Eddy Elfenbein: Investing is a Bottom-Up Activity

The longer I’ve worked as an investor, the more I’ve come to realize that successful investing is a bottom-up process. By bottom-up, I mean it starts with the very basics of a company (its products and markets) and gradually works upwards from there (i.e., balance sheet, cash flow, valuation ratios).

The problem is that most people are strongly averse to this approach. I don’t know exactly why, but there’s a natural propensity to view the investing world top-down. This clouds nearly every investment discussion. Heck, I’m guilty of it myself.

Here’s how it works. An investment discussion (particularly in the media) invariably starts with the Federal Reserve and the macro economy. Then it works its way down to partisan politics: the budget, taxes and the debt. Throw in a discussion of EMH and how bad hedge funds are (curiously, we’re never told the flip side of EMH—that it’s impossible to lose to the market consistently before fees), and maybe touch on CAPE. Then if we’re lucky, one or two comments about Apple. And we’re done.

This is a huge disservice to readers, and almost none of it matters to being a good investor. The skill set one needs to be a shrewd stock picker doesn’t involve complex math or defending your political party. Rather, it’s closer to that possessed by an investigative reporter or a private eye. Don’t laugh. Whenever I’m in a department store, I’ve gotten in the habit of asking the kid behind the counter, “What’s popular?” He’ll tell you. In fact, he’ll tell you a lot. Just by doing this, you can learn a lot more than what a stock screener will tell you.

Look, I love financial ratios as much as anyone, but the information they give you is very limited. I’ve long called the Balance Sheet the overlooked cute sister of the 10-Q report, but even that only says so much. Here’s an important generality in corporate finance: a good company isn’t usually transformed into a bad one by taking on too much debt. Sure, it’s possible, and certainly it has happened before. But what really happens is that companies take on too much debt precisely because they’re bad. They have a growing need to mask their deficiencies.

A few years ago, I stumbled across Nicholas Financial (NICK). I’ve probably written about this stock more than any other. NICK isn’t followed by any analyst. It rarely generates news. I visited a branch office and later called up the CFO. He patiently answered my many questions. With a little bit of work, I probably knew more about them than anyone outside HQ.

I remember when NICK dropped below $1.64 per share five years ago. It’s really hard to believe in efficient markets when your stock is trading at one-fifth book value and roughly one times earnings for the year after next. The market was offering me dollars for dimes, and I bought them. (NICK just agreed to be bought out at $16 per share.) Inflation, Obamacare, the euro—none of that mattered. To be fair, the Fed’s low rates played a role in helping NICK, but connecting that policy to being a NICK bull would be a stretch.

I also have a growing distrust and outright aversion to the tiresome bull-bear debate (Barry Ritholtz has led the charge on this for years). It’s a fun parlor game, but again, how does it help investors? Not much.

Another favorite game of the top-down view is to find a sector that ought to be big in the future. I know! Green Energy! Robotics! Biotech! China! Chinese robots producing green energy biotech!!

A basic fact about business is that money can be made just about anywhere. Your objective shouldn’t be finding the next so-and-so. You should try to find superior ROE. No top-down approach would lead anyone to Danaher (DHR), but it’s been one of the best-performing stocks of the last few decades. Their stable of businesses is pretty ordinary. That’s what they do, and they do it well.

My advice to investors is to grant yourself a healthy distance from those who view investing from 30,000 feet. It’s easy to wave your hand and say everything’s overpriced and the Dow could go to 1,000. Instead, if you’re interested in a company, start at the ground level and found out why it’s successful.

Posted by Eddy Elfenbein on January 15th, 2014 at 7:56 am