Practical Investment Analysis: Mosaic Theory
Before buying any stock, it is important to do your research and do it thoroughly.
DISCLAIMER: This article references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.
When you take a position in a company based on fundamentals, you believe that the market has not valued the business appropriately. The difference between your predicted valuation for the company and the current value is what you want to capitalize on, with the hopes that catalysts make the market come to its senses. Though, it’s important to understand that knowing more than the market is not easy, and is why most investors, even the vast majority of hedge funds, underperform the S&P 500. To have a high conviction in your assumptions and the derived value, there’s a whole lot of due diligence that needs to be done. But how can you know more about a company when all investors have access to the same information? That’s where the mosaic theory comes in to play.
What Is It?
Mosaic theory is a method of analysis for companies involving the accumulation of public information and nonmaterial information that is not public, pieced together to get a unique, holistic view of the business — a more informed view than the average investor.
Ways that many analysts go about learning non-material information about a company are by talking to management, reaching out to and talking with employees, looking at Glassdoor reviews to understand general employee sentiment, going to retail locations or product showcases, or even looking at related Google search trends. Talking to management is a good way to better understand the larger vision and understanding how a company’s leadership thinks through decisions, while talking to employees can give a better look as to how the management is viewed amongst subordinates. Retail locations and product showcases can be argued to be the most important as they are often the main touchpoint with consumers. A company is only as relevant as the product or service which it produces. Google search trends can offer additional macro-insights for consumer demand.
The goal of the mosaic theory is to combine all the different tidbits of information that you gather alongside public material information to develop your own unique view on the business. By the end of all of your research, know the business like the back of your hand. After this, you can produce an operating model and conduct a discounted cash-flow valuation with a much higher level of conviction, allowing you to make a trade based on your analysis while feeling confident.
Material and Nonmaterial Information.
As stated before, the non-public information that you collect must be nonmaterial. The United States’s Securities and Exchange Commission defines material information as any company knowledge that, were it to be made public, would result in a “substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security”. That would include things like hard earnings data for unreleased quarterly reports, an unannounced acquisition, and things of that nature. These are examples of things that you cannot learn about without risking getting charged with the violation of insider trading laws (very serious!).
The 1983 US Supreme Court case Dirks V. SEC solidified the legality of mosaic theory in investment research and analysis. That’s not to say that it can be used as a work-around for legitimately illegal activity. That was the defence for Raj Rajaratnam, who was a very well-respected hedge fund manager until he was found guilty for being part of one of the largest-scale insider trading rings in October 2009. He was sentenced to 11 years in prison.
Example
A nickel refinement company based in Winnipeg by the name of Manitoba Metals is publicly listed on the Toronto Stock Exchange with a market cap of $340 million. They recently made a $20 million acquisition of a smaller nickel processor, Calgary Refineries, located in Alberta.
The first thing you do in your quest for research is scouring the company website for financial filings, press releases and anything else that may be important. The next step is to read through news articles and third party information sources to learn more. Congratulations, you now have a basic understanding of the business, but don’t kid yourself, you are nowhere near where you need to be before making a bullish or bearish position in the company.
This is when you go to begin looking for non-material non-public information. Start by finding the email addresses of management and shooting them a quick email, asking if you can hop in a call with them sometime soon to address some questions for the purpose of investment research. It’s a good idea to reach out as soon as possible because often they take some time to respond. You can find their contact through either the company website or Bloomberg. Optimally, you want to talk to the Chief Financial Officer of the company, though you may settle for another member of management or even someone from the investor relations team if that doesn’t work out.
While you await a response, you can conduct employee research through previously mentioned websites, or find and reach out to employees through a platform like LinkedIn to schedule a call with them. (You would be surprised how friendly and responsive people are to help and answer any of your questions). Clarify any questions about the business and only ask for non-material information. Once you’ve done this, you can move on to the product/service research.
Product/service research consists of learning more about the company’s main source of revenue. For Manitoba Metals, that means looking into the general nickel refinement process as well as nuances in the company’s processes. Some companies post annual information reports on their websites with their annual financial reports with more qualitative details. If you live close to the factory, maybe try to talk to a manager about going in for a tour.
Once you understand the operations of the business and intricacies of the product or service, you want to find customers that use the product or service regularly. Even if the customer uses the competitor’s version, they can offer more insight. Looking into macro research through Google search trends or websites like the Pew Research Center can help you target your questions based on demographic and psychographic trends.
At first, it may seem difficult to translate a lot of the qualitative information you are learning about the company into business value, but it will get easier as you continue. The things you learn help you reconcile numbers in financial reports, be able to pinpoint sources of risk, and see a far more clear path for the company. This will become especially clear after talking with management.
Company management tends to be very considerate and cooperative, but it is your job to come prepared. It is your job to know the company’s products, business model, competitors, strengths, weaknesses, opportunities, and risks. Come with many prepared questions because you may not get the opportunity to ask them again. Good questions may be about how management thinks through an acquisition, steps the company plans on taking to deal with some potential risk, etc. People’s time is valuable so make sure that you aren’t asking questions that have already been answered in press releases and reports. For Manitoba Metals, you may choose to ask what the company’s five largest clients are by revenue, or what sort of contract structure they use for their clients. You may also respectfully for management’s plans for the consolidation of Calgary Refineries; does the acquisition represent a larger shift to the Albertan nickel refinement market? Keep in mind that the other person may decline to answer any of these questions.
Now that you have all your questions answered, you can do more digging based on what you learned from your conversation with management. If they answered your question about their top clients, you may want to reach out to them and ask about the quality of the product they receive from Manitoba metals, etc. Once you are satisfied and have answers to as many of your questions, you can finally move on to putting everything into your projection models. Assuming you kept notes on everything along the way, this should be much easier now. Congratulations!
Hopefully, this article helped you learn how to go about researching a company before making a position. If so, be sure to look over some key takeaways and at some next steps you can take to support us and further your learning!
Key Takeaways
- Mosaic theory is a method of analysis for companies involving the accumulation of public information as well as non-material information that is not public, pieced together to get a unique, holistic view of the business
- Any non-public information you collect cannot result in a “substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security”
- Employee Research, Product/Service Research, Customer Research, Macro Research, Management Research
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