How Not to be Dumb Money: Channel Check Research
By: Lester Golden
Tags: Stock Market, Value Investing, Investment, Finance, Investing

Why channel check firms exist — and how an individual investor can channel check

How the Information You Don’t Have Can Take Your Money

Anyone reading the title must think the writer believes he’s smart money. I confess to having been both, though not simultaneously. My purpose here is to show how dumb money can become smart money, because being at the wrong end of information asymmetry is the very definition of dumb money.

Giulio Andreotti, postwar Italy’s Machiavellian prince of power politics, coined this aphorism: “power exhausts only those who don’t have it.” Similarly, information can exhaust the finances of individual investors because they don’t know about the catalyst that institutional investors may dig up through the channel check research firms they hire to gather data about what’s happening in the company’s business on the ground: supply chain orders, inventory turn rates, etc. When I worked for such research firm and did channel check research for one hedge fund, I learned the benefits and dangers of information nobody had yet. Legally obtained information, since insider trading is a crime. Finding the information everyone else needs, but nobody else can obtain, enabled one institutional investor and channel check researcher to harvest the difference between market expectations and a business’ real prospects.

What is Channel Checking and How Tradeable Is It?

Channel checking combines the skill set of investigative journalists with deep dive gossip. Think of the “scuttlebut” that Philip Fisher wrote about in his 1958 classic “Common Stocks and Uncommon Profits”, the first retail investment bestseller. It can be as simple as this: Magellan Fund manager Peter Lynch asked his wife and kids to tell him about hot new products they and their friends liked. The purpose: to solve the quadrilemma at the top of the page.

The investigative reporting side of channel checking can get much more detailed than counting the size and quantity of shopping bags going through the doors of Urban Outfitters’ stores or visiting Chuck E. Cheese restaurants to feel the pulse of the business weakening.

Citron Research’s recent long form piece on Rosetta Stone (RST) made its case by channel checking how the company’s school clients were ramping up online learning. This research told traders there was limited downside along with the prospect of a buyout that has now materialized. No trader can know the buyout price in order to choose a call option strike price without committing a felony. But good channel checking can uncover a trend that reveals very limited to no downside to selling expensive puts with 50%+ implied volatility. Channel checking can tell you when fear is wildly overpriced, so you can lucratively sell some. In the case of FSYS/BRC fear was wildly underpriced because there was a high entry barrier to Mr. Market USA channel checking the company’s business in Italy.

Case Study: Fuel Systems Solutions (FSYS), or My Big Short

FSYS was an Italian-American company producing, distributing and installing the systems to convert gasoline (petrol) car engines to compressed natural gas (CNG) and liquified petrol gas (LPG). FSYS was originally an Italian company that did almost half its sales in Italy under the name BRC (https://brc.it/home/). It sold, converted and installed its CNG and LPG engines through a network of dealers all over Italy and the USA. The health of FSYS’ business depended on a large gap between gasoline prices vs CNG and LPG prices.

With the Great Recession of 2008–09 crude oil prices dropped from a June 2008 peak of $147/barrel to a low of $33/barrel in January 2009. Despite this crash in crude, and consequent drop in gasoline prices, FSYS’ stock price, which had peaked with the mid-2008 oil bubble at $60/share, still held up fairly well considering the overall market crash:

$40/share at the end of November 2008

$36.38/share at year end 2008.

$28/share at the end of January 2009

Acquired for $7.54/share in 2015 by Westport Fuel Systems (WPRT):

The End Game for previous bagholders

No investor viewing FSYS’ chart would think anything especially amiss about the stock relative to the rest of the market in crash mode. FSYS did a little better than a market that had crashed 57% from peak to trough. Either the market was looking through the recession and the crash in crude, or it viewed FSYS’ Italian business as insulated from it because government taxes on gasoline were such a high percentage of the price at the pump.

Market expectations were wrong — big time. Therein lay a lucrative short opportunity, exploited by the hedge fund that hired me to channel check FSYS’ Italian business. Why me? Fluency in Italian from living in Italy 16 years.

For other American investors, it was a case of “the information you need is not the information you can obtain” due to the language barrier. Channel checking an Italian company’s distributors required fluency in Italian, a time-eating and costly to find skill among American channel check firms and hedge funds. This created a barrier to entry in the information collection race funds and channel check firms are always running.

The Short Position

FSYS was due to announce sales and earnings in mid February 2009. My client had a seven figure short position in an illiquid small cap stock whose shares were costly to borrow. He not only had to be right, but be right fairly soon to profit from the difference between expectations and on the ground business reality. Being right in six months would not be profitable.

Uneven Information Landscape

Channel check research follows a rough 80/20 rule: you spend 80% of your time drilling error-filled dry holes that yield 20% of the least useful information. And you find 80% or more of the best information that validates the trade in the last 20% of the time you have to research the case. The war to find the real time information-based catalyst is a winner take all tournament.

From NY I started calling FSYS’ BRC distributors and other Italian sources such as the statisticians at the Fiat dealers’ association and the car manufacturers’ trade association. Calling BRC itself was pointless due to SEC laws against revealing non-public information. But channel checking is about digging information out of the company’s supply chain or sales network or other industry sources tangentially linked to the company.

BRC had about 150 distributors and installers all over Italy. Some in or near big wealthy northern cities like Milan and Turin were big car dealers and repair shops. Others in provincial towns down south were mom and pop shops with only a couple of employees. The latter were more willing to talk, but were small enough to constitute sampling error. So how to avoid the first of the four lines at the top of the page — “the information you have is not the information you want” — when you’re cold calling sources out of the blue from across the ocean?

Crafting a pitch to get sources to open up is a question of iterative design. In this case hearing the first few distributors complain bitterly about being abandoned by BRC when business had collapsed due to the oil price crash speeded up the process. Being an American fluent in Italian calling from NY for a hedge fund piqued enough distributors’ curiosity to lower the rejection rate to avoid sampling error. Soon the hit rate of calls yielding reliable quantitative data went way up. Some distributors in the southern Puglia and Campania regions had relatives in NY and invited me to dinner when I returned to Italy.

The bottom line: business for BRC’s distributors had collapsed by 60–100% and I could hear many complain even holding the phone two feet from my ear. Some installers were nice enough to write back with qualitative info that included valuable color. Dealers were giving away the systems on new cars and state-financed incentives to reduce Italian cities’ famously high air pollution were in flux:

“Demand for us installers is a disaster. Few conversions are done because unfortunately the car dealers give away the