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Your No. 1 Job as an Investor Before You Buy a Stock

By Mike Barrett, analyst, Extreme Value
Wednesday, June 8, 2016

When you read about a business that might be a promising investment idea, your No. 1 job is to develop an understanding of what it does and how it makes money.
It sounds simple, but we all know better.
As Michael Shearn, author of The Investment Checklist: The Art of In-Depth Research, once said: "The value of a business cannot be condensed into a few simple factors."
He couldn't be more right. And recognizing this will put you far ahead of the vast majority of investors out there...
To understand what makes a business tick and how it has evolved, you've got to put in the time. There's no shortcut, but there are two important things that will help you understand a business...
One, don't forget the customers. Shearn says that, according to the American Customer Satisfaction Index (ACSI), customer satisfaction is a leading indicator of a company's financial performance. He adds that many companies with high customer-satisfaction scores produce higher stock returns than the S&P 500.
Do your best to understand the company you're evaluating from the perspective of its customers. Some key, customer-focused questions per Shearn include:
•   Who is the core customer?
•   What pain does this business alleviate for the customer?
•   To what degree is the customer dependent on the products or services of this business?

My favorite story in Shearn's book is one he tells about trying to understand why customers shop at 99 Cents Only Stores. He visited 120 of the 150 stores, and spoke to as many as 10 shoppers per store. What he learned was customers shopped there because they could buy smaller package sizes and thus increase their grocery variety, while still stretching their budgets. He discovered key information about what makes the business successful.
Two, focus on the business model. Last year, an interview with one of my favorite money managers, London-based Aled Smith, turned me on to an interesting idea about how businesses really operate.
Smith thinks the analyst community has it all wrong classifying businesses by industry, rather than how they actually make money. Cintas (CTAS), for instance, is a well-known service provider to a large base of industrial customers. If you asked 100 Wall Street analysts, every one of them would tell you it should be classified as an "industrial" business.
But Cintas makes most of its money renting uniforms to other businesses. This is a far different enterprise than manufacturing a product – and often, far more profitable. So Cintas is actually more comparable, in terms of its business model, to other landlords of physical items, like hoteliers and rental-car agencies.
Ten years ago, MIT students published a research paper on the topic titled "Do Some Business Models Perform Better than Others?" Though dated, the paper is an excellent starting point if you'd like to better understand companies in terms of their business models.
One of key findings was this: Business models based on the three non-physical types of assets (financial, intangible, and human) all have significantly higher operating income and market capitalization than those based on physical assets.
In other words, capital-light businesses have the potential to earn much higher returns on capital and thus represent attractive investment ideas. The challenge is finding those with shareholder-friendly management teams, and buying them at attractive prices.
I'm convinced that fully understanding a business before investing in it is a major key to getting results. Unless and until you've developed a working understanding of a business and its economics, you're simply not prepared to imagine how its story will change in the future.
Over time, it's also imperative you update your view of the business as new information arrives. Having already developed a working knowledge of the business will help you react decisively, without emotion, when the time comes.
Take the road less travelled when it comes to understanding a business. Do the work others won't. In the end, you will be rewarded.
Good investing,
Mike Barrett

Further Reading:

"How many piano tuners are there in Chicago?" At first glance, that question may seem unrelated to finance. But as Mike explains, the thought process behind it can put you ahead of most investors when it comes to the stock market. Read more here: To Become an Elite Investor, You Must Master This Skill.
Investing isn't only about understanding a business. It's also about knowing what types of companies to avoid. Find out why Dan Ferris says "not losing money is more important than making it" right here: The Five Types of Stocks You Must Avoid.

Market Notes


Today's chart suggests that America is doing just fine...
Regular readers know we check the "pulse" of the U.S. economy in several different ways. One of those ways is looking at payroll-processing companies. As long as companies are hiring, this sector enjoys healthy growth. In the past, we've checked in on the No. 1 company in the sector, Automatic Data Processing. Today, we're looking at one of its main competitors.
Paychex (PAYX) offers payroll support to small and midsize businesses, which account for about half of the jobs in the U.S. And business has been good lately. In late March, Paychex beat analyst expectations and reported big profits.
After shares fell with the broad market to start the year, PAYX has rallied 18% in less than five months, recently hitting a new multiyear high. It's another sign that things can't be all that bad in the U.S. today...

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