Library / Investment Tools
Date of review: September 2021
Book author: Avner Mandelman
Вook published: 2007
Book author: Avner Mandelman
Вook published: 2007
The Sleuth Investor: Uncover the Best Stocks Before They Make Their Move by Avner Mandelman (2007)
A book I highly recommend. To my own surprise, the book was published back in 2007, and I have not heard about it until this year, even though I put quite a lot of effort to find good books on investing. This is probably the only book that truly teaches how to analyse companies in the real world, not through financial statements.
Most young investors (myself included) start by learning key financial ratios and valuation multiples.The benefit of such an approach is its objectivity (you cannot argue that 5x PE is lower than 10x). But its main drawback is that the business is viewed as static, you get its snapshot at a single point of time, maybe you get an idea of the historic development, but it does not help you much in understanding the company's future cashflow. It does not help you to understand where the company would be in 3, 5 or 10 years. And this ultimately determines the share price performance over the long term.
For a company with a 100-year history (like Coca Cola), past performance could be a reasonable indication of its future, but even then, there could be issues (e.g. Coca Cola has been facing declining sales of its main product for many years now as customers switch to healthier drinks).
Researching a stock through external observation, getting a deep understanding of its top management, of the product, why customers buy it and so on is probably the only big advantage that humans have over computers. Relying on pure numbers in the investment decision making process exposes you to the risk of being outsmarted by a modern computer processing more data faster and more accurately than any human can do.
I have come to similar conclusions on the importance of understanding business economics, the position of its products on the market, relationships with suppliers and internal culture. But the book goes further, and most importantly, it provides many practical tools and a few very interesting case studies.
The big question, just like with many other pieces of advice which look useful, is how to implement this advice in practice. Some methods described in the book require quite a bit of courage, and without having the strong will and discipline, there is a risk that the advice from the book will just remain the advice.
A small drawback of the book is that the same messages are repeated in different chapters, and there are also a few divergences that add to reading time but are not critical, in my view. Nevertheless, it is possible to read the book in just a few days as it is relatively short and easy to read.
At the very end of the book, there is an unexpected short diversion: on just one page, the author summarises two types of people echoing my own thoughts on the value of independence and freedom, which I partially shared in my recent posts (see here).
Next, I provide key quotes from the book, which I would like to refer to in the future and which I think would be helpful for all looking to improve their investment skills and find new tools to have an edge. You will also find an overview of two types of people at the very end (Warning: it may not appeal to everyone).
For a company with a 100-year history (like Coca Cola), past performance could be a reasonable indication of its future, but even then, there could be issues (e.g. Coca Cola has been facing declining sales of its main product for many years now as customers switch to healthier drinks).
Researching a stock through external observation, getting a deep understanding of its top management, of the product, why customers buy it and so on is probably the only big advantage that humans have over computers. Relying on pure numbers in the investment decision making process exposes you to the risk of being outsmarted by a modern computer processing more data faster and more accurately than any human can do.
I have come to similar conclusions on the importance of understanding business economics, the position of its products on the market, relationships with suppliers and internal culture. But the book goes further, and most importantly, it provides many practical tools and a few very interesting case studies.
The big question, just like with many other pieces of advice which look useful, is how to implement this advice in practice. Some methods described in the book require quite a bit of courage, and without having the strong will and discipline, there is a risk that the advice from the book will just remain the advice.
A small drawback of the book is that the same messages are repeated in different chapters, and there are also a few divergences that add to reading time but are not critical, in my view. Nevertheless, it is possible to read the book in just a few days as it is relatively short and easy to read.
At the very end of the book, there is an unexpected short diversion: on just one page, the author summarises two types of people echoing my own thoughts on the value of independence and freedom, which I partially shared in my recent posts (see here).
Next, I provide key quotes from the book, which I would like to refer to in the future and which I think would be helpful for all looking to improve their investment skills and find new tools to have an edge. You will also find an overview of two types of people at the very end (Warning: it may not appeal to everyone).
