Todd Combs in Updated Security Analysis Book

Combs provides a unique look into his investment research process

The 7th edition of the Graham & Dodd classic, Security Analysis, was recently released. The interesting part of these updated editions of the book is the chapter introductions by modern investment managers. Berkshire Hathaway’s ( $BRK.A $BRK.B ) Todd Combs writes the introduction to Part IV, “Finding Value in Common Stocks”.

Combs’ intro is only 17 pages, but he gives a unique overview of his research process. Although it reinforces many ideas, his section is one of the more interesting things I’ve read regarding investment process.

Below are select quotes that were particularly interesting. I recommend buying the book and reading the section in its entirety - I do not do it full justice with just the quotes below.

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On the goal of an investor:
“When done well, investing involves learning how to process information in order to determine when the odds are in your favor; the goal is to make educated bets based on facts and not stories. In investing and in life for that matter, you can’t choose outcomes, but you can choose the decisions that may get you the outcomes you want.”

On how hard work is required to get to “simple”
“In attempting to value companies over my career, I’ve come to appreciate that the difference between a good analyst and a great one lies in the ability to keep things simple and determine what matters the most. People misinterpret this to mean that investors should keep things at the surface level. In fact, it paradoxically takes a great deal of depth to stay simple. The analyst’s job is to tear apart an investment in order to understand its essential elements. A great security analyst is willing to rip a company down to its studs and understand each part before they reassemble it. In the massive sea of information that an analyst is continuously digesting, there is always one piece that matters more than the others. Find that morsel is what keeping it simple means.”

On the three investment research buckets:
“Because finding simplicity can be complicated, I break down my process into three buckets - find a good business, with good management, at a good valuation. You don’t need or expect to find all three of these to the same degree in every investment; there can be a sliding scale with puts and takes. Nonetheless, all three must be present. Think of it as a multiplicative series where a zero in any of the cells will yield a zero overall regardless of how the other elements may rate.”

On determining business quality from quantitative factors:
“In determining if a business is great, I like to start on the quantitative side: I focus on the balance sheet, accounting practices, and unit economics, and then turn to cash flow generation. Meanwhile the qualitative side involves reference calls to assess the quality of management and channel checks to reveal how a company products are selling in real time.”

On starting with facts instead of opinions:
“In seeking to determine intrinsic values, I like to start with the concept of working inside out versus outside in. Start with facts not opinions. If you start with opinions, it’s easy to become wedded to them even when the facts run counter to the popular narrative. Start with SEC filings, annual reports, and trade magazine articles - not with management or colleagues’ narratives or sell-side reports. The biggest mistake an analyst can make in the initial state of their research is to start their assessment by looking at earnings (or even worse, management’s presentation f adjusted earnings). When you look at these reported numbers, keep in mind that you’re not looking at completely objective facts so much as a management’s team’s perception of them. The income statement is a snapshot of what has recently transpired, and this snapshot may well have been photoshopped. I want to focus on process rather than outcomes, so starting with the income statement is putting the cart before the horse.”

On aggressive accounting practices:
“I find it interesting to take two very similar companies and align their accounting practices. When I compare such factors as their expensing versus capitalizing of expenses, gain on sale accounting versus long-term holding of mortgage securities, acquisition accounting practices, and balance sheet variances, I’m often flabbergasted at the difference. The point is that earnings are a by-product of many assumptions and choices made by management. The treatment of reserves, choice of a discount rate on contingent valuations, assumed pension returns, and method of funding lead to a result that can be either significantly overrated or underrated. The number of games that can be played here is almost limitless.”

On understanding the unit economics of a business:
“Just as you can drop a dollar of revenue or cost through the cash flow statement and balance sheet, you can do the same in replicating unit economics of the company. For example, looking at the earnings for Costco COST 0.00%↑ is one thing, examining the balance sheet another, but understanding the unit economics of an individual store is far more powerful than either of those. While the company doesn’t overtly disclose store-by-store unit economics, in the case of Costco we can use company disclosures to triangulate into the average cost to build a store. Then by estimating the approximate time to get to run rate revenues and margins, we can approximate the individual store ROI.

…American Tower AMT 0.00%↑ was a breakeven business when it had an average of two tenants per cellphone tower, but adding a third tenant led to extremely attractive unit economics per tower and a compelling overall ROI. Similarly, Walmart WMT 0.00%↑ did not generate earnings or cash flow for over a decade while they were growing, but a look at the store unit economics led to the true story and foreshadowed what the picture would look like in the future.”