Should investment focus on in-depth research or broad coverage?

This article is from Qi Le Club.

Research is the Cost of Investment

Let's start with the recent phenomenon of "small-cap companies" being abandoned.

Small-cap companies are being abandoned by institutions for various reasons, and one of them is the inefficiency of research.

Many people think that large institutions, with their large number of staff, should have no problem conducting research. In fact, covering a company for an institution is not as simple as it is for individual investors. For a new company without any institutional coverage, from research to drawing conclusions (many of which may not even lead to reports), a more rigorous approach would take one to two months, a significant amount of manpower and resources, and still leaves no room for error. Just last month, a well-known institution's researcher was fined by the securities regulator for citing incorrect data in their report.

On the contrary, large-cap companies have a wealth of institutional research results. By standing on the shoulders of many, they can identify market changes that have been overlooked, which is a relatively low-cost method.

Research costs for small-cap companies are high, yet they cannot acquire a large position, resulting in lower returns compared to large companies.

The reason for bringing up this example is to emphasize the main theme of this article:

Research is not about quantity or depth, but rather an investment cost that also needs to consider ROI. Even for large institutions, they must be willing to let go of certain opportunities. Therefore, individual investors must choose between "in-depth research" and "broad coverage."

More importantly, these two research systems of "in-depth research" and "broad coverage" are closely related to the trading systems discussed earlier.

Advantages and Disadvantages of In-Depth Research

Let's first look at the advantages and disadvantages of in-depth research.

For an in-depth researcher, the depth of research on a company should at least include: industry background and trends, company development trajectory, main business and products with competitive advantages, competitive landscape of various businesses, major financial conditions of the company, governance structure, forecasts for the company's future development in the next few years, key catalysts and risks, and so on.

More importantly, it is not enough to just gather this information. The conclusions drawn from these fundamentals need to form a logically progressive and self-consistent closed loop, and be validated by financial data.

The advantage of in-depth research is that the understanding of individual stocks reaches the depth of institutional researchers. However, institutions separate research from investment, and fund managers usually do not have the same depth of understanding of the companies they invest in as researchers do. This often leads to the phenomenon of fund managers not being able to hold firm in the face of negative news. On the other hand, individual investors who combine research with investment can better reflect research conclusions in their investment behavior.

However, the disadvantages are also evident, mainly the research risk caused by covering too few companies.

Typically, the research risk of large-cap companies is lower, but their valuations are fully reflected, making it difficult to achieve excess returns (which has been abnormal in the past two years); companies with high research returns, such as those undergoing turnaround or accelerated growth, require a comprehensive scan, in-depth analysis, and long-term tracking of the company.

Research is a cost, and investment returns are the rewards. After spending a lot of time on research, discovering that a company has no value, or even suspicions of fraud, is a perpetual embarrassment for in-depth researchers. Therefore, in-depth researchers are prone to falling into the "sunk cost" trap, leading to decisions based on past investments rather than current circumstances, resulting in an overweight position in a company during its difficult times.

In addition, the market style tends to be polarized easily, with many people focusing solely on industries such as consumer goods or pharmaceutical companies, which can be a test for shareholders' mindset.

For investors accustomed to in-depth research, I have several suggestions:

Advice for Deep Investors

1. Deep investors are more suitable for older researchers with entrepreneurial or business management experience.

Without the macro perspective of a business manager, getting entangled in details can lead to drowning in vast amounts of information, treating details and core logic equally. Details serve as evidence, not opinions. Their role is to verify the logic, assess future operational trends, rather than proving how good things are now.

1. Deep researchers generally prefer bottom-up stock selection. Even with a bottom-up approach, it's essential to understand the industry framework, have a holistic view of industry development, and delve into business operations step by step based on performance and valuation.

For example, many researchers focusing on banks get caught up in financial data like asset quality, provisions, and bad debt reserves, without studying the relationship between the profitability of foreign bank stocks and macroeconomic stages, or the correlation between valuation and industry economic characteristics. We are investors, not bank auditors, so the analysis should be approached from an investment perspective.

1. It's necessary to eliminate one or two companies every year.

Companies that can sustain growth for over five years are rare. Company growth is often phased, and the focus of research needs to be refreshed continuously. Although in-depth research is like a marriage, if it's no longer suitable, don't cling to illusions. Divorce is sometimes inevitable.

1. Deep research usually involves long-term holding after purchase, suitable for investors with average trading capabilities.

Advantages and Disadvantages of Broad Coverage

Broad coverage means covering a wider range of investment targets, naturally leading to a less comprehensive understanding of companies compared to deep investors.

Fund managers in A-shares generally adopt a broad research approach for two main reasons:

Firstly, due to the extreme style and rapid changes in A-shares, to achieve stable performance, one must understand the logic of multiple industries and seize opportunities from numerous companies.

Secondly, institutions have research teams where analysts conduct in-depth research. The separation of investment and research requires a combination of broad coverage and deep research.

However, the disadvantages of broad coverage are quite apparent:

Broad coverage prioritizes winning rates. For retail investors, this means having to give up many good research targets, including companies too small to be covered by research institutions, companies constantly questioned financially, and companies sensitive to supply-demand dynamics - requiring continuous tracking of upstream costs and downstream demand data.

Broad coverage also means missing out on certain profit segments, such as the early stages of a company's fundamental turnaround or periods of significant fundamental changes, leaving only profits from stable growth periods.