Important to use versatile sources/channels of information
The probability of wrong decisions rises when we carelessly let ourselves be fed with information through a single channel, and allow our other channels to be blocked… An unknown broker with a seductive voice calls with a hot tip that must be seized immediately, and so we buy without bothering to first visit his office (which, we later learn, is in a second-floor walkup next to the Salvation Army's soup kitchen).
Many poor decisions can be prevented if we engage more of our senses in the decision making, giving a chance for our healthy pang unease at arise. And in matters of importance, bringing in five or ten more opinions to supplement our five senses is wise.
Many poor decisions can be prevented if we engage more of our senses in the decision making, giving a chance for our healthy pang unease at arise. And in matters of importance, bringing in five or ten more opinions to supplement our five senses is wise.
General purposes of external surveillance
Evaluating individuals. Important to understand what drives the CEO, what are his values, do you see photos of him with celebrities in his office or photos with happy customers? Is top management obsessed with the product or with external wealth?
Evaluating group interaction. Important to understand how effective employees are as a team. "You can often find this out simply by seeing the group in action. Who talks to whom, who treats others with disdain, who seems to be the natural leader, who seems subservient, who provides ideas, and who vets them".
"Is the team structured to achieve necessary aims? How well do these people work together? Are they all pulling in the same direction, or do their individual goals diverge? Why? What are the internal ambitions?"
Company gatherings can be quite useful. Also observing the office layout – who sits where, who sits closest to the CEO.
Evaluating group interaction. Important to understand how effective employees are as a team. "You can often find this out simply by seeing the group in action. Who talks to whom, who treats others with disdain, who seems to be the natural leader, who seems subservient, who provides ideas, and who vets them".
"Is the team structured to achieve necessary aims? How well do these people work together? Are they all pulling in the same direction, or do their individual goals diverge? Why? What are the internal ambitions?"
Company gatherings can be quite useful. Also observing the office layout – who sits where, who sits closest to the CEO.
There are generally four key areas that investor should try to investigate
1. Customers
One important question to start the analysis is to understand if customers are worth serving.
"Many more companies waste their talent and resources on unworthy clients than those who serve good clients. It's as if Alan Greenspan became the in-house economist and investment adviser of a small brokerage firm in a tiny mining town. The town residents might be very happy to have him, but as for maximising his own income – and impact on the world – Greenspan would be wasting his time. In a similar way, many companies waste their resources by putting their capital, their executive's years of education and experience, and long hours of work and dedication, at the service of unworthy corporate customers. That is, those who have no individual decision-making power, engage in a group-think, pay little, are not loyal, and jump to another supplier at the first opportunity".
Near-ideal customers are those where the product's users recommend it quickly, decision-makers approve it fast, and purchasing officers pay for it soon after.
Ideal customers have three additional qualities. "First… all three check-paying functions are performed by the same person… Second, he or she is directly reachable by XYZ's salesperson. Third, not only does one person perform all these three functions, but beyond that, the product should fulfil not just the corporate needs, but the user's personal ones, too. It is far more important that the product fulfil the personal needs of this ideal corporate buyer, than that it fulfills the buyer's employer's needs".
"Many more companies waste their talent and resources on unworthy clients than those who serve good clients. It's as if Alan Greenspan became the in-house economist and investment adviser of a small brokerage firm in a tiny mining town. The town residents might be very happy to have him, but as for maximising his own income – and impact on the world – Greenspan would be wasting his time. In a similar way, many companies waste their resources by putting their capital, their executive's years of education and experience, and long hours of work and dedication, at the service of unworthy corporate customers. That is, those who have no individual decision-making power, engage in a group-think, pay little, are not loyal, and jump to another supplier at the first opportunity".
Near-ideal customers are those where the product's users recommend it quickly, decision-makers approve it fast, and purchasing officers pay for it soon after.
Ideal customers have three additional qualities. "First… all three check-paying functions are performed by the same person… Second, he or she is directly reachable by XYZ's salesperson. Third, not only does one person perform all these three functions, but beyond that, the product should fulfil not just the corporate needs, but the user's personal ones, too. It is far more important that the product fulfil the personal needs of this ideal corporate buyer, than that it fulfills the buyer's employer's needs".
