Bottom-up Investing and the Blind Taste Test

by | Sep 23, 2014 | General

What is it and why we believe in it

How do we find the individual stocks we own in Dock Street portfolios? 

Let’s start with how we don’t do it. We don’t go “top down.” By that we mean first examine the economy, then try to identify trends in business, and then look for companies that will benefit from those trends. We will explain below how this can backfire once we explain our approach.

Not surprisingly, we start at the bottom. We search for great businesses by screening for financial characteristics that indicate that a company may enjoy a significant competitive advantage. High profit margins indicate a lack of competition, while lower profit margins indicate greater competition. If returns on invested capital (the cash invested to start or grow the business) are high, that might mean the company has a highly disciplined management. These are only two of several financial symptoms we search for, but they’re good indicators of a company that is well run. 

Once the company has been identified, we can then, and only then, attempt to discover what trend they might be riding. 

So what’s wrong with starting with a trend, or top down investing? There are two ways for this to go wrong: 1) the investor can be late to the party and 2) he may get the trend right and the stock wrong.

Being late — If the information comes from TV, the Internet, or worst of all a newspaper, it’s probably old news in the stock market. The stocks you find have probably been going up for a year and while something might be left, often being late is the same as being wrong.

Right on the trend, wrong on the stock — Let’s say the investor gets in on a trend early; he still needs to find a great company. Instead, he may settle for a mediocre company, which suggests that the industry is highly competitive. The result might be OK, but it could also turn out badly. For example, we know that China needs more cars, but we also know that the industry is plagued by overcapacity and profits will be hard to come by.

Contrast these two risks against our bottom-up approach. We already know we’ve found a great business, so we only need to understand 1) how they make money, and 2) are they riding a business trend that can support their growth well into the future? 

Often we are stumped by question #1. Either the business is so complex that we can’t figure it out or management does a poor job of explaining. These we file under “too hard” and move on to something else. Why? We think it’s very important to understand what we own. Few things are more exciting (to us) than finding a clean, simple business that comes to market with a unique or innovative approach. 

Number two is easier and more fun. It’s not enough to know the general trend that should benefit the company if the company isn’t particularly suited to take advantage of that trend better than its competitors can. Instead, finding a great business often reveals a need that has yet to be understood by the press or the market. And this is the right way to find a trend!

Both the top-down and bottom-up methods try to find a sustainable trend in business that can yield great profits over time. The difference is in how the trend is identified. We think ours is less risky.

So what is the “Blind Taste Test?” Once we have a screened a list of businesses that appear to be superior, we print the financial material on a single page for each company, leaving off the names. Each of us divides the pile into two or three stacks—great business, not so great, and “I don’t know”. Then we compare our stacks.

By leaving off the names (and a stock chart!), any prior knowledge we have of the business is left out of our judgment. By doing it this way, we remove some of the preconceived notions about a company from our analysis and focus on the quality of the business. 

This is how we found Fastenal 15 years ago, Factset 12 years ago, and Visa two years ago. Our best investments in the next ten years will be found the same way. The hard part is patience.

Best regards,

Daniel A. Ogden


Disclosure: Dock Street Asset Management, Inc. and our clients may own securities. This article is not intended to be used as investment advice.

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