Someone who reads my blog sent an email saying he was in the midst of researching a stock and felt he was stuck. He’d hit a dead end. It happens.



So how do you get unstuck?



Admitting You Have a Problem



The first step is admitting that data alone doesn’t solve anything. Data is not the problem. You are the problem.



A lot of folks believe that if you don’t have an answer it’s because you lack the necessary data. While this is theoretically possible, it’s actually implausible. Think about it. If you were stuck because you hadn’t read the 10-K, you’d just read the damn 10-K. Problem solved. You know where to find basic information. So you would never get to the point in your analysis where you were stuck and didn’t know how to get unstuck.



Your problem isn’t a lack of data. You don’t lack data. You lack connections. Insight. You can’t put it all together.



You don’t have a good grasp on the stock yet. You’re looking at it the wrong way. And so you’re squinting very, very hard. Trying to do projections based on gross margins and all this stuff – and yet you really don’t have confidence in your grasp of basic customer behavior at this point. Often, it’s something as simple as that. It’s kind of like an optical illusion. You see the duck but not the rabbit. You see an aspect of the object and think that’s the entire object. The only way of looking at it. The only way of organizing it.



That’s wrong. You can always organize data in more ways than one. Whether any of those ways will be useful to you is a different story. But you’ll drive yourself crazy staring at a duck and swearing it’s a duck over and over again.



Keeping Things Simple



Some people start by diving deep into a stock. Depending on how you do this, it can be a mistake. The right way to do this is to learn everything you can about the business without worrying about the price. This is the slow method. The leisurely method. You learn about companies you’re interested in all the time. Then you focus on analyzing them only when their stock finally gets cheap.



Most people don’t use this method. They feel they simply don’t have the time.



Instead, they…



Look at the price first. See the stock’s down a lot. Or some fund manager is buying it. There’s nothing wrong with this approach either. It can work.



But it can lead you to leap over some basic information. Like how cheap the stock is in rough terms. Not relative to its past or its peers. But how cheap is the stock in terms of the amount of free cash flow or earnings it’s likely to produce each year as a percentage of the price you’re paying.



This is one of the most important numbers in investing.



You don’t want to skip this calculation.



So, once you’re ready to look at a stock’s price, this is usually the best way to start.



Ask yourself: What is the normal earnings yield on the price I’m paying?



Or



What is the normal free cash flow yield on the price I’m paying?



There are a few ways of doing this.



The two simple methods we’ll propose here are:



· 10-year average free cash flow margin / Price-to-sales



· 10-year average return on equity / Price-to-book



You should do these calculations by looking at the company’s 10-K reports for the last decade. But you can eyeball them by going to a site like Morningstar. Morningstar has 10-year financial data for stocks. It includes information like the free cash flow margin.



In both calculations, you are seeing what an average return on some number (sales or equity) times the current level of that number (sales or equity) per share divided by the price per share equals. Doing this gives you some sort of normal earnings yield.



You should have a hurdle rate. Mine is 10%. I want a 10% return on my investment from day one. Yours can be higher or lower.



Obviously, don’t buy stocks that fail to clear your hurdle. You hold cash instead. Otherwise, there’s no point in having a hurdle rate.



Let’s look at a couple stocks and see if they clear my 10% hurdle rate.



Omnicom (OMC): 10-year average free cash flow margin of 10.86%. Sales per share of $44.88. Stock price of $38.72. Price-to-sales ratio of 0.86 ($38.72/$44.88 = 0.86). So the normal free cash flow yield calculation is:



Free cash flow yield = 10-year average free cash flow margin / Price-to-sales



Free cash flow yield = 10.86% / 0.86



Free cash flow yield = 13.24%



Hurdle Rate = 10%; Free cash flow yield = 13.24%



Omnicom’s free cash flow yield is higher than my hurdle rate. So, it could be an acceptable investment. In fact, the stock seems cheap to me. So my analysis would tend not to focus on the price (which is perfectly acceptable) but on the sustainability of sales and margins.



And on the company’s future capital allocation. Will it make acquisitions, buy back stock, pay dividends? Has the share count been rising or falling over the last 10 years?



Carnival (NYSE:CCL): 10-year average return on equity of 12.20%. Book value per share of $30.15. Stock price of $30.86 a share. Price-to-book ratio of 1.02 ($30.86/$30.15 = 1.02). So the normal earnings yield calculation is:



Earnings yield = 10-year average return on equity / Price-to-book



Earnings yield = 12.20% / 1.02



Earnings yield = 11.96%



Hurdle Rate = 10%; Earnings Yield = 11.96%



A word of warning here. For this article, I used Carnival’s return on equity including intangibles and its book value including intangibles. Don’t do this. It just made it easier for me to give you the 10-year ROE. I didn’t have to check EDGAR. But you should. Always calculate return on tangible equity. And always use the price-to-tangible book value ratio.



