I often get asked by readers to create a step by step guide to researching small cap companies. If I were to write such a guide, I think step one would be to ask “what is the bias of the sources I’m using for my research?” Diving into this question is one of the funnest and easiest ways to improve your researching ability.
Historiography is the study of the writing of history itself, and the cumulative information about a company is its history. Investors study that history themselves but it pays better to be a historiographer as well. The information you receive has been created by individuals. It is worthwhile thinking about who they are.
Incentives shape the nature of the information we receive as investors. For example, if a company is running out of money, and looking to raise capital, there may be a heightened incentive to conceal negative information and emphasise the rosier view. In comparison, a board to directors to play down a company’s prospects, while the company itself is buying back shares (potentially increasing their own proportional ownership of the business).
I’ve made a list of the different kinds of sources, sorted by their bias. My pronouncements are not necessarily perfectly accurate, but this can at least serve as inspiration fo you to think about the various sources you might use. Generally speaking the main mistake most small cap investors make is to only rely on positive or very positive bias sources. This means while they may feel like they are using multiple sources, in fact, there is still a strong bias in their source material.
Very Positive Bias Sources
Heavily Promoted Company Presentations With Adjusted, Non-Audited Metrics
Company presentations, often made with the assistance of an investor relations firm, are designed to serve the incentives of the people who order them. They invariably emphasise the positive.
Private Conversations With Management
Many investors boast about having talked to management, but it is equally reasonable to consider conversations with management as an opportunity for them to shape the information you receive in a way that gives you an overly positive view of the company. Generally, formal questions on the record in a public Q&A format are much more reliable than private conversations.
Five Star Employee or Former Employee Reviews On Glassdoor
When a company gets some negative one start reviews on Glassdoor, it looks really bad for the HR department, who may even get fired for it. The usual response is to put out a bunch of ridiculously positive 5 star reviews. Anyone with a company email can access it. You can spot these sometimes if the usual frequency of reviews (say 2 per year) gives way to a cluster of 5 star reviews in a few months. Most HR Departments are smart enough to seperate the positive reviews by at least some time but you will occasionally see a cluster of 5 star reviews over a couple of days.
Positive Bias Sources
Audited Annual or Half Year Reports
Audited company reports have parts of them that have been parsed by an independent person, the auditor. In particular, if a company is lying about its accounts, and the auditor signs off on them, then there can be potentially severe ramifications for the auditor. This changes the incentives shaping the nature of the source; the auditor has an incentive to ensure accuracy. However, the auditor is paid by the company, and also the CEO and Chairman craft letters where they will generally try to paint a positive view of the company and their contribution to it.
Management Answers To Public Q&A
These days, many companies give shareholders and analysts and journalists the opportunity to ask questions. Overall, the fact that the answers are coming from management means that there is a positive bias. However, the identity of the questioner also becomes important. Public answers to tough questions from a neutral or hostile questioner may have a positive bias, but can still provide some of the best insight to the truth of a company and its prospects.
Variable Bias Sources
Journalist and Analyst Generated Content
Content created by journalists and professional analysts can have a variable bias. In the best case scenario the content creator is monetising content in a way that means they have an incentive to make their content consumers succeed. It is very important to consider how a creator is paid. For example, if someone is paid by a company to write about the company, then there will likely be a very positive bias. Analysts who work for brokers may feel pressure to be positive about a company that needs to raise capital, because their own brokerage firm might lose a contract to raise capital for the company, if the analyst coverage is negative. For a retail investor, I would generally argue the best kind of content is content paid for by subscription, then the next best is content paid for by advertising (though it depends on the advertisers).
Shareholder Generated Content
Many shareholders contribute to the story of a company by talking about it or writing about it. One of the reasons I disclose when I own a share I am talking about is that owning shares in a company could be making me have a positive bias. Generally speaking, shareholders have a positive bias. Sometimes, shareholders even pump a stock. My article on 4 Signs Of An ASX Facebook Stock Pump looks at how you can use language to spot overly promotional material.
