By Axel Steinmetz
If you’re an investment professional reading this, then you probably already know about the use expert networks can bring and how their usage does not mean the analyst is after insider information. As a student, however, I personally was at first surprised how access to extremely knowledgeable sources of company information is allowed and how there’s a whole industry built up around finding connections for analysts.
In my “Why Michigan” blog post, I spoke about VVI wanting to leverage our Michigan-centric membership base to talk to people in the companies we are looking into. In the post, I wrote:
“Many funds make use of expert networks, which cost something like $100,000 a year. For anyone who doesn’t know, these are companies that help link investors to employees where information can be exchanged freely as long as nothing pertaining to inside information is revealed. While these services can be of enormous value to investors, VVI doesn’t have the luxury of hiring a service which makes connections for us. However, by focusing on Michigan companies, we have a higher chance of knowing someone at the company we are interested in. Thus, we can get some of the benefits of using an expert network without actually using their service.”
While it is true that expert networks are a highly debated topic, funds who use them for long-term investment purposes can be after much different information than short term.
The most famous abuse story of expert networks actually involves the University of Michigan, so I imagine this discussion is especially sensitive in Ann Arbor. The story involves SAC trader Mathew Martoma and University of Michigan doctor Sid Gilman. After getting connected with Dr. Gilman from the expert network GLG, Martoma met with GIlman on many occasions before eventually learning that a certain drug tests’ were failures. SAC shorted the stock and made a huge profit once the announcement became public. Martoma is still in jail, and SAC was forced to shut down operations (Sheelah Kolhatkar’s book Black Edge is an excellent fast read about this story for anyone interested).
With stories like that, it’s easy to see why expert networks get the bad press they get, and probably rightly so. Thus, when I talk about VVI wanting to use connections we have to Michigan companies, I can see why there may be similar cause for alarm.
The fundamental difference is that Martoma is a scumbag who knew what he was doing. Long-term investors who use expert networks are asking completely different questions.
When more respectable firms use expert networks, they aren’t wondering what inventory will be next quarter, or if earnings slightly miss expectations. Instead, investors wonder how management approaches problems, if employees are engaged, what qualities management looks at in potential acquisitions, etc. VVI uses connections with Michigan companies to ask these kinds of questions, a research strategy that is both fundamental to value investing philosophy and used by many. In fact, VVI wants to use it’s connections in just about the exact opposite way as Martoma.
So why make use of connections in the first place?
First, without speaking with people, our investment decisions cannot be as informed without talking to people in the industry. The annual reports can only tell us so much, and we have to talk to the people who actually make up the company to fully understand what the company is doing.
Second, as I alluded to earlier, every other actively managed long-term investment fund is doing it, so VVI should as well. Getting out there and asking people questions helps our educational goals an indescribably amount. Through this process, members must think of tough questions that they think will help their invest decision and then digest the answers to either validate or challenge their perceptions about the company. I believe it also helps with club engagement. No matter how “professional” an undergraduate club is, students are students, and thus there is little motivation to debate investment theories for many students when essays are due and tests are approaching. Talking to people helps with getting members to care about the project they’re investing their own time in, providing a professional investing experience at the same time.
Finally, it’s part of the fun! Talking to people is my personal favorite part of the research process. In my experience, I’ve found that people like to talk to us as well. Talking to young people about your company is fun for most adults, and some of the time, we are the only one’s interested in hearing people talk about their jobs. That may sounds sarcastic, but it’s completely true. Talking to students interested in what they do is an experience not many employees get, and many are willing to chat.
I heard rumors (although I haven’t checked it out yet myself) that there is a whole graduate level class in Stanford which uses Philip Fisher’s Common Stocks and Uncommon Profits as its textbook. In it, Fisher describes his 15 point scuttle butt method which states the importance of talking to employees, management, and competitors.
Here’s a quote from him about this issue that I think just about every value investor knows:
“Go to five companies in an industry, ask each of them intelligent questions about the points of strength and weakness of the other four, and nine times out of ten a surprisingly detailed and accurate picture of all five will emerge.”
I would actually like to expand on Fisher’s comment here. The best managers will tell you the strengths and weaknesses of their own company as well, so it’s always good to ask. But how can you know without actually talking to them? Very few annuals describe the true weaknesses of a company, and I have read many which are overly optimistic and read like bad marketing material. Sell-side reports often focus on short term metrics, and only get the value investor so far. To make better investments and learn the most, it is critically important that VVI gets out there and talks to people.