In this post, we’ll break down the steps involved in building an investment thesis for a company in which you are interested.
It Starts With an Observation
All investments – good and bad – start with an idea, or an observation. I’ve referred to the Peter Lynch story about seeing L’eggs eggs all over the house and how that observation lead to his research into whether the company was a good investment. Read One up on Wall Street for lots of great advice on investing in stocks. See the post here.
One of my observations was Netflix. Somewhere around 2000, I bought a DVD player. In the box, I found a coupon for a company called Netflix which offered DVDs by mail. I signed up for the free trial and I was hooked. Not long after I started with Netflix, I started to wonder about the company. Who came up with this great idea of DVDs by mail? Does the company do anything else? Do they make a profit?
Whether it’s L’eggs or Netflix, an interesting observation and some curiosity is where great investment ideas start.
What Happens Next?
Research.
I hated research in school. I much preferred to wing it. The idea of going to a library, poring over books to find the information I needed was my idea of a bad time. So how did I get into investing in companies since research is such an important part?
There are many ways to research.
Story Time
I hate research but I love a good story. Early in my career, I had the opportunity to attend an orientation class at a large investment firm in Boston. This older guy came in, and proceeded to tell story after story about the investmen management team. One particular one has stuck with me. Here it is:
Every day, executives from several large S&P 500 companies would come to our investment firm to pitch their companies. Our top research analysts and portfolio managers would attend these sessions to hear the stories. The executives would go through their financials, growth projections, market opportunity, their strategic advantages, competitors…After the session, as folks were walking out. Some folks would say “Great presentation, I’m buying shares.” Some would say “I’m not buying the story.” I’m selling my shares.”
Who’s right? All these folks have MBAs in finance from prestigious universities. They are well trained and they all saw the same presentation.
Who knows who’s right. Investing is a long game. We don’t get immediate feedback, or the feedback we do get doesn’t tell the whole story. Let’s say we’re optimistic after the meeting and we buy shares. The next day the stock is down 20%. 2 years later it is up 120%. I’ve gone through these stories in other posts so I won’t go through them again here, but the point is, it’s not easy to tell. There will be many strong opinions on both sides and all will have a compelling story. For more, read here and here.
Create a Thesis
If these guys can’t agree, what chance do we have as individual investors? You need a thesis. A thesis is basically a list of the reasons you’re interested in investing in a company. One of the investing services I subscribe to publishes 5 green flags and 3 red as part of their thesis. The green flags are things that are going well that need to continue for the company to hit its projections. The red flags are risks. These are things that are working now but could go wrong in the future. If they do, they will make it difficult for the company to meet its goals.
Your thesis should be test-able. When the company publishes earnings, you want to test these results against your thesis. As a Netflix shareholder, I am interested in seeing that the number of subscribers is growing. I also want to see that profit margins are growing. Netflix has invested a ton in developing content. I want to see that they are growing subscribers and growing revenue faster than their content costs. And it’s not just the earnings report. As a customer I can see that there are some Asian and Turkish films and TV shows that are in the top 10 in the US. That means they are leveraging their content in multiple markets.
That wasn’t that hard, was it?
Find a Good Analyst
No, not a psychologist, but then again, who am I to say. But find market analysts that you trust and respect. Whether it is a podcast or a website, there are lots of folks publishing their thoughts. I look for folks who will foster healthy debate. If the post screams “Here’s the next market beating stock” it’s probably not. I listen to Motley Fool Money every weekend because they talk about most of the stocks I’m interested in and the analysts challenge each other. They talk about stocks on their radar – companies they are looking into and why they might be a good investment and why they might not. I want to hear the pros and cons, do some reading on my own and then develop my own thesis for the company.
Thesis = Commitment
If we’re having ham and eggs, the chicken is involved and the pig is committed. Similarly, if you get a hot stock tip at a party, and you buy some shares, you are involved. Do some research and create a thesis, you are committed.
Evolving Systems
I’m with friends in Key West. Over drinks, an “investment guy” I just met tells me about Evolving Systems. It’s going to go to the moon. I’m new to stock investing so I assume hot tips are the way to find solid investment opportunities. Writing it now, it sounds foolish, but at that time, who knew?
When I returned home, I took $500 and bought shares, fully expecting to make a killing. It dropped 20% almost immediately and I sold.
What Did I Learn
I had done no research or reading about Evolving Systems. I couldn’t tell you what they did, where they were located or who their competitors were. I was not committed.
Contrast this with Netflix. I can’t count the number of times Netflix dropped 20% or more. Not once did I sell on a drop. Not even after the Quickster debacle where it dropped somewhere around 80%. I had a thesis with Netflix. I was a happy customer and the stock price change did not make me any less of a happy customer. They were also geting into this “streaming thing” which seemed to have possibilities, even though I was still on a dial-up modem and I could barely get a page of text to load.
I’ve gone a bit off-track, but the point is that building the thesis builds commitment and you must have commitment to stick with your investments when times get tough.
Am I Always Right?
No.
I considered ending it there, but I’ll expand a bit.
Yellow Trucking, ticker YELL, now YELLQ after the bankruptcy. If you’re guessing it didn’t go so well, you’re correct. I was looking into logistics. We’re ordering lots of stuff online and there is a huge need to move stuff around. At that time, Yellow is the low-cost LTL (less-than-truckload) carrier. It has lots of debt but it is restructuring and has some new management. A turn-around play for sure, but I buy a small investment and begin to watch. It’s not long before Yellow can’t make a debt payment, and soon after that it is in bankruptcy. I had a thesis. I was committed so I stuck with it. I was wrong.
I was also wrong on Intel, Under Armor, and several others.
Why Stick With It?
I have more winners than losers. My winners have gained a lot more than my losers have lost. My $500 investment in Evolving Systems lost me a quick $100 when it dropped 20%. My $2,000 investment in Apple in 2011 is worth over $29,000. A stock can only go down to zero, but it can double many times over. I’ve found that if I do my research, create a thesis, test my thesis regularly, and learn from my mistakes, I can do pretty well.
Diversify
I also diversify. I have a healthy load of low-cost S&P 500 index funds. I own bonds, and I have a good size emergency fund. I keep a reasonable portion in individual stocks.
A Note on Choosing Companies
In this, and in my other posts, you’ll note a pattern in the companies I talk about. Starbucks, Netflix, Apple, Amazon, Nike, Under Armor, Visa, Mastercard, T-Mobile…. These are companies whose products I use. I follow their earnings releases and test my thesis against them, but I test my thesis every day as I do business with them.
Starbucks
As an investment, Starbucks hasn’t delivered a whole lot in the past few years. If you bought it in 2019, you may have lost money. I bought my first shares in 2012 and they’ve handily beaten the S&P 500, but they’ve been a poor investment the last several years. I’m not worried because my thesis holds, and I can see that the company is doing well. There is always a line at the drive thru – any time of day. 5 years ago, when Rich and I started going every Saturday for coffee, take-out was not a big deal for Starbucks. Most people came in, sat down and used the free wi-fi. Now, the counter is jam-packed with to-go orders. There is a parade of uber eats and door dash drivers picking up and delivering. Mobil app ordering has skyrocketed.
My boots on the ground research tells me Starbucks is doing something right. I’m concerned about labor costs, unionization, stories of poorly treated workers and I’m watching to see if this improves under the new CEO who came in last year.
Wrap-Up
As usual, it’s been a wandering journey to get to the end so I want to reiterate some of the key points.
- Have a thesis – it doesn’t need to be a 100 page single-spaced report. It could be 3 things you like, 2 you’re watching.
- Write down your thesis and test it at each earnings release. Bonus points if, like Starbucks, you can test it in person.
- Don’t react. Conviction should help you to stick with your investments in the down times, assuming your thesis remains largely intact.
- Experts – real experts as well as media personalities – will have opinions. There will be some for and some against. Nobody knows for sure. Read those that you trust and look for dissenting opinions. This will help you identify opportunities as well as areas to watch.
- Learn from your mistakes. You will make mistakes. What went wrong? What did you miss? How can you account for this in your next thesis? You can keep this to yourself so be honest.
- Diversify. Stocks are a fabulous opportunity and nothing is more exhilarating than watching a company you believe in double in value again and again. But, remember, you are investing for your retirement, to fund an education, to buy a home. Balance your stock investments with Mutual Funds, bonds or bond funds, CDs, Treasuries, or other investments.
Thanks for hanging in there. I’d love to hear comments or questions.