2. Suppliers
The main purpose is to find evidence of how the business is doing by observing trends among suppliers. Do they see increasing orders, or do they get longer payments? Follow the full physical chain of the product, pay especial attention to packaging as it is relatively easy to track and is a direct indication of customer demand.
3. Product
This is a fairly straightforward type of analysis. Learn as much as possible about the product, your impressions, its qualities, purchase experience.
4. Plant
This is also a fairly clear step focusing on the production process and potential bottlenecks but also paying close attention to all kind of details that you observe during the site visit.
4 categories of stocks to research (sleuth)
1. "Cheapies are value stocks of the kind of Ben Graham recommended – stocks trading below book value, below working capital, at a low PE, at low cash-flow multiples, with a high dividend yield. You can find lists of them in any ValueLine survey".
2. "Goodies are stocks of excellent businesses with a lasting franchise that keep generating earnings and growth even with mediocre managers. Munger recommended buying franchise stocks even if they are not very cheap, because their ongoing value creation will make them cheap eventually. So if such goodies tank temporarily because of some transitory problem, so much the better".
3. "Rockets are momentum stocks …of companies that experience explosive growth. IF you buy them even at a high price and hang on so long as they grow, you can make several multiples of your money. Or you can lose it all if you don't get out in time".
4. "Tradies are a sort of catchall investment category that covers special situations, where a sharp change is about to take place. If you find out about this change in advance, you can buy the stock from those who don't know about the change".
2. "Goodies are stocks of excellent businesses with a lasting franchise that keep generating earnings and growth even with mediocre managers. Munger recommended buying franchise stocks even if they are not very cheap, because their ongoing value creation will make them cheap eventually. So if such goodies tank temporarily because of some transitory problem, so much the better".
3. "Rockets are momentum stocks …of companies that experience explosive growth. IF you buy them even at a high price and hang on so long as they grow, you can make several multiples of your money. Or you can lose it all if you don't get out in time".
4. "Tradies are a sort of catchall investment category that covers special situations, where a sharp change is about to take place. If you find out about this change in advance, you can buy the stock from those who don't know about the change".
Why stocks go to the doghouse
"Stocks become values for many reasons, but tech stocks fall into the value category for only a few reasons. The first and foremost is a product crossover: This is a situation in which an old product is dying, and the new product that is supposed to supplant it does not yet sell at a similar volume. This occurs even as the heavier capital investment and R&D spending depress earnings or cause a loss. At such times, you can often pick up good tech companies for a song, if sleuthing finds that the product crossover is proceeding normally and is about to succeed".
"Or, a tech stock can fall into the value category because its particular market niche is now a cyclical trough. And just as everyone thought the stock was going to the moon when it peaked, now they all think it is going to zero".
"Other times, there may have been a temporary mess-up in a good company, which new management is now trying to turn around".
"Or, a tech stock can fall into the value category because its particular market niche is now a cyclical trough. And just as everyone thought the stock was going to the moon when it peaked, now they all think it is going to zero".
"Other times, there may have been a temporary mess-up in a good company, which new management is now trying to turn around".
Three types of Value Stocks: 'Neglect', Cheapness', and 'Reemerging growth"
'Neglect'
"Neglect is usually the result of stocks that had been rockets in the past and disappointed egregiously, or were run by rascal managers who messed up…When a high-flying stock crashes and burns, those who still own it are often so ashamed that they simply try to forget about the stock".
'Cheapness'
Cheapness is a company that screens cheap on all key metrics, including on cash as percentage of market cap.
'Reemerging growth"
"How do you look for growth? Talk to the customers, who should be happy; to the competitors, who should be nervous and surly; and to the suppliers, who like the customers, should be happy".
"There is also a second way to find where growth may be coming from – by following where both the company and its customers have been focusing their time and money. If you hear that the company has been hiring R&D people for a certain technology, and the customers have been hiring people experienced in using the very same technology, you may glimpse the future when it is still in the intention stage".
"There is also a second way to find where growth may be coming from – by following where both the company and its customers have been focusing their time and money. If you hear that the company has been hiring R&D people for a certain technology, and the customers have been hiring people experienced in using the very same technology, you may glimpse the future when it is still in the intention stage".
