Michael Shearn founded Time Value of Money, LP, a private investment firm, in 1996, to devote his attention to selecting and researching stocks and private investments. He launched the Compound Money Fund, LP, a concentrated value fund, in 2007. Shearn serves on the Investment Committee of Southwestern University, which oversees the school’s $250 million endowment. He is also a member of the Advisory Board for the University of Texas MBA Investment Fund.
Michael is the author of “Using an Investment Checklist: The Art of In-Depth Research.”
Question: Hey Micheal, it’s great to have the opportunity to ask you a few questions!
I have three, but they’re all on completely different topics so I’ll make them separate comments. First one:
With the subtitle of your book being “The art of in depth research” (purchased the Kindle version today by the way, can’t wait to read it!), and the reviews all confirming that your approach is pretty exhaustive, do you think it’s possible for the average every day guy to successfully pick stocks given very limited time to do research? This debate gets brought up very often here; how many hours would you say need to be devoted to researching a company before an idea can be turned into a good investment?
Answer: I personally believe it is difficult to do anything well in a limited amount of time. Although I will say if you can focus 2-3 hours a day on research without interruption (no email, phone calls, distractions) then you can closely match the time that most investment professionals spend on actual research – if not more. One of the dirty secrets of the investment management industry is that most investment professionals do not have time to research a lot of businesses because they have to spend their time building their business (money raising, client relations, operations, etc.) Therefore, if you can develop the habit of being able to focus on a daily basis on stock research then you will be quite surprised at your outcomes.
As far as how much time it takes to determine if something is a good investment or not this is difficult to answer because it varies by your experience level in investing and the number of mistakes you have made and more importantly your ability to learn from your mistakes. Therefore, the answer is that it depends on you and your experiences. The best investors have failed many times and have learned from these experiences so on the next investment they learn what to look for or more importantly what to avoid. For example, one of my first investments went bankrupt so I learned about the importance of avoiding highly leveraged businesses.
Question: Do you recommend that retail investors develop their own investment process or adopt one from a pro?
If an investor decides to create their own do you have any advice about how they should go about doing that?
Answer: I think you should learn as much as you can from the pros such as Warren Buffett because they can help you short-cut the process and more importantly you are in a position to better recognize and learn from an investment mistake. In other words, you need to learn the principles of making successful investments from the pros and then go out and apply them on your own. There is no better teacher than making your own mistakes but the key is to not waste them or let them get you down. The key is to learn from them.
As far as creating your own there is no thing as an original idea. In other words, no one can sit in a room and come up with an idea in a vacuum. They have to be constantly studying others in the industry who have had long-term success and try to extract the time-tested principles and lessons learned by those people. Where people go wrong is studying the wrong “pros” such as those who have recent success or in trying to copy others exactly the same way. The key is to formulate what works for you. For example, I used to copy other investors and looked at investing in distressed assets because I saw some pros were successful at this but frankly I did not enjoy this that much and never got very good at it. For me, learning about management teams is something I really enjoy and is the niche I have carved in the investment world. The big benefit to the investment world is that there are so many niches and methods to make money. The key is to learn which one you enjoy the most and then get busy learning as much as you can about it-whether it is qualitative or quantitative investing.
For each investment some questions on the checklist are more important to answer than others. For example, if a business has debt then it is critical for us to answer the questions on debt but if it has limited or no debt you can just ignore this question. The checklist is therefore meant to be flexible.
The strategy I have learned to use is to improve my ability to judge management teams. When you are investing for the long-term you have to be partnered with the right people because if not time works against you instead of for you. I would say spend some time learning how to identify great management teams. A great starter is the book by Robert Miles “Warren Buffett CEO” because it profiles many of the different CEOs that run the subsidiaries of Berkshire Hathaway.
They are all in completely different industries yet they share many of the same qualities and characteristics. Another book is Sam Walton’s autobiography Made in America which I think is terrific in helping you understand what are the qualities inherent to a great manager. I would then study what makes a bad manager by reading a book such as Bethany McLean “Smartest Guys in the Room” so you can learn who to avoid and what are the characteristics of these managers.
Question: What was your experience running a fund, and how does that contrast to what you’re doing with Southwestern? Do you think that endowment management or something similar could be a decent alternative to hedge funds for someone who is really passionate about the industry?
Answer: Endowment management is focused more on picking asset classes or investment firms rather than picking individual stocks so it is a different skill set. I believe you have to choose one or the other.
