The Sleuth Investor - Avner Mandelman

The Sleuth Investor: Uncover the Best Stocks Before They Make Their Move, written by Avner Mandelman, offers a radically different approach to investing, emphasizing the importance of finding information that other investors don’t have.
Mandelman challenges conventional wisdom by asserting that investing isn’t purely about numbers and math. He outright rejects the efficient market theory, stating that most market participants don’t truly know what they’re doing.

Investing in a company means owning a part of that business. To gain an edge, it’s essential to know more than others and go beyond what’s available in public documents. Becoming a “sleuth” and digging for hidden insights can make all the difference.

3 Key Sources of Information:

People: Speak with individuals connected to the company, such as employees, clients, and suppliers.
Product: Analyze the company’s product as well as its supplies and competing products.
Plant and Periphery: Visit and observe the company’s facilities and surrounding areas to gather firsthand impressions.

People

In the Company

Make a List of Relevant People

Leverage SEC Filings
Make use of 10-Ks, 10-Qs, and annual information circulars, which are accessible through the SEC’s EDGAR database. These documents provide vital details about a company’s operations and financial health.

Identify Key Individuals
Your research should include top executives, leading salespeople, engineers involved with critical products, and any other employees tied to important areas or projects. Understanding who these individuals are and their roles is crucial for your analysis.

Know What You’re Looking For

Before starting your investigation, set specific objectives and outline the key questions you need answered.

Connecting with Key Personnel
Ideally, getting to know key figures personally can yield valuable insights. Pay attention to subtle details about their character and motivations, such as:

Office decorations (e.g., posters, trophies)
Personal demeanor and habits
Background information (e.g., resumes, place of birth, political views)
Visible signs of lifestyle (e.g., type of car, clothing)

Understanding their motivation involves looking at their compensation structure, which could include wages, bonuses, and stock ownership. While SEC filings indicate share ownership, they often do not detail how individuals are compensated, so additional digging may be necessary.

Observe Group Dynamics
Attend company events or meetings to understand power relationships and team cohesion. The office layout can be revealing; those seated closest to the CEO are often considered priority figures.

Document and Analyze Your Observations

After each investigative step, jot down all details you can remember. Collaborating with a partner is beneficial—they may notice connections that you miss. Share notes and use them to answer questions such as:

What are the strengths and weaknesses of key team members based on your findings?
Is the team structured in a way that supports its objectives?
How effectively do they work together? Are their goals aligned, or do they conflict due to poor incentives or rival ambitions?
What internal tensions or factions exist?

Gathering Information

Use every available method—face-to-face meetings, phone calls, or even informal chats at nearby restaurants where employees may gather for lunch. These interactions can provide unfiltered insights into the company’s culture and internal dynamics.

Getting to Know the Customers

Four key questions you need to answer about the customer:

Who are the customers? (Both the client company and the decision-makers within that company)
What exactly are they buying? Clarify what both the company and the decision-maker gain from the product.
What exactly are you selling? Define what the company is offering and how it benefits the decision-maker.
Why would they buy from you? Clarify the reasons, both from an individual and company perspective.

Key Customer People

Sleuthing customers is similar to sleuthing the company’s employees and executives, except there are far more of them. Focus on the main clients who bring in the highest revenue and growth potential.

The payment process is typically divided among three people:

Those who recommend writing the check – users and vetters.
Those who decide to send the check – decision-makers.
Those who actually send the checks – paymasters.

The ideal customer fulfills all three roles, is directly reachable by the company’s salespeople, and benefits personally from the product. This last point is often the most crucial, yet it’s never mentioned in reports or analyst calls.

Talking to customers is also an excellent way to engage with management later. Insight about the people who pay the bills is a powerful way to get their attention.

(Page 61: Worth rereading the example of SmallTech)

Tips for Investigating Customers

Check for User Groups:

Before contacting individual customers, see if the company has user groups and identify their coordinators. Contacting them can give a quick and comprehensive understanding of the business from the customer’s perspective.

Make Personal Contact:

Direct interaction with the company’s customers is crucial. Rule: Never invest in a company’s stock until you’ve spoken to at least three key customers. This practice can prevent potential investment losses and provide valuable insights.

Ask About Their Jobs:

Start by asking customers about their job roles. This helps you identify if they are a user, approver, or paymaster. It also reveals how the product fits into their work life and whether it meets personal or corporate needs. Focus on the customer before jumping to product-related questions.

Inquire About the Sales Cycle:

Explore how the customer became aware of the product and the purchase process:
- How did they learn about the product?
- How long did it take before purchasing?
- Who approved it, and was there any resistance?
- What follow-up did the vendor provide after the purchase?

