Practical Investment Analysis: Primary Research
When looking at a company, talking to management is where you often learn the most and how you really get an edge over the rest of the market.
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.
This is a continuation of the previous article on practical investment analysis regarding mosaic theory. As a refresher, mosaic theory refers to the method of conducting investment analysis by compiling a combination of public information and non-public non-material information to form a unique view. The most important part of this process is the collection of non-material non-public information through primary research.
What Is It?
Primary research is what you learn directly from your source, the company you are looking into. The most effective form of primary research is through calls with management of the company (preferably the CFO), though if this is not possible, investor relations is a good second bet. To make the best of the opportunity, you should do as much secondary research as possible before the primary research. This includes financial reports, press releases, mission statements, subsidiaries, associated risks, market conditions, etc. Understanding the business better will help inform which questions to be asking and how much importance to give each one.
How Do You Do It?
Prepare
Secondary research methods are covered extensively in the mosaic theory article, involving employee research, product/service research, customer research, macro research, and management research. Once you compile all secondary sources to form a cohesive report, it’s time to make the first draft of an operating model and DCF. A comparable companies analysis and/or precedent transactions analysis may also be a good idea depending on the amount of data you have access to and the size of the company’s peer group. Through the process of developing your model, areas of ambiguity or questions may stick out to you that aren’t made clear in your research. Jot these down. Good questions aren’t directly about a specific number or ratio, but about what drives that number or ratio. So instead of “What will the cost of goods relative to revenue be next year?”, a better question would be, “Are there plans to reduce material costs or streamline production? If so, what is the timeline?”. That is a very vague example, but questions will often relate back to things that you already know about the company, and go from there. Don’t always go out of your way to think of questions that directly relate to your model. Genuinely be curious about the company. Think about what you are really left wondering about the business. Applying what you learn will come later.
Contact
Now you have come up with a rough model and have all your questions and concerns noted. It’s time to talk to management. You can usually find management’s contact information on the company website, Bloomberg, or LinkedIn. In some tougher cases, websites like hunter.io can help quickly search for all emails listed with a certain website’s domain. In your email, make your intentions clear: that you are considering buying shares in the company and you’d like to get in a call to ask some questions for the purpose of investment research. They should get back to you within 2–3 business days at most. If you don’t get a response, then try another contact method or if all else fails, try investor relations.
Once your call is scheduled, go over all your research and make sure that you know your company and the industry like the back of your hand. For the call itself, have at least an hour set aside, even if you don’t think it will take that long. It’s not uncommon to come up with an entirely new line of questioning or to expand on something you hadn’t planned to at first. It’s a good idea to make notes on everything you learn and to go back and decide whether it is useful only after the call is over. If you have trouble summarizing in real time, transcribing word-for-word is also fine.
Analyze
After you’ve gathered all of your facts, it’s time to analyze it and understand all the implications — direct and indirect — that they will have on the business. For example, streamlining production would likely decrease the cost of goods sold, plans to diversify revenue would likely narrow the spread between your bear and bull cases, etc. It is recommended to make all your changes to the operating model in a duplicate file so that you can go back and compare with your rough draft later on. Making comments throughout your spreadsheet explaining the changes you are making will also make it much easier for other parties as well as yourself to understand your reasoning and where your assumptions are coming from.
This has all been very abstract thus far, so let’s go through an example to paint a clearer picture of this process.
Examplar: Pollard Banknote (PBL:TSE)
Pollard Banknote is a publicly listed corporation based in Winnipeg, Manitoba that specializes in lottery and charitable gaming manufacturing. Their primary source of revenue comes from instant ticket printing, supplemented with ancillary products like ticket displays, lottery vending machines, and such. Recent developments such as the joint venture NeoPollard Interactive LLC represents expansion into the digital iLottery and app development space for established lotteries in North America and Europe.