As far as your first question I would start off by saying that you are lucky to have found your passion in life (not many people do). Second, you have identified what you don’t want (a firm that does not value work/life) so you can now more quickly determine whether an investment firm meets your criteria or not.
I would personally avoid those firms that do not value work/social life balance (i.e.most hedge fund firms in New York). Investing is a long game and you never want to be burned out or be at a firm that is more interested in how much you work rather than the quality of your research. I personally believe it is critical to have balance and the opportunity to step back and see the big picture in investing. The best investors spend a lot of time analyzing an investment but then step back on the investment for a couple of weeks to get perspective on all of their prior work. It is an iterative process and having balance in life helps you be more productive.
The key is to constantly uncover rocks and keep looking. I had an intern once who said that he wanted to travel to third-world countries to look for investments and he dedicated a lot of time to identifying all of the investment firms that specialized in emerging markets. He then looked for articles on these firms to understand what their investment approach was and looked at their historical investments. He would then call the manager with the benefit of knowing a lot about the firm and ask them more pointed questions on how they applied their investment methodology of investing in emerging markets and asked if he could be of value to them. He eventually got the job he was looking for so yes, it can be done but like anything in life it requires a lot of legwork. Good luck on this endeavor!
Question: What is your opinion of the overall usefulness of “Wall Street” and the investment management industry? Of course people always trot out the “more efficient allocation of capital” argument, but do you think that Wall Street is really benefiting the economy as much as they are taking away from it by using up talented engineers and physicists and statisticians or screwing people on shady CDO deals and all that?
Answer: I agree with your premise that the investment management industry as a whole does not create a lot of value and that it mainly serves the personal interests of those who manage the money. As a mentor once told me “the money is not made in New York, it is sent to New York where it is chopped up in fees”. That being said this argument can be applied to any industry or profession. In my opinion there are always a limited number of shining stars in any given profession or industry. For example, in physics Richard Feynman is a great star but there are many examples of physicists who are only interested in getting published or being lauded by their peers instead of creating new and valuable ideas. On the whole though your argument is extremely valid for Wall Street in particular. I don’t know if I could argue that it is taking away talent from other professions because those who enter Wall Street tend to be more interested in making money so I don’t know if Einstein would be taking a job on Wall Street because his interest was always more on ideas than in making money. I am still in the process of formulating this opinion though…
Question: We’ve had a big debate around here recently regarding high frequency trading. Do you have any thoughts on the matter?
Answer: I believe it is the next big shoe to drop (i.e. scandal) in the securities industry. If you look at the total fees spent on buying and selling securities on all exchanges 10 years ago such as the NYSE, NASDAQ it was in the $2-3 billion range but with the advent in high frequency trading this amount has been multiplied by 10 times so it therefore is more expensive to buy and sell securities today than it was in the past because these high frequency trading firms are front-loading most transactions. Mutual funds and other institutions have been complaining about the increased cost for some time and prosecutors are finally starting to listen so there will definitely be more regulation in the future in this area.
Question: What books have been most influential for you in your career? Are there any that you’d recommend that may have flown under my radar (i.e. something outside the typical “Intelligent Investor”, “One Up On Wall Street”, “Margin of Safety” classics)?
Answer: I recommend the book Antifragile by Nassim Taleb because if you can adopt the mind frame of always looking for optionality in your investments then you will put the odds of investment success in your favor. What I mean by optionality is that if you invest in a highly leveraged firm then the future outlook for a business is more narrow because the management team is often forced to make short-term decisions that are detrimental to the long-term health of a business.
The reason for this is that the high debt does not give them many options on what they can do. Think about how a management team would not be able to commit to losing money on research and development on an important project that could be profitable 3 years from now because they must instead focus on making interest and principal payments on the debt. What I like about the book is that it helps you adopt this mental framework in investing of always looking for businesses that have lots of optionality which are businesses that will not be severely impacted by things such as downturns in the economy or black swans.
Question: Could you give us a brief overview of your checklist? Is it a list of yes or no questions, or metrics, or what?
Answer: The questions help guide you on deepening your understanding of a business and its management team. The key to investing in anything is having an understanding of what the future cash flows of the investment will be. The only way to do this is to examine a business from a variety of perspectives. You want to know if a business has some type of competitive advantage that protects its cash flows or whether it is one that a competitor can easily come in and under price them. Sometimes, you have a great business but if the management team is not good then the cash flows will not grow.