Ask About Vendor Impressions and Gossip:

Gather the customer’s impression of the vendor’s staff and any additional information they can share. Listen carefully for any gossip, as it may reveal hidden company issues. However, be discreet and always act honorably to maintain your reputation.

The Company’s Suppliers

Product Suppliers

If products are stored at the supplier’s facility, try to count them. Packaging often allows for an accurate estimate of production.

Service Suppliers

Knowing the professionals involved is key. If you see the CEO with a lawyer known for mergers, it’s a clue that something is up. Recognizing these key players can be crucial for spotting such signs.

Product Research

Get a Sample or the Actual Product
Order the product yourself and document each step of the ordering process. Once it arrives, unbox it carefully and observe every detail:

Is the packaging secure and appealing?
Does the product look high-quality?
Is the brochure or accompanying material professionally printed?

Pay attention to any signs on the packaging that hint at the product’s physical journey.

Visit Production Facilities
Reach out to investor relations to arrange a tour of the production facilities. This visit can give you a comprehensive understanding of the production process, from raw materials to the final product.

Ask Insightful Questions About Production Changes:

What would happen if production volume increased by 25%, 50%, or even 100%?
What additional machinery or equipment would be required?
How much more space would be necessary?
How many extra employees would be needed, and in which roles?
Where would the company find these new hires?

Observe Physical Signs of Performance
Look out for subtle, telling indicators of the company’s current state. For example, seeing a celebratory event, such as a champagne party, before a results announcement could signal unexpectedly strong performance.

What to Look For:

When interacting with corporate personnel, stay alert for any habits or procedures that hint at unexpectedly good or bad outcomes.
Assess whether these signals can be legally observed from outside the company, either directly or indirectly.
Develop a plan to detect these physical cues. Remember that only a few of these efforts will yield tangible results, and those results may be infrequent. However, when they do happen, they can indicate near-certainty of significant change, making the effort worthwhile.
Build relationships with potential informants and offer legal gratuities. For instance, tip service providers generously near the company’s premises to encourage positive responses when you reach out.

Compare with Competitors
To gain a well-rounded understanding, apply the same investigative steps to the company’s competitors.

Plant and Periphery

This includes the physical environment where business is conducted. It’s most useful when unexpected issues arise with no clear explanation. “There is seldom just one cockroach in the kitchen.”

Visit the places where the company does business. Listen to what employees say in cafes, and try to talk to lower-level staff to get direct answers.

Putting It All Together

Organize all this information into a visual star map, like in a police investigation.

Tips for Using Star Maps:

Treat stock analysis like a police investigation. Learn as much as possible about everyone involved: motivations, skills, personal and professional details—everything.
When investigating a stock, set up a situation room with whiteboards and wallboards to track tasks, maps, and photos. Make sure you and your team can see this while making calls.
Draw a star map showing connections between the main actors: the company, clients, competitors, lawyers, accountants, bankers, suppliers, etc. Note past workplaces, hobbies, birthplaces, family ties, affiliations, ambitions, and others’ opinions about each participant.
Once you gather a critical mass of information, the situation will come alive. Follow your instincts. If you get a hunch that there’s no deal here, move on to another stock.

Picking Stocks to Investigate

Four Categories of Stocks Worth Investigating

When sleuthing for investment opportunities, there are four primary categories of stocks you should consider. Each category has its unique characteristics and risks, so it’s crucial to understand them fully before deciding where to focus your efforts. Let’s break down each category in more detail:

1. CHEAPIES

Cheapie stocks are classic value investments, often trading well below their intrinsic worth. These are the kinds of stocks Benjamin Graham, the father of value investing, famously recommended. Here’s what to look for in cheapies:

Trading Below Book Value: These companies have a market price lower than their net asset value (assets minus liabilities). In other words, the company is worth more if it were liquidated than what investors are paying for its shares.
Low PE Ratios: Look for companies with a low price-to-earnings (PE) ratio compared to industry peers or historical averages. A low PE ratio might indicate the stock is undervalued relative to its earnings.
Low Cash Flow Multiples: Companies that generate strong cash flow yet trade at a low multiple (i.e., price-to-cash flow ratio) are usually good candidates. It suggests the market might be underestimating the company’s earning potential.
High Dividend Yield: A high dividend yield means the company pays a generous dividend relative to its share price. This can indicate a strong cash position, providing some safety cushion if market conditions worsen.