Carnival’s earning yield is clearly higher than my hurdle rate. So, this stock could also be an acceptable investment. Again, it seems cheap. Actually, in both cases – if you’d been following the industries – you could have seen the cheapness of the stocks right off the bat. Carnival and Omnicom have strong market positions. You wouldn’t expect Carnival to sell below book value unless things were very bad in the cruise industry. Likewise, you wouldn’t expect Omnicom to sell below sales unless things were very bad in the advertising industry.



As a rule, Carnival should probably trade above book value and Omnicom should probably trade above sales.



You’ll see that in their future prices. A few years from now, Carnival will trade above book and Omnicom will trade above sales. People will forget they ever got this cheap.



Okay. So if you ballpark the situation and find you have a 10% hurdle rate like I do, but you still want to buy Kraft (KFT), what do you do?



Well, Kraft has a 10-year average free cash flow margin of 7.47% and a price-to-sales ratio of 1.1. This leaves you with a free cash flow yield – on the current $34.27 a share price – of just 6.79%. Which is unacceptable if you have a 10% hurdle rate.



Now, you could argue growth will make up for this. But I wouldn’t. For me, those numbers are enough to convince me I need to wait for the spin-off. Kraft – at the current price – might be cheap. But it’s not cheap enough for someone with a 10% hurdle rate unless they are convinced positive changes are coming.



These two simple methods will eliminate most stocks from consideration if you have a fairly high hurdle rate. A 10% hurdle rate when used with either of these methods will eliminate most big stocks you see discussed in the news. That is because relatively few of these stocks are likely to deliver double digit returns over the next decade or more. Stocks like Omnicom and Carnival could be an exception.



Those are the ones you want to focus on.



Okay. Let’s assume the stock has passed these basic tests, but you’re still bogged down in your analysis.



What else could the problem be?



Fear of Moving Forward



You’re unsure of the stock.



You don’t really know what it is.



Maybe you could see it another way. But you won’t.



Why not?



Sometimes you get stuck not because you don’t know what to do next, but because you don’t want to do what comes next. I’m not talking laziness. I’m talking fear of heading down a certain path. There are two motives for trying to stop your analysis from heading down a certain – fruitful – path:



1. You’re afraid you won’t reach your destination



2. You’re afraid you will reach your destination



Fear of Getting Lost



This one sounds silly. Obviously, you never know exactly where analysis will lead. Otherwise, you’d have already made up your mind. But let me put it this way. It’s not the destination you’re afraid of. It’s the journey.



If you’re a Ben Graham type value investor you know how analyzing a net-net works. The process doesn’t scare you. It’s predictable. Familiar. You know cheap when you see it. The good news is that you are in your circle of competence. The bad news is that there are other stocks outside of net-nets that are cheap too. And you’re missing out on these opportunities. You could probably recognize some of them as cheap yourself. But it might require shaking up your process a bit.



And that’s scary.



Sometimes people send me emails asking about more than one stock. We’ll bounce ideas back and forth for awhile. We could be talking about a dozen stocks over a period of a couple months. Doing this, I’ve noticed something kind of frightening about the way folks work through a sequence of stocks.



Let’s say a person starts by analyzing a net-net, then a net-net, then a net-net, and then a terrific business. Now, if they absolutely loved any of those net-nets – or if they bought one of the net-nets – they are utterly blind to the virtues of the last stock in that group. They don’t always say it’s a bad stock. Sometimes they just say it’s a confusing stock. It stops them cold.



They wouldn’t have been blind to the virtues of the wonderful business if it was the first stock they analyzed. But – because it’s the last – they’re trying to analyze a high return on equity, low capital intensity business as if it’s about to be liquidated. No talk of moat here. We’re suddenly discussing the receivables position of the next Coca-Cola (KO).



Obviously, the reverse is true. New investors who cut their teeth on truly extraordinary businesses do a lousy job of analyzing really cheap but totally ordinary companies.



I’ve even seen the more complicated – but equally self-destructive – variant where someone who knows quality when they see it and cheap when they see it has trouble recognizing cheap quality when they see it. I’m surprised by how many people will initially pass on the highest quality net-nets out there. It’s as if they are so focused on the balance sheet cheapness they can’t simultaneously see the earning power cheapness.



Sometimes you have to see a stock two ways at once.



By the way, this third problem (having trouble seeing quality and cheapness simultaneously) is the most fun predicament to watch someone squirm through. You can taste the mental tension. They don’t lack a model to work with. They just think they have to pick one when they can really use two.



It might seem that value investing newbies simply lack the models or routines they need to analyze a certain stock. But that’s not true. It’s not like they know Graham but have never heard of Fisher. It’s not really knowledge we’re talking about.



It’s comfort.



Every value investor knows Graham and Fisher. But some value investors have only applied Graham. And if they’ve applied Graham successfully – then why would they ever think to use Fisher?



Maybe they are just reaching for the tool at hand. For the familiar routine.



I’d buy that. It makes perfect sense to apply the exact same problem solving technique to Problem B that solved Problem A.