Another drawback of broad coverage is the risk of mistakenly overlooking good companies. In-depth research involves strict screening of long-term tracked targets, with layers of elimination mechanisms for companies that are too complex or incomprehensible, fail to meet financial requirements, etc. Broad coverage lacks this "safety net" in research. When a company's fundamentals change beyond one's research capabilities, the only option is to "move on".

Advice for Retail Investors (Individual Investors)

1. Retail investors usually adopt a top-down investment approach, starting with industry research to identify promising sectors. It is recommended to spend a week understanding the industry investment framework and then research multiple companies within the industry simultaneously to enhance research efficiency.

   Additionally, studying companies along the industry supply chain to understand profit distribution is crucial. I have previously published a series of articles on industry chain research on my public account, which you may find beneficial.

2. Having breadth does not mean lacking depth.

   Broad researchers may not delve into the details of financial statements and products or track every aspect of a company over time. Therefore, it is essential to focus on the big picture, highlight key points, and grasp logical aspects that are relatively stable and less likely to change.

   For instance, tracking supply and demand relationships is crucial, as they evolve continuously, while a company's position in the industry chain competition remains relatively stable and suitable for breadth researchers to analyze.

3. If you choose to focus on breadth, it is advisable to avoid speculative stocks. If there are leading companies in an industry, there is no need to research smaller companies beneath them. By allocating less research effort to each company, you must ensure higher certainty within the companies themselves.

Suitable Research Types for Retail Investors

Consistency in Investment Approach

Your research and trading systems must align within the same investment framework, reflecting your personality and worldview. There are four key differences to consider:

1. Alignment with the trading system:

   • Deep research covers a limited number of targets, requires long tracking periods, and is more suited for a long-term odds-first trading system.

   • Broad research covers multiple targets, necessitating an initial assessment of the win rate of investment targets, whether based on long-term certainty or short-to-medium-term market conditions (refer to the previous article in this series for trading system details).

2. Comparative advantage:

   From a comparative advantage perspective, retail investors are better suited for deep research.

   Broad research may not compete with institutional investors. Even if you are not a breadth investor, the exchange of various information within a group of over a dozen individuals daily broadens your perspective. Investments in breadth require precise timing, where a good logic often peaks after extensive discussions. Without these informational advantages, entering the market often leads to idle waiting.

   Conversely, the time sensitivity of deep investments is not as critical. While initially lagging behind institutions, as they chase new hotspots, your persistent research catches up over time.

3. Personality, skill set, and information gap:

   Deep research requires a research-oriented personality, the ability to endure solitude, and hold positions.

   Conversely, if you have rich trading experience but are not fond of research, breadth coverage may be more suitable for you.

   The profitability of breadth coverage stems not only from the company's growth but also from switching between different companies and industries or adjusting positions within the same stock. This requires considerable trading skills, a profound understanding of industry cyclicality, or insightful observations on market style changes.

In addition, the greatest advantage of research is having research resources that others do not have in their daily life or work. For example, if you or your friends are in this industry, or if you have used related products or have business relationships.

Therefore, when there is information asymmetry, grasp the information gap, that is, conduct in-depth research. When there is no information gap, pursue more certain research opportunities, then you must have broad coverage.

Fourth, Worldview

The fundamental difference between in-depth research and broad research is between "knowable" and "unknowable".

"Knowable" proponents believe that as long as there is enough time and energy, the value of a company can be understood. However, "unknowable" proponents believe that most companies are "black boxes", and their core internal values are unknowable. We can only study the visible parts, so the best approach is to have broad coverage, shining a light on both the East and the West.

"Knowable" and "unknowable" are not right or wrong, they are part of a person's worldview, which is difficult to change. Those leaning towards "knowable" tend to eventually delve into in-depth research, while those leaning towards "unknowable" tend to eventually pursue broad research.

Not mutually exclusive, the key is coherence

The choice between breadth and depth mainly concerns the cost-effectiveness of research input, so they are not absolutely contradictory.

Yan Wenxin from Haitong Medicine said: "For those not from the medical field, the simplest thing to do when investing in medicine is to first invest in companies with channel barriers. Relatively speaking, researching the end market is simple, holding positions will also be reassuring. For them, although understanding barriers is difficult, after in-depth research, buying becomes reassuring because the competitive landscape is relatively stable. Finding companies where the strong get stronger is enough."

Researching "companies with channel barriers" means that due to the stable competitive landscape, in-depth research can cover multiple years in one go, without the need for close monitoring. This saves energy to cover more companies, combining both depth and breadth.

In fact, some investment models with high difficulty and high returns require a combination of in-depth research and broad coverage.

For example, turnaround investing aims for performance gains, while growth investing focuses on earning valuation gains. The former not only requires enduring loneliness for the long term, focusing on neglected unpopular stocks, but also controlling the investment pace to avoid running out of ammunition too soon. The latter not only requires understanding the company, but also a deep understanding of industry characteristics, market styles, themes, and catalysts.

There are many research methods and trading methods, some of which are contradictory, such as fundamental research and casual trading. Some methods do not complement each other well, such as in-depth research and prioritizing win rates. In-depth research and broad coverage themselves are not superior or inferior. The weak water can hold a scoop, the key is coherence, knowing which scoop is yours.