These types of stocks often come with their own set of risks. They might be facing temporary issues or operating in a depressed industry. However, if you can identify a situation where the market has overreacted to a short-term problem or overlooked the company’s long-term potential, you could find a lucrative opportunity.

2. GOODIES

Goodies are stocks of outstanding companies that have a lasting competitive advantage or “moat.” These companies generate consistent earnings and growth, even if they aren’t managed perfectly. Charlie Munger, Warren Buffett’s partner, has always advocated for investing in these high-quality businesses. Here’s what sets goodies apart:

Durable Competitive Advantage: These companies have a unique product, strong brand, intellectual property, or market dominance that shields them from competition. This advantage allows them to maintain profitability and grow over time.
Earnings Consistency: Goodies are known for their stable and reliable earnings, regardless of economic cycles. Their robust business model allows them to continue generating profits even during downturns.
Ongoing Value Creation: Even if these stocks aren’t cheap by traditional metrics, their ability to generate ongoing value makes them worth the premium. Over time, their sustained growth and profitability will justify the investment, often turning expensive-looking stocks into bargains in hindsight.
Buying on Dips: One strategy for goodies is to wait for temporary setbacks—such as a poor quarterly report or an external issue impacting the market as a whole—before buying. This could provide a rare opportunity to purchase a great company at a discounted price.

Goodies are generally safer investments but finding them at the right price is challenging. The key is patience and a deep understanding of the company’s business and long-term prospects.

3. ROCKETS

Rockets are high-growth, momentum stocks. These companies are experiencing rapid expansion and can potentially multiply your investment many times over. However, they come with significant risk. Rockets include:

Explosive Growth: Rockets are companies in sectors experiencing rapid growth, often characterized by disruptive technologies or new market trends. Examples include Microsoft, Cisco, Dell, and Taser during their high-growth phases.
High Valuations: They often trade at high price-to-earnings ratios and other valuation metrics, reflecting investors’ optimism about their future potential. While this makes them expensive to buy, the growth prospects can justify these valuations if the company continues to perform.
Volatility: Rockets are highly volatile. Their prices can swing dramatically based on quarterly results, market sentiment, or changes in industry dynamics. Investors must be prepared for sharp declines and have a strategy for when to exit.
Timing Is Key: To succeed with rockets, timing your entry and exit is crucial. Many investors ride these stocks up but fail to exit before the growth slows, leading to potential losses. Due diligence, market research, and sometimes a bit of luck are essential when dealing with rockets.

Investing in rockets can be incredibly rewarding if you identify the right company early in its growth cycle and know when to cash out. However, the high risk means they aren’t suitable for every investor.

4. TRADIES

Tradies (short for “trading stocks”) are a catchall category encompassing special situations where a sharp change is about to occur. These changes can take various forms, offering unique opportunities for those who know how to spot them:

Special Situations: This category includes companies undergoing mergers, acquisitions, spin-offs, bankruptcies, restructurings, or other transformative events. Identifying these changes before the broader market does can provide a significant investment edge.
Turnarounds: Look for companies in distress or turnaround situations where management is implementing a new strategy to improve operations, reduce debt, or refocus the business. If successful, these companies can see a rapid recovery in their stock price.
Shorting Opportunities: Tradies aren’t just for buying. If you have access to reliable information indicating an impending negative event—such as poor earnings, regulatory trouble, or operational missteps—you can short-sell the stock to profit from its decline.
Information Advantage: Investing in tradies requires sleuthing to uncover the real story behind a company’s situation. If you can identify change before it’s public knowledge, you can take advantage of the opportunity before the market catches on.

Tradies offer high rewards but also come with high risk. Success depends on your ability to gather insider-level knowledge legally and accurately assess the situation.

Which category is best? It depends on your personal bias and comfort level.

Finding Stocks Worth Investigating

Text Screens

When looking for stocks to short, search for phrases indicating brewing issues, like:

“Management denies that…”
“Left (resigned) for health reasons”
“Left to pursue other interests”
“Lowered guidance to…”
“Reiterated that the rumors have no basis…”
“Filed a lawsuit against short sellers…”
“VP of sales/marketing left for personal reasons…”
“Company hired a new VP of sales…”
“Management took issue with the analyst’s conclusion…”

These suggest potential problems not yet officially announced.

Numerical Searches

Look for imbalances between supply and demand. For example, when capital spending doesn’t match depreciation, it may signal a depressed industry that investors are avoiding.

Cyclical Disasters

Many businesses are cyclical, depending on the economy or having their own cycles. Becoming an expert in a cyclical industry can lead to wealth by buying stocks at the bottom of the cycle and selling near the top.

The Sleuth Investor – Avner Mandelman