But actually getting “stuck”. That clearly goes beyond reaching for a hammer when you need a wrench. I mean – you try it for a second, realize your mistake, call yourself an idiot, and then go back into the toolbox.



So, why do some folks actually feel stuck after using the wrong tool?



In Thursday’s article, I went off on a bit of a tangent talking about myself. I thought it fit. More than anything, I thought it illustrated the idea I was trying to get across in a way that would really stick in the reader’s mind. That tangent was kind of hard to write. When you’re trying something new, there’s a moment where you’re adrift. The journey is unfamiliar. You might be lost. A lot of times you are. Sometimes you aren’t.



So how do you explore without getting lost?



I don’t have a good answer for this. As far as I can tell, you do get lost.



Some analysis is pretty rote. I have an Excel worksheet I created for analyzing net-nets. And other stocks. But especially net-nets. I fill it out for every single net-net I consider. It’s only part of the process. But for that short part of the process everything feels very warm and safe. Because I know I can’t get lost entering numbers into a spreadsheet. I know the kindly sheet will give me some numbers back. And I know I can use the numbers it spits out.



But that’s never enough.



What if there’s one customer who accounts for 80% of a company’s business? My spreadsheet doesn’t record that risk. It doesn’t tell me about technological risk, legal risk, shoddy management, or fraud.



I don’t feel as comfortable analyzing those risks.



And Warren Buffett didn’t feel as comfortable analyzing American Express in 1963 as he did analyzing net-nets in the 1950s.



You can see it in his letters.



From 1964 through 1966, his description of the “Generals – Relatively Undervalued” category is basically a description of his investment in American Express (AXP). You can feel the ambivalence in his language. He’s in flux. Buffett thinks American Express is more “ethereal” than net-nets, but he’s also betting big on it. By the end of all this, the only thing mooring Buffett to Graham’s side of the investment waters is familiarity. Comfort. I don’t think Buffett considered Graham’s approach objectively superior to a more qualitative approach. But he still felt more comfortable with it.



When we say we’re stuck, sometimes what we really mean is that we’re afraid of getting lost. We’re about to go down an unfamiliar path. And that’s scary.



So how can you do it?



How can you “get lost” in a productive way.



Here are my purely personal suggestions.



Finding Another Angle



You’re lacking an insight. You're learning a lot of new stuff, but you don't know what old stuff to hang it on. You don't have a mental model that fits. If that's the problem, try a totally off the wall comparison or two.



For example, look at the stock’s 10-year return on tangible equity or the 10-year free cash flow margin and find a company in a totally different industry with a similar ROE or FCF margin. The point isn't to actually compare the two stocks expecting similarities. That's usually not necessary. If the numbers are similar, ask: “what makes them different?”



You can also do this with prices.



If you know the price-to-sales ratio and the price-to-tangible book ratio go find other companies (maybe familiar ones) that have very similar ratios. Ask yourself which stock you'd buy if someone held a gun to your head and made you pick. The idea here is that once you make the choice you'll be open to justifying that choice.



Once you've said you'd rather buy FICO (FICO) than Carnival (NYSE:CCL) even though they both trade around the same price-to-sales ratio, you'll be open to justifying it. So ask yourself: why? What does FICO have that Carnival doesn't? Or vice versa. It may be something simple. You may realize it’s the debt in one case. Or it's some concern about the future allocation of capital. Or it’s about the difference between earnings that are reinvested for growth and free cash flow that is available today. These things are easy to talk about when you have two contrasting stocks in front of you. They are hard to see when you are squinting very, very hard at just one stock.



Contrast isn’t a magic bullet. It can force you to say aloud stuff that was lurking in the back of your mind. Maybe you love the company, but not the price. Or you love the price, but don’t feel the debt load is safe. Sometimes, getting “stuck” is more about recognizing a stock’s really big pro and its really big con and not wanting to pick a side. You’d love to keep the pro. But the stock comes with the con. By forcing a manufactured choice on yourself – and I know this exercise sounds silly – you can push yourself into taking a stand. Into presenting a case you would rather have left unargued.



You can force yourself to offer possible answers to questions. To try to justify why something might be. Then you can try to prove yourself right or wrong if that's the key issue. Even if it's not, sometimes it helps you better understand the stock.



This is all simple advice. Try to look at new aspects of a familiar object. Force yourself to take stands. Then justify your stands. Then explore your justifications.



Basic stuff.



But, I’ve found it can break a mental logjam. It usually does no good to keep running the same numbers over in your head from one day to the next.



If you’re not looking at a stock in a new way, why are you still analyzing it?



When I get stuck, I always try to step back from the really detailed numbers. That’s the easiest place to hide. If avoidance is your goal, detailed numbers are your friend. They’ll harbor you. The big picture won’t. Try re-focusing by reading the CEO letters or an analyst report. Try studying a competitor in depth. Or try comparing the stock to ones you know really, really well. Maybe stocks you already own.



Change your perspective.



That’s the key.



Follow Geoff at Gannon On Investing





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