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Scuttlebutt complements financial analysis by adding a qualitative component to the quantitative data that builds a mosaic from non-material and non-public information.Michael M Santiago/Getty Images/Getty Images

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What is scuttlebutt and how can using scuttlebutt generate alpha – that coveted, yet often illusive investment metric that measures excess return relative to a benchmark index?

The etymology of the term comes from seafarers early in the 20th century. Scuttlebutt was the cask of potable water on the ship’s deck where sailors congregated and gossiped while at sea. Think of it as the nautical version of the office water cooler chit-chat.

Contrary to popular belief, successful investing over the long term is not only about parsing data. Today, any beefy computer can do that. Generating alpha consistently will generally mean diverging from the consensus view. This requires other skills, and some of these, like mastering the art of scuttlebutt, are not taught in business schools but learned on the job.

To be clear, scuttlebutt doesn’t mean trading on insider information. Instead, it involves being a dogged investigator, much like an ace reporter or forensics expert, to gain a deeper understanding of a company’s business from multiple viewpoints.

Scuttlebutt complements financial analysis by adding a qualitative component to the quantitative data that builds a mosaic from non-material and non-public information.

An example would be meeting with restaurant franchisees about customer traffic and menu preferences or average ticket size to understand the payback of a location, or meeting with a farmer about what’s most important for them to better understand issues relating to agricultural technology companies.

The goal is to bring a company’s numbers to life and assist in determining if it’s likely to be a good investment.

How to use scuttlebutt to gain differential insights

Once there’s a deep understanding of the company’s financials, it’s time to get to work. That means reaching out to both internal and external stakeholders.

Internal stakeholders can include management, employees, owners, and even former employees. External stakeholders may include suppliers, customers, creditors, shareholders, government agencies, as well as competitors and industry experts.

In our highly digital age, it’s amazing how much valuable information can be collected by simply making a phone or video call or meeting someone for a coffee. Beyond annual reports and shareholder meetings, those ways are how to gain a deeper understanding of factors such as how the company makes money and how much is recurring revenue? How could a competitor hurt the business, and what keeps the owners/managers up at night? And, perhaps most important, what’s the quality of the management team?

Other sources of quality information include accessing interviews with industry experts and reading meeting transcripts from services such as AlphaSense and Tegus, surfacing insights about the company culture and personnel changes and job postings through LinkedIn and Glassdoor, as well as from blogs, message boards, forums, and review sites.

Google Trends, Google Ads, and ChatGPT can provide further insights on the popularity of a firm’s products or services.

Looking for an investing edge

Fundamental, bottom-up investors have an affinity for scuttlebutt because they search for something “awesome around the edges” that others may overlook.

It will come as no surprise that Warren Buffett is a proponent of scuttlebutt. One famous example is the Salad Oil Scandal of 1963. American Express had extended a large loan to Allied Crude Vegetable Oil, a salad oil company. The loan was based on collateral of US$150-million of oil.

It turned out that the company faked its inventory by filling its tanks with seawater and only a small amount of oil, which floated on top and was undetected by inspectors. This created substantial loan losses for American Express and its stock rapidly dropped 50 per cent.

The consensus was the company could go bankrupt. Mr. Buffett tested this consensus view by visiting local restaurants. He saw customers were still happily paying for their meals with their Amex credit cards. He concluded the customer franchise remained solid and took a 5 per cent position in the company. The subsequent recovery in Amex shares generated tremendous profits for Mr. Buffett well in excess of the returns of S&P 500 during 1964-67.

With the growing abundance of public company information and data, the notion of adding scuttlebutt or “boots-on-ground” component may be seen to be antiquated and superfluous. But nothing could be further from the truth.

If everyone else is consuming the same information and coming to similar conclusions, having an investing edge is essential to assist in generating alpha. Just ask Mr. Buffett.

Sharon Wang is senior equity analyst at PenderFund Capital Management Ltd. Inc. in Vancouver.

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