I spent a number of days conducting secondary research through annual reports, press releases, news aggregation, and came up with the following report and rough operating model:
I would recommend skimming through to get a better understanding of the important research concepts, especially to put the next portion into context. My conclusion from my model pre- primary research was bullish. My model’s base exit-multiple DCF forecasted ~25% upside, though to be fair, my bull-bear case spread was fairly large as I didn’t very high conviction in a number of my assumptions. These were my main questions I wanted to talk to management about:
- What is the plan for consolidation of the recent acquisition of Mkodo?
Both Mkodo and the previous acquisition of Fastrak Retail earlier in 2019 are based in the UK; Does this represent a larger shift in focus towards the European market? - If so, how does Pollard Banknote plan to generate leads outside of the formal RFP process being used in North America?
- How has the acquisition strategy of Pollard Banknote evolved over the past few years, given that 5 of the company’s 7 acquisitions have been made since June 2017?
- What is Pollard Banknote’s response to the regulatory developments with the DOJ’s new interpretation of the Interstate Wire Act? What precautions are being taken in case the ruling is unfavorable and deems online betting — including iLottery — to be prohibited in the US? If an unfavourable verdict is reached, how much will this affect management’s outlook?
- How much revenue is being generated specifically from the online lottery management and consulting business? (iLottery)
- As the 10 largest customers account for more than half of fiscal 2018 revenue, are there any such large contracts approaching expiry without the intent to extend?
- How likely is the collective bargaining unit at Ypsilanti facility expiring August 2020 to cause labour disruptions?
- Considering the high level of fragmentation in the charitable gaming market, how quickly and effectively does management believe that Pollard can consolidate market share?
It took some time to schedule the call with the CFO, Robert Rose, though it was well worth it. He had very detailed answers for each question and offered a lot of insight into the views of Pollard Banknote’s management. I won’t go over his response to every prompt, though I’ll go through a couple to give examples as to what I learned and how I applied that to the operating model.
Implications
The most important piece of information that I learned was that the digital iLottery business, in management’s words, makes up an “immaterial” portion of current revenue, and its success in becoming more significant in the future is “a big what if”. This indicates that management is highly unconfident in strong growth for the digital lottery business even if the Wire Act is interpreted in their favour. Applied to the operating model, that means that the bull-case for Pollard Banknote’s revenue is much closer to the base-case.
Another important thing that I learned from the call is that management’s acquisition strategy should become a lot more tame moving forward. The large number of acquisitions was not necessarily planned, but only because a number of opportunities presented themselves at the right time and price, according to management. As the most-recent acquisition of Fastrak Retail comes to a close, Pollard Banknote plans to spend some time consolidating their businesses and ensure everything runs smoothly. This can be translated to a decrease in capital expenditures — capex — moving forward.
A change to the exit multiple in the DCF was also made after further research showing a temporarily inflated EV/EBITDA compared to Pollard Banknote’s peer group. There are some more changes to the operating model based on the primary research. These are explained in notes throughout the updated model below:
After countless adjustments and tweaking to the model, I feel far more confident in my assumptions as well as the final DCF. My new model has led me to the conclusion that Pollard Banknote is fairly priced at current levels. My new base-case exit-multiple only shows 5% upside, whereas the bull-case is only slightly higher, and the bear-case shows significant downside if things go wrong for the company. This is a perfect example of a situation where primary research made a substantial change in my opinion, bringing me from a buy position, to a hold, whilst giving me higher conviction in my current assumptions.
Hopefully, this article helped you learn how to conduct primary research to add conviction to your investment decisions. 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
- Primary research is what you learn directly from your source, the company you are looking into. The most effective form of this is getting in a call with the management of a company.
- Talking to management is where you often learn the most and how you really get an edge over the rest of the market.
- Conduct as much secondary research as possible before moving onto primary. Prepare a research report and rough operating model + DCF based on this. You should know the business and industry very well before talking to management.
- Highlight key areas of uncertainty and questions about the business. Go over these during your call. Make notes on everything that you learn throughout.
- Determine the implication of all of your new pieces of informations and apply them to your model, commenting the spreadsheet along the way.
- You should now have a fairly high level of conviction in your assumptions and thus the result of your model. Congratulations!
Next Steps
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