Previously, I discussed why I do not use screens. What’s the alternative? I believe one option, although I am not dogmatic enough to think it is the only one, is to put together a list of potential investments using a “telephone book approach”. Starting with the As, you would go through the list looking for value. This may, at first blush, seem patently absurd. However, when you begin to attempt it, it becomes quite instructive. I have done it with the Russell 3000 twice in each of the past three years. People may quibble about my telephone book (the Russell 3000), but the process itself is worthwhile. Although not easy, I don’t believe it is too difficult–i.e. astronomical IQ is unnecessary, but patience and lots of reading time are a must.
First, there are hundreds of companies that I couldn’t possibly understand (see below for examples). In fact, I wonder if most of the people in the company even understand what they do. For example, all biopharmaceutical companies, computer chip companies, launching satellites into space, etc. Some people may understand these companies, but they are probably working at these companies, NASA or not in my office (it’s a solo office).
Second, there may be sectors that you aren’t inclined to look into, i.e. fast food. You can easily mark these companies off the list.
Third, you should have a lot of time to just read. In the beginning of each 10k (Annual Report), the company gives a brief description of what it does. Read it and ask, Is this a business I can understand?
Currently, I am at the end of the I’s and beginning in the J’s. The first 5 on my list from today were:
–IXYS Corp: IXYS Corporation is an integrated semiconductor company. It specializes in the development, manufacture and marketing power semiconductors, advanced mixed-signal integrated circuits (ICs), application specific integrated circuits (ASICs), microcontrollers, systems and radio frequency (RF), and power semiconductors. The Company’s power semiconductor products are divided into two primary categories: power MOS, or metal-oxide-silicon, and power bipolar products.
They lost me after “is”…That was quick, simple and painless.
–Jack in the Box–Fast Food Chain (summary is mine)
A good example of an industry I just blindly avoid. I am happy for someone to make profitable investments in this space, but I don’t feel that I understand it well enough to pick the winners and losers. And with margins that are razor thin and competition on every corner fierce, I think it requires a certain skill level I do not possess.
–Jakks Pacific: is a multi-line, multi-brand toy company that designs, produces, markets and distributes toys and related products, pet toys, consumables and related products, electronics and related products, kids indoor and outdoor furniture, and other consumer products. JAKKS’ products include traditional toys and electronics, and role play, novelty and seasonal toys.
Basically, Jakks makes toys. Picking up after my kids toys may be the extent of my knowledge, but the business does not seem all that complicated. I am willing to put it on my list to read the 10K.
–Jazz Pharmaceutical–Our marketed products address medical needs in the following therapeutic areas and include the following products:
Narcolepsy: Xyrem® (sodium oxybate) oral solution, the only product approved by the United States Food and Drug Administration, or FDA, for the treatment of both cataplexy and excessive daytime sleepiness in patients with narcolepsy;
Oncology: Erwinaze® (asparaginase Erwinia chrysanthemi), called Erwinase® in markets outside of the United States, a treatment for patients with acute lymphoblastic leukemia, or ALL, who have developed sensitivity to E. coli-derived asparaginase, and other products, including products for oncology supportive care;
Pain: Prialt® (ziconotide) intrathecal infusion, the only non-opioid intrathecal analgesic indicated for the management of severe chronic pain for patients who are intolerant of or refractory to other treatments; and
Psychiatry & Other: A portfolio of products, including FazaClo® (clozapine, USP) LD and FazaClo HD, orally disintegrating clozapine tablets indicated for treatment-resistant schizophrenia, and Luvox CR® (fluvoxamine maleate).
Way, way beyond my circle of competence. I only include the entire introductory description because it provides a clear example of how easy it can be to cross off a company from a list of potential investments. Almost the entire description is highlighted by my spell check program.
–Jetblue Airways Corp–Discount Airline
Another good example of an industry I think is beyond my circle of competence. Airlines sell a commodity product with high fixed costs and little proven ability to raise prices. A lot of money has been made selling airline stocks at the peak, but any long-term holder has probably seen the bankruptcy court more than once.
Those were just 5 companies that I looked at this week because that is where I am in my telephone book. The elimination process probably took me 10 minutes and I came up with one company whose 10k I will read. Of the 3,000 companies, that ratio of 20% has been my experience over the past two years.
Humility: I think the biggest aspect of the process is recognizing what lies beyond your circle of competence. Being humble enough to admit quickly and often what you don’t know will speed this process. Sure, you might be able to learn the inner workings of Narcolpsy in order to understand Jazz Pharmaceuticals (medical school is only 4 years), but why try to “jump over 7-foot hurdles when you can step over one-foot bars.” (Buffett)