However, it is also possible for shareholders themselves to have a negative bias, for example if the company has behaved disrespectfully with unfair capital raising, or if the company has been overly promotional for many years. I am not saying it is wrong for shareholders to have a positive or negative bias, just that a specific individuals experience with making or losing money in a stock will create a bias over time.
Product Reviews On Consumer Websites
While all kind of user generated reviews can be gamed, genuine reviews for services (such as broadband connectivity) tend to skew negative. In comparison, fake reviews (often for consumer Apps) are generally positive vias. You can see an example of how I used analysis to identify potential fake App reviews for Sezzle.
No Or Low Bias Sources
Nothing is ever really 0% biased but you can get pretty close.
An inadvertent disclosure can be the best kind of source. For example, a company might prepare a presentation or report that excludes or re-defines a metric that they previously reported on. This scenario might inadvertently disclose that the company’s performance on this metric is bad.
The Numbers Over The Long Term, Especially The Cash Flow
Although the numbers can be misleading in a range of circumstances, generally speaking, over time, the history of how a company has performed is a fairly unbiased source. For example, the historical dividend payments are essentially just a fact. Has the company always increased its dividend for the last 10 years? If so, that is useful information, but it isn’t really biased.
However, please note that this truly refers to the numbers over the long term. In any single period a company can make any single financial metric look misleading. For example, you could accept prepayment for services and pay your bills late, in order to make cash flow look better, temporarily.
Negative Bias Sources
One Star Employee or Former Employee Reviews On Glassdoor
Personally, I think that you can get a lot of value from negative bias sources such as disgruntled employees. These kinds of sources are relatively rare, but that’s what makes them useful. I’ve lost count of the times potential issues in a company were first brought to my attention (inadvertently) through negative bias sources. Mostly, the writers of these reviews are more gunning for an individual in the organisation, than to suggest that the organisation itself is bad. However, it is important to remember that a former employee will often be bias against the company they left.
Short Seller Reports
Just as a shareholder in a company may well have a positive bias, a short seller in a company will generally have a negative bias. This is all the more true with short sellers because unlike long investors (who may receive a dividend while they wait) short sellers have to pay money to borrow the stock. Therefore, they would generally like to see their short thesis play out sooner rather than later.
Perhaps a little close to home for me, but if a group of farmers are opposing a coal mine, then they will likely have a negative bias against the company proposing the coal mine. Similarly, companies that damage people (think tobacco or gambling companies) will often have disadvantaged many people in society one way or another. This generally makes some people bias against such companies. Perhaps this is quite fair, however, it is still a bias to note.
Sources For Small Cap Investors Matter
This list of sources, categorised by their bias is not meant to be exhaustive. You may disagree with my thoughts on any of these sources… if so, feel free to write to me about it! However, the important lesson here, for my investing 101 class, is that you must consider the bias of your sources. If you are relying mostly on sources with a positive or negative bias, your own views are likely to be skewed positive or negative.
As small cap investors, the first and best step you can take is to ensure you are consuming content with varied biases, in order to inform a more balanced opinion. As investors, we cannot eliminate our own bias nor the biases of others. What we can do is be aware of the biases around us, and attempt to course correct so that our own views are closer to the truth than that of the general market.
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Disclosure: the author of this article does not own shares in Supply Network (ASX: SNL) or Maxiparts (ASX: MXI) and will not trade these shares for 2 days following this article. The editor of this article Claude Walker does own shares in SNL and will not trade these shares for 2 days following this article. This article is not intended to form the basis of an investment decision. Any statements that are advice under the law are general advice only. The author has not considered your investment objectives or personal situation. Any advice is authorised by Claude Walker (AR 1297632), Authorised Representative of Equity Story Pty Ltd (ABN 94 127 714 998) (AFSL 343937).