How to find sleuth-worthy stocks (Quality businesses)
"Text search, database screens, and gossip". "You may screen for words that indicate that a perceived disaster is not as severe as others think. Such word combinations might include 'debt reduction surpassed', 'cash grew faster than', 'settled a lawsuit', 'sold the plant / real estate/division'.
I would caution, though, that with the rise of AI, this type of opportunity (based on simple keyword search) will unlikely bring unique opportunities today.
Another way to look for such opportunities is to analyse the financial performance of sectors to identify those with declining capital investments as a sign of improving supply/demand situation in the future (e.g. look for industries with Capex below DD&A, declining PPE, declining Inventories-to-Sales ratio). Following a particular sector and buying stocks at the bottom of a cycle is another option.
I would caution, though, that with the rise of AI, this type of opportunity (based on simple keyword search) will unlikely bring unique opportunities today.
Another way to look for such opportunities is to analyse the financial performance of sectors to identify those with declining capital investments as a sign of improving supply/demand situation in the future (e.g. look for industries with Capex below DD&A, declining PPE, declining Inventories-to-Sales ratio). Following a particular sector and buying stocks at the bottom of a cycle is another option.
A word of caution
"Even when you end up knowing mostly everything about a company through sleuthing, don't let it go to your head. Check the public information – what you don't know can trip you just the same…Be very careful with investing in companies with debt…Be careful of companies at the very peak of a technology pyramid…Do not view insider buying as infallible…insiders can be wrong, too… Be humble. Even when you sleuth a company diligently, you can still be wrong. Never put too much into any one stock – even if you think you are absolutely sure. Especially if you think you are absolutely sure".
An unexpected characteristic of two types of people
As promised at the start, I would like to quote the author on his two characteristics of people, which I fully share. You may wonder why a book on investing suddenly diverges into a discussion of personality types. Well, as part of his effort to encourage people to follow his method of sleuthing to be able to find multi-baggers, I think the author decided to bring these two types of people pushing readers to make their choices.
The author brings the concept of Agents and Principals and the difference between them. "Agents are like hunting dogs, while principals are like wolves. The two may look similar, but the difference between them is profound. Hunting dogs need a master who will pay them a wage, tell them what to hunt, appropriate their catch, and throw them a bonus bone. The CEO of Morgan Stanley is an agent. Though highly compensated, he is really a peddler of other people's companies. He is paid a wage and a bonus, and he is given stock options. But he doesn't own the company; he works for the owners, which, in this case, are the public. He is paid to hunt".
"A wolf, on the other hand, hunts only for itself and its family. It works for no one, hunts what it pleases, and the game it catches belongs to it alone, although it may share with other wolves that partnered in the hunt… The difference between agents and principals is more than just ownership. The real, primal differences are who you take your orders from and for whose benefit you are working. Principals take orders from themselves and their customers, and work for their family's benefit. Agents take orders from the master, and work for the benefit of the master's family, not theirs".
"Why do most agents work for others? … they value comfort over freedom and so often end up with neither. On the other hand, principals value freedom over comfort, and so often get both".
The author brings the concept of Agents and Principals and the difference between them. "Agents are like hunting dogs, while principals are like wolves. The two may look similar, but the difference between them is profound. Hunting dogs need a master who will pay them a wage, tell them what to hunt, appropriate their catch, and throw them a bonus bone. The CEO of Morgan Stanley is an agent. Though highly compensated, he is really a peddler of other people's companies. He is paid a wage and a bonus, and he is given stock options. But he doesn't own the company; he works for the owners, which, in this case, are the public. He is paid to hunt".
"A wolf, on the other hand, hunts only for itself and its family. It works for no one, hunts what it pleases, and the game it catches belongs to it alone, although it may share with other wolves that partnered in the hunt… The difference between agents and principals is more than just ownership. The real, primal differences are who you take your orders from and for whose benefit you are working. Principals take orders from themselves and their customers, and work for their family's benefit. Agents take orders from the master, and work for the benefit of the master's family, not theirs".
"Why do most agents work for others? … they value comfort over freedom and so often end up with neither. On the other hand, principals value freedom over comfort, and so often get both".