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Subject:  What is 47X63? Date:  2/11/2013  3:20 PM
Author:  MrTompkins Number:  13489 of 18444

This is a follow up to RaptorD2's question regarding due diligence. I believe the following passage from an investment manager who was interviewed for the latest Graham & Dodd newsletter at Columbia sums up my view and experience (a lot quicker than me trying to explain it :) (Also ties nicely I believe into rjf53's comments.)

Generally speaking, we're big believers in the notion that you need to focus early on in the analysis on the major drivers of what's going to make or lose you money in the investment, and avoid the temptation to simply go out and gather a lot of data.

The reason I say that is not only because it’s a waste of time to do the latter, but in the worst examples, extraneous data are a red herring that can cause a person to draw an incorrect conclusion.
There’s an interesting book written by the CIA for their internal use that talks about this concept. The book can actually be read online for free on the CIA’s website – just Google “CIA intelligence analysis book and you should be able to find it. In it, it describes how the human mind can keep very few concepts in mind at any one time. As an example, the book asks the reader to try to multiply any pair of two-digit numbers in one’s head, say 47 X 63. This is a task that is easy to do with a pen and paper but is tricky to do in one’s head because it’s hard to keep all the pieces of the puzzle at the forefront of one’s mind together at the same time.

In that regard, what I say to the students in my class as a tip, and something that we do around here, is to try and build the model very early in the process. If I ask you to analyze a bond that's trading at 52 cents on the dollar, and let's say it's a company that makes TVs, your first inclination is to read a hundred things about the company and go talk to them and do a bunch of calls and other stuff. That's all important work to do, of course, but I might suggest to you that you should do a little bit of work first, and then you should start to think about what's going to make that price look cheap or expensive. Think about the variables that go into the analysis: sales growth, margins, capex, whether they win or lose a contract, things like that, and then build your valuation model in Excel, and think about what the blue assumption cells are.

Without doing a lot of hard work, you won’t yet have good views about what the right numbers are to plug into your blue assumption cells, but you'll then go out and talk to the company and be able to ask targeted questions that specifically address the blue cells. Over time the model will evolve and become more refined, and you’ll be building on earlier work and making improvements, not just gathering more facts. What I found in my time doing this and going to conferences or sitting in small group meetings, is that a lot of people will have an hour with the CEO and ask about a lot of industry jargon that could only possibly matter if you knew absolutely all there is to know about everything else in the universe, and these were the last few things you didn’t know. But most of the time there's two or three big things that really matter and it makes sense to focus the research effort there...


Link to newsletter: http://www.grahamanddoddsville.net/?p=1631

If you are interested in the CIA book:

https://www.cia.gov/library/center-for-the-study-of-intellig...

Matthew
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