Fundamental research

I watched the movie The Big Short on Friday. The movie tells the true story of four people in the finance industry, including three investors and one salesperson, who benefited from the 2007-2008 subprime mortgage crisis in the US. Not only was the movie entertaining, it also carried an important takeaway regarding the importance of performing fundamental research to arrive at your own conclusions.

In the movie, the first investor to bet against subprime mortgage backed securities (MBS) is Michael Burry who runs hedge fund Scion Capital. Michael combs through the thousands of underlying mortgages that make up a MBS in order to arrive at his conclusion that MBS’s are overvalued. He then determines when they are likely to fall in value by researching the percentage of mortgages in a MBS that need to default in order for banks to begin marking down the value of the MBS.

The second investor, who goes by the name Mark Baum in the movie but actually represents Steve Eisman in real life, also runs a hedge fund. Steve and his team gain the conviction to bet against subprime MBS’s by visiting the individual homes on which the mortgages have been taken out. They discover that many of these homes have been vacated, and that the ones that haven’t are occupied by residents who have taken out mortgages on multiple homes using the same single source of income. They also discover that some mortgages were even given to people with no income, no job, and no asset verification. These are called NINJA loans.

The salesperson and the third investor hear about the research and the bets placed by Michael Burry and fact-check his analysis to arrive at the same conclusion. Although they take Michael’s signal as their starting point, they also perform their own research to sanity-check his research.

The reason why the movie resonated with me is because fundamental research is equally important when investing in startups. One way to invest is by participating in party rounds where you perform little research of your own, and instead rely mainly on the signal and information being provided by other investors. The other way to invest is by really understanding a founder and their startup. This requires repeat interactions with the founder, reference checks, talking to the team, using the product, developing a thesis for where the market is heading and where in the market the company needs to position itself to capture value, speaking to suppliers/customers/users, and arriving at a reasonable valuation for the company based on how big you believe it can get and the risks that remain along the way.

We’ve invested in both ways. Most of our investments are the result of performing fundamental research. However, we have also invested in companies by doing less fundamental research and relying instead on the signal of other investors. Unsurprisingly, our results show that the first approach produces much better returns than the second.

The reason for this difference is simple. Anyone with money can do the latter. This excess supply pushes down returns. On the other hand, it takes skill and effort to do the former. Fundamental research is in short supply and this pushes up returns.