Witness how both Coke and Microsoft which are great businesses have not created much value over the last decade or so. Most of this is due to not having the proper management in place. So instead of being a yes or no response it is more of why do we believe the management team is competent or has integrity? Are the products good for customers and why? Is the CEO product (Steve Jobs at Apple) or sales (Balmer at Microsoft) focused? If the business disappeared tomorrow what impact would this have on the customer base? The questions help you understand the stability of cash flows today and how they are likely to change in the future.
Sometimes, the questions help you understand that you really don’t understand an investment and therefore should avoid it or they can help you understand what areas you need to further research by those questions you are not able to easily answer. This often can tell you the potential risks you face in an investment.
Question: What would be the sub-categories on your investment checklist? Currently on my own I have:
1) Risks 2) Costs and Cost Structure 3) Units (Capacity, Elasticity, SSS, Volume, Pricing power etc.) 4) Management/Insiders 5) Balance Sheet 6) Competition 7) Income Statement 8) Compensation 9) Cash Flow 10) Products/Services (Switching Costs, revenue mix, reoccurring etc.)
all with about 5-10 more specific questions below for a total of about 85 questions. Is this too much?
I am not sure If I am missing any big themes and would love to hear your opinion.
The 2nd question being at what age did you “break into” the industry and what would you recommend someone wishing to create a partnership should do if they are under the age of 30. Is the CFA an ideal achievement?
The 3rd question being, what would be the first 3 questions you ask yourself in terms of your investment checklist?
Answer: No – it is not too many questions because you will not have to answer all 85 questions in each investment that you make. For example, if a company has no debt you can ignore 5) balance sheet but if it is a business with a high fixed cost base then you have to pay attention to 1) Risks, 2) Costs and Cost Structure way more than the others. You weigh the questions for each particular investment you make and also for your experience level. When I first started it was important for me to ask more questions because I was learning more about investing but as I made investment mistakes and my judgement was being formed I learned what questions were more important to ask for a particular investment (which is a process that is always ongoing). The list should be comprehensive because it brings certain things top of mind and makes sure that you are not forgetting to ask what could be a very important question or you can learn what you don’t know by the questions you are unable to easily answer.
As to your 2nd question I broke in right after college because I frankly could not get a job at an investment management firm because I did not have any distinguishing background that would pique their interests. I later learned that when I applied to New York firms that these firms were looking more for pedigree (what school I went to) and since I went to a small liberal arts school in Texas with limited name recognition in New York I did not stand out in any way so I started doing analyst research work for an individual investor basically for peanuts but I was doing what I enjoyed. As far as forming a partnership you need to determine how many people will invest with you in your close circuit such as friends and family because it will be extremely difficult to get outsiders to trust you so you have to focus on those who already trust you first. I don’t believe the CFA is an ideal achievement but if you are raising funds from institutions then it becomes a “must have” so depends on the type of investor base you are targeting.
The first three questions we ask is 1) If the business disappeared tomorrow, what impact would this have on the customer base? 2) What is the background of the CEO? Are they sales focused or product focused? and how did they rise in the organization 3) Is this a business that we would be interested in learning more about – in other words can we sustain interest learning about this business over a long period of time. For example, we avoid banks because I frankly am not interested in them and therefore will never be good at analyzing them. So the top questions are geared towards our investment style and what our criteria is for an investment which has been developed over time.
I remember when I first interviewed with firms that I was focused on selling myself. When I got to the other side (I was interviewing others to hire them) I realized how wrong I was. The key is to ask the interviewer questions to determine if the firm is one where you can add value. I remember interviewing one applicant who kept asking me specific questions on how we did things and then commented on whether he thought he could add value to our process. This made the candidate stand out from all of the other people who were focused on selling themselves.
When you don’t have pedigree you need to have something that demonstrates you can add value to a firm such as a thorough investment report on an investment that highlights how you think about investing and your process. Your investment does not have to be successful but it has to highlight your thinking. In other words, let the actions (your report) speak rather than words and then genuinely try to figure out if you can add value or if it is frankly a firm or people you would be interested in working for.
I would avoid firms where the HR department interviews you for a job instead of the person you will be working for. If you get an interview with the person you are potentially working for ask them what their expectations are of you and what you could bring to the table. What is it they are trying to accomplish by hiring you. Then be genuine about whether you fit this criteria and be honest if you don’t.
I have many examples where I told potential clients that I would not be a good fit for them and they ended up referring me to others who were so being authentic and not trying to fit the criteria of someone else is key. You will eventually self-select where you belong and if you lie about it or try to fit the criteria you will end up paying the price down the road. I hope this answers your question?
[Bonus] Michael Shearn on How Assess Company Management and Talks About Investment Checklists