May 26, 2016

Here is how you can analyze stocks the Doug Kass way

Always be creative in your research process. Most people simply interpret and analyze the same fundamental and technical data, view research from similar sources and attend the same conferences and management presentations. In other words, most players are simply talking to each other!

I call this "Group Stink." While the investment world has never before been this transparent, remember that:

-    We're inundated more than ever before with the same data.
-    The technicians are all reading the same charts.
-    The fundamentalists are all interpreting the same data and listening to the same eternally optimistic company managements.
-    Much of the business media report the same pablum over and over again from the same commentators and "talking heads" (who are usually just "talking their book" anyway).

I've tried over the years to differentiate my research by employing creativity and a lot of hard work to deliver proprietary views. Most of the time, this has served as a productive and profitable exercise.

How I Analyze Stocks

To begin with, I conduct ongoing channel checks and bottom-up research, often with offbeat contacts who typically don't spew the company line. That's why I sometimes disappear for hours at a time in between diary postings. This isn't easy -- it's labor intensive, and sourced by nontraditional contacts that I've developed over years.

Secondly, I take all company-management interviews that I see in the business media with a healthy dose of skepticism."

Let me explain in greater depth how I do research, using an example that I remember quite well from 26 years ago.

I used to do harness racing, but I broke my legs, nine ribs and eleven vertebrae in a near-fatal accident during a July 1990 race. This left me in a wheelchair and body cast for nearly two years.

While convalescing, I took it upon myself to do research on Marvel Entertainment. Among other things, I simply called numerous comic-book stores from my hospital bed in New York. This research ultimately developed into a negative cover story on Marvel for Barron's. 

Anyone willing to spend the time and be creative can do good, independent research. In fact, you have to these days -- because as I noted above, company managements rarely provide good, objective information or express negativity. To paraphrase Warren Buffett: "They lie like ministers of finance on the eve of devaluation." The same often applies to sell-side analysts, too.

Lending Club's fall 
Let's look at troubled LendingClub (LC) as another example for how you can do independent research.

For those unfamiliar with LC, the firm operates an online marketplace that aims to connect consumers, small businesses and other borrowers with investors who are willing to loan them money. The goal is to allow everyone from banks to hedge funds to high-net-worth individuals to offer such things as personal, educational or medical loans.

LendingClub stock got as high as nearly $30 a share in late 2014, giving the firm about a $15 billion market capitalization as numerous hedge funds got on board with this seemingly new and disruptive idea. But since then, LC's price has dropped by almost 90%, as this chart shows.

Let me share how I avoided buying the stock back in late 2014, when many money managers were loading up.

During LendingClub's heyday, I certainly wasn't going to take what the CEO said in his frequent appearances in the business media. Instead, I did my own primary research, just as I did with Marvel Entertainment.

How did I do that? Simple -- I became a LendingClub customer.

I deposited $5,000 with the firm in November 2014 to see how the company's investment process worked and how profitable it might be. I set up an automatic-investing account and picked a mix of the available loan-quality categories (from "A" to "F"), putting about 20% toward each.

But within a year, two of the 15 loans that I made had to be entirely charged off. All told, my total internal rate of return, or IRR, for the first 15 months was an abysmal minus 1.31%! So, I knew that there was less than meets the eye to LendingClub's business.

My experience also showed me that sometimes, disruptors aren't really all that disrupting. In essence, LC is just a combination of an on-balance-sheet lender and a traditional investment bank that packages loans to sell to the marketplace.

All told, I concluded that there simply wasn't enough peer-to-peer demand to fund LendingClub's growth, so I avoided the stock (although I wish now that I had shorted it).

You, too, can do this sort of thing from home -- in your pajamas. All it takes is some time and a little creativity!