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Stock Strategist

Scuttlebutt: Five Firms We Recently Checked Out

Annual reports tell only part of the story.

In his timeless classic Common Stocks and Uncommon Profits, legendary investor Philip Fisher wrote about the value of "scuttlebutt" for evaluating companies. This refers to the part of the investment research process in which one seeks out unconventional, sometimes subjective sources of information through such activities as store visits or phone calls to customers in order to unearth new information. While reading a company's annual report, listening to its conference calls, and asking questions of investor relations are all excellent forms of research, they are by no means the only sources available to investors.

Scuttlebutt can be enlightening for a variety of reasons. One can test a theory, for example, or detect a trend before it becomes apparent to the investing public and, thus, reflected in the stock price. Naturally, a firm may not always want certain information to be widely disseminated before a certain time, if ever. But investors can employ the "mosaic theory" to piece together bits of information found on these trips to come up with a new conclusion. While management may not like or openly agree with the conclusion (perhaps because fair disclosure laws prohibit it from doing so), only so much can be hidden from prying eyes.

Morningstar analysts have recently conducted several forms of scuttlebutt research, and each time came away with insights that could not necessarily have been gleaned from the firm's annual report or latest conference call. Here's a quick rundown of some of our most recent activity:

Channel Checking
Channel checks are one of the most valuable forms of scuttlebutt research, as they can gather information about a company that is not screened by management. As such, channel checks are a great way to test theories. Our analyst who covers the largest operator of animal hospitals in the United States,  VCA Antech  (great ticker, by the way), heard anecdotally that the quality of the firm's laboratory service might be slipping. In order to get the real story, she conducted a survey of several customers to see if they were considering other vendors. The investigation led her to conclude that switching costs for laboratory service were high enough that more-severe mistakes would be necessary for firms to consider switching vendors. Thus, she was able to confirm that a trend was not emerging, which is just as valuable as uncovering a real trend, because management would be unlikely to be forthcoming with that sort of information. Read more about her survey  here.

On-Site Visits
Whether at a retail store accessible to the public or on the factory floor, on-site visits are a great way to evaluate a company's strategic execution and its positioning versus the competition. Yours truly recently visited the highly successful truck manufacturer  PACCAR (PCAR) for a tour of one of its primary facilities. The firm is particularly secretive about the drivers of its success, so digging deeper into that was one of the main goals of my visit. Having previously visited one of its less prosperous competitors' facilities, I also had a solid base for comparison. At PACCAR's facility, I was blown away by the firm's technological sophistication and the efficiency of its operations, both of which seemed far greater than those of its competition. The company touts these advantages, but seeing them live enabled me to confirm that management was not merely spewing hot air, and I could point to specific examples. Read more about my visit  here.

Company-Sponsored Workshops
A few of my colleagues recently attended company-sponsored workshops for  GE (GE),  Aeropostale , and  CVS (CVS). With management in complete control (and, thus, projecting the company in the most positive light possible), these sorts of visits are less likely to turn up earth-shattering information. Nevertheless, they can still be informative, because attendees can observe intangible data points like employee morale and management experience. They offer access to members of management who are typically too busy to speak individually with the investment community and they also usually include an on-site visit of some sort, such as a tour of a new research and development facility. The CVS workshop, for example, included a tour of a distribution center that helped our analyst get his arms around some of the firm's cost advantages versus its competitors. The Aeropostale workshop, on the other hand, enabled our analyst to speak individually with the firm's chief merchandising officer about the firm's back-to-school strategy while also picking up valuable insight on a jeans-sourcing strategy not discussed in the firm's annual report. Read more about our visits with GE  here, Aeropostale  here, and CVS  here.

Conclusion
Scuttlebutt research clearly has its merits, but it is also not without limitations. As one of my colleagues mentioned in a previous column, uncovering new information is far easier when an investor is looking at a smaller company that has fewer eyes doing the digging. Though there is truth to that, scuttlebutt research for larger companies is still worthwhile since the information gathered still may change or support one's opinion of a company, even if it isn't necessarily hidden.

Another limitation is that many investors do not usually have time for such in-depth research, nor would they know what to look for if they did. Fortunately for them, we at Morningstar recognize the value of this type of research, so we try to conduct as much of it as we can and present it in an unbiased fashion. That said, motivated individual investors can still conduct some scuttlebutt research themselves, particularly in the case of smaller companies. Speaking with employees, ex-employees, customers, or even a firm's competitors can potentially turn up valuable information without breaking the time bank. When the next  Wal-Mart (WMT) or  Home Depot (HD) emerges, you can bet there will be many happy long-term investors who confirmed the company's dominance with scuttlebutt research long before it became a household name.

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