My Secret Recipe: Inspecting the Ingredients

Mike Schellinger Blog, Educational 6 Comments

In my first installment I discussed the recipe of what I want in a stock that I purchase. I talk about the ingredients of profitability, sustainable growth, and compelling valuation. In the second installment I touched on where I shop for my stock ideas. I talk about scanning SEC filings/press releases, networking with friends, reading message boards such as MicroCapClub, and using stock screeners. However, I haven’t talked about the process of determining if a prospective company is actually one that meets the recipe. Are the ingredients really good, or are they filled with chemicals that aren’t healthy and will be toxic to your portfolio? The purpose of this third installment is to provide the highlights of how I research a company.

When you are researching a company you are trying to learn both positive and negative aspects (ingredients) about a company. Every company has both positive and negative ingredients. Your job as an investor is to find out if the positive ingredients outweigh the negative and thus the company makes a good investment. Furthermore, we all have different financial needs or tastes which need to be considered.

Press Releases and Regulatory Filings

The first place I look is the company provided information such as press releases and regulatory filings (e.g. SEC filings). These sources are analogous to the labels on a food product. The first order of business is to inspect the financial summaries for the past few years to find trends. Are revenues and profitability increasing or decreasing? Are margins improving? Are expenses being managed well? Once I have a handle on the financial trends for a company, I will read the press releases and delve further into the regulatory filings. When I read these documents at first I’m often looking for disclosures which give me hints as to why trends are happening. Were these trends caused by one-time events or are they sustainable? One-time events can impact revenue, expenses, and margins. Has the company introduced a new product or penetrated a new market that will give them growth in the future? Is backlog increasing or has the company received a number of new orders? Is the market for their product or services growing or shrinking?

Three other aspects I investigate are the balance sheet, share structure, and cashflow. The balance sheet is important to investigate to determine if the company has the necessary resources to continue in their business plan and to weather any storms. The valuation of a company is significantly impacted by the strength of it’s balance sheet. The share structure is important to inspect to know if the number of shares are going to increase going forward and how much they might increase. Finally, checking out the cashflow is important. A company that has good earnings but bad cashflow can be a recipe for disaster. If I like enough of what I see at this point I’ll continue on with my analysis of the company. Otherwise, I’ll move onto the next company.

Conference Calls and Investor Presentations

If the company has quarterly conference calls or does investor presentations, I will usually listen to these next. These often provide additional information that further expands upon what you learn by reading the press releases and regulatory filings. When listening to a quarterly conference call, I often find that the question and answer session is more enlightening that the company prepared remarks. The reason this is often more enlightening is that other investors tend to ask questions about key points that are important for the company’s future. This often gives me hints regarding other aspects of the company to consider.

Annual Report and Most Recent Quarterly Filing

My next step is usually to read the annual report (e.g. 10-K) and the most recent quarterly filing (e.g. 10-Q) in detail. This is where the negative aspects often come out. It is like reading the fine print on a label. In this read I’m looking for items like lawsuits that may harm the company, risks to the company that may derail their success, information regarding debt that may cause problems going forward, etc.

Company Web Site

If a company has made it past my scrutiny so far, the next step is usually to look at their web site. This is often a great source to learn more about their products and their business. You can also learn more about management of the company. How long have they been in charge, where did they work before, etc. Companies often list their hiring needs on their web site. This can often provide insight into their growth as growing companies often need more employees. If they are hiring too many employees, it can also be a sign of expenses out of control.

Talking with Management

Talking with management is another thing that is helpful. Often this is a good way to learn more about items such as how the company’s business model works, the competitive landscape, management strength, etc. There are a few really good articles on this topic on MicroCapClub that I recommend reading including one by Ian Cassel and one by Chip Maloney.

Social Media, Internet Searches, and Networking

Another way I investigate is to look at comments on the company by other investors. Searching through social media such as comments on MicroCapClub, Twitter, and other investment sites can often provide clues to other positive or negative aspects about the company. Internet searches for information on the company’s products and management can also be a great way to glean more information on the company. Utilizing my investing network is also helpful as I may know of someone that has investigated this company before and can provide me a different perspective on the company.

Valuation

I assess the current value of the stock based upon a number of parameters to determine if the stock is undervalued or overvalued. As much as possible I also determine what I believe the company will be worth in the future. I’m not going to talk about the details of this process as there would be too much to discuss in this article.

The Final Product

The whole process of researching a company is time consuming. To fully research a company takes several hours to days. It is more like baking something from scratch than cooking a prepackaged food in the microwave. Also, while I’ve hit the high points of research I haven’t touched on everything as this whole topic could be a book rather than an article.

At the end of the process a decision has to be made. I weigh all the good and bad ingredients and decide if the company is for me. The decision doesn’t need to be a binary decision either. In addition to deciding a stock is a buy or is not a buy, I often decide that I need to see the story play out a little bit further. Often this is the case when a company is near or just at an inflection point as one data point does not make a trend.

The next time you are looking at a new company, consider using the techniques in this article to inspect the ingredients as I believe they will make your portfolio tastier.

My Secret Recipe Series:

Part 1: The Index Card

Part 2: Shopping and a Taste Test

Part 4: The Bargain Rack

MicroCapClub is an exclusive forum for experienced microcap investors focused on microcap companies (sub $300m market cap) trading on United States, Canadian, and UK markets. MicroCapClub was created to be a platform for experienced microcap investors to share and discuss stock ideas. Investors can join our community by applying to become a member or subscribing to gain instant view only access. MicroCapClub’s mission is to foster the highest quality microcap investor Community, produce Educational content for investors, and promote better Leadership in the microcap arena. If you enjoy the search for the next great company, Join Us.

Comments 6

  1. Mike,
    I really enjoyed this three part Secret Recipe series. I think any investor could dramatically improve their investment results by focusing on the ingredients that go into a successful investment and following the search strategy and research process that you laid out. Thanks for sharing.

  2. I agree with the other two commenters: this series of posts is so useful!

    I know you said that valuation could be huge subject but it would be awesome if at some point you touch on the basics or things that drive under or overvaluation.

    Again, great article!

  3. Mike,
    Sometimes I come across a company that looks as though it might have potential but just seem to be compelling at the moment. As you mention in your article, it is worth putting them aside and coming round to them later. I have a folder labelled “Possibles” in which I keep some of these beauties. In effect I put them on a back burner simmering a little. Oftentimes, the problem is price: a promising item has been run up, and needs a good rest (read: drop in price to a better zone). Another aspect of this is the notion that some companies that seemed pretty awful deserve
    an occasional glance to see if some of the excess fluid has been boiled off. (I’m trying to stay in your metaphor.)
    Anyway, good exploration of the vetting process. Thanks
    John Gay

  4. Hi Mike

    Thanks for sharing your investment process. I thought it was very informative. I know you read a lot of press releases everyday and I was wondering where you go to read them.

    Thanks

  5. William,

    I use a pay service that gives me press releases and filings in real-time. I will not name them as I am likely replacing them this year. There are a number of services like this that are available.

    Mike

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