The Importance Of Ground Checks

Foreword from ShareInvestor

This article “The Importance Of Ground Checks” by Cai Haoxiang was first published in The Business Times on 08 Sep 2014 and is reproduced in this blog in its entirety.

Get a dose of reality by talking to customers, suppliers, rivals as well as fellow investors about the company

NUMBERS on a page do not mean much if taken at face value.

Profit may have gone up by 5 per cent year-on-year, or it may have been down by 20 per cent.

But all this happened a few months ago. What is going to happen next?

Accounting statements, by their very nature, are backwards-looking.

But stock prices are forward-looking.

If the company is making more and more money, the investor should ask himself whether increasing profits can be sustained.

If the company suffered a drop in profit, is it just going through a temporary bad patch due to a cyclical downturn in business?

Or has something more permanent happened, and profits are expected to keep sliding in the future?

Is it going to change to a winning strategy?

Investors often find it useful to project where revenues and profits are going in the next year or two.

By having a sense of how fast earnings are likely to grow, one can then judge whether the stock is currently trading at a price that reflects that earnings growth. For example, if a stock had been trading historically at 12 times earnings and it historically grew 5 per cent a year, it will be trading at a higher earnings ratio if it suddenly could grow 15 per cent a year for several years.

Getting The Numbers Right

To get started on projections, analysts typically try to answer some of these questions:

  • How have revenues, costs and earnings grown in the last few years?
  • How large is the market, and how fast is that expected to grow?
  • What is the company’s market share? Will it gain an edge over its rivals?
  • How are the company’s selling prices and costs expected to change in the future?
  • How is the mix of products the firm is selling expected to change in the future?

Investors can rely on secondary data such as research reports and government statistics to help with projections. Sometimes, it is not easy to get hold of industry reports and investors are left with only historical information. Using historical information to project future revenues and profits is most advisable for large, mature companies.

For companies undergoing change, such as Eratat, projections are more difficult. So are companies growing a product segment quickly, such as tech giant Apple when it first launched the iPhone in 2007.

Analysts are employed to add some rigour to the projection exercise, but their assumptions might also be incorrect. The best way to make more accurate projections is to go on the ground, and talk to people, understand industry nuances and see things with your own eyes.

Noted investor Philip Fisher described this method as “scuttlebutt”, a seafaring slang for gossip or rumour. While we commonly understand relying on rumour as a bad way to invest, Mr Fisher was referring to a rigorous way of getting primary information: talking to as many customers, suppliers, competitors, and even fellow investors as possible to get a sense of industry trends and how the company is perceived.

For example, to check how Eratat’s products are doing, a retail investor could:

  • Visit as many Chinese retail stores that stock Eratat products as possible and note the crowd sizes;
  • Check the prices the products are being sold for, and whether there are massive discounts offered;
  • Ask retail assistants how consumers view the Eratat brand compared to others;
  • Ask young Chinese professionals with spending power if they have heard of the brand.

You can then tweak your projections accordingly after these checks. Your survey might not be comprehensive, but you might still learn something beyond just going to a company’s annual general meeting and talking to its managers and investor relations officials.

Just surfing local stock forums, too, would have turned up numerous warnings about various aspects of the company. You can then decide if they are justified or not, based on your ground checks.

Scuttlebutt

Famous Apple analyst Gene Munster, of investment bank and asset management house Piper Jaffray, offers an instructive example of ground checks.

A Bloomberg video titled How the Apple Oracle Predicts the iPad’s Future tracked his day covering an iPhone 5s and 5c launch event on Sept 20 last year.

By 6.15am, he is shown walking to the Apple store on Fifth Avenue in New York, surveying those in line on their thoughts and also doing a count of how many people there are in the queue.

He found that at that particular store, the number of people waiting in line was the same at the launch of the iPhone 4, which was a peak number – better than he expected at that particular store. He then moved on to other stores.

Going through this exercise gives him a sense of the staying power of the brand, the excitement around Apple’s products, and whether a product is likely to flop or do well – even before markets opened for trading.

Mr Munster even offers some survey tips.

“Sometimes if someone says no and declines to do the survey, there’s this feeling around the other people that feel like maybe I shouldn’t do the survey. And the best thing to do at that point is to leave that group and restart,” he said.

Mr Munster’s company surveys American teens regularly, and this year, it asked about 7,500 middle and upper-middle class teens on whether they would buy a wearable tech device. Partly based on the survey, Mr Munster predicted that Apple could ship five to 10 million “iWatches” in its first full year of sales.

How do we apply this to Eratat? Its operations are overseas, so a serious retail investor would need to do some legwork in China – perhaps while on holiday – before coming to a conclusion.

After all, when at least thousands of dollars are at stake for a typical retail investor investment, you want to make sure your decision is as watertight as possible.

You can project all you want using numbers plucked from the air or the Internet, but understanding the present will give you an advantage in predicting the future.