earnings, dividend discount, or discounted free cash flow - estimate a value for your investment. We avoid companies that have business models that we can’t estimate profitability (ever wondered why it’s so hard to estimate the value of a company with no earnings or free cash flow?), financials so obtuse it’s impossible to understand (Enron comes to mind here), or proprietary technology and operations that can’t be shared (I’m looking at you Theranos). If you don’t know how to value a company, then it clearly doesn't fit inside your portfolio.
Do I Fully Understand How the Company Makes Money?
It seems like a relatively easy question, but it’s surprising how few investors can answer this question about their holdings. For instance, many investors will tell you pharmaceuticals’ main customer is a physician. Actually, pharmaceuticals have no business or financial relationship with a physician beyond providing free samples or paying thought leaders to speak on their behalf. Pharmaceuticals manage the actual distribution of drugs from manufacturing facilities to drug wholesalers - and in some cases - directly to retail pharmacy chains, mail-order and specialty pharmacies, hospital chains, and some health plans. They have no relationship with managed care companies, patients, or almost all employers. If you don’t understand how your investment makes money, then don't make it an investment.
Will the Company Be As Successful 20 Years From Today?
The concept of having a wide moat means it will take considerable time and treasure for a competitor to make inroads against your investment’s products and services. We are all relatively clear on what Coca Cola (KO) will be doing for business twenty years from now (though there moments when clarity was lacking – like the time they acquired a shrimp farm), but how clear are we when it comes to Building 19 (“Good stuff….cheap”). The latter isn't really an option (it filed for bankruptcy several years ago), but what about a company like Lexmark (LXK)? Could you really – with a real sense of security – predict what Lexmark will be doing in 2036? If you can’t come up with a concise and confident answer within 30 seconds it doesn't belong in your portfolio.
Are My Data Inputs Valid and Well Reasoned?
This is a relatively subjective question but still critical. The easiest person to fool in investing is your self. The ability to obtain multiple data sets, understand their sources, work out any assumptions, and assure yourself of their accuracy is essential to building out great valuation models. Nothing pleases me more than when I can get to completely opposing viewpoints supported by a great deal of data. Rather than seeing that as a problem, I like to see it as a tremendous learning tool. For instance, I was recently reading two diametrically opposed viewpoints on Nintai Charitable Trust (NCT) holding Expeditors International (EXPD). One writer believed the international supply chain was near collapse based on the China slowdown, crash in commodities, increasing competition, and pricing pressure. The other highlighted EXPD’s operational strength, deep industrial relationships, outstanding management, and slow (but upward) international growth. Who was correct? I think they both were in some ways. In both articles the data was well founded/researched and the arguments provided a tremendous resource in my investment education.
How Do I Break My Investment Case?
In a recent article (you can read it here) I discussed the importance of getting to zero or “breaking” your investment case. In most cases when I calculate an estimated intrinsic value through my discounted free cash flow model, I will halve the companies 1, 5, and 10 year free cash flow growth estimates. After reviewing the impact on valuation, financial strength, etc., I halve it again. Why do this? To me it’s a simple - and ruthlessly effective - tool in creating a scenario that tests the financial limits of a potential holding. As an example, CBOE Holdings (CBOE) - an NCT holding - has grown free cash flow by 14.3% annually over the past 5 years. What would the impact on my valuation if growth was halved to 7.1%? Or halved again to 3.5%? Does the company have the financial strength to handle such a catastrophic event? As you run such models you find there aren’t that many companies that can take such an event in stride. Those that do qualify for further research at the Nintai Charitable Trust.
Asking questions that give you out-of-the-ordinary insights is far more art than science. Much like trying to figure out the best query on Google (how many times have you heard someone say, “I’m a terrible searcher”), investors need to really think about what they are trying to solve and then develop the best questions to obtain helpful insights. In the last twenty years the world has flattened considerably when it comes to finding investment research. GuruFocus is something Warren Buffett would never have dreamed possible starting out in his father’s brokerage house. But data is slowly becoming a commodity. Insights - ones that give an investor a true advantage - are much harder to come by even with all of today’s technology. If you can create a handful of core questions that provide insights into a value-based investing model, then you are half way home already.
 Her full interview can be found at www.latticework.com
 “Tech Startups Come Up With Some Creative Definitions for ‘Profitable”, Bloomberg, Ellen Huet, May 15th, 2016
 Anybody who grew up in New England will realize this is an actual example along with Building 19 ¼ and 19 ½, 19 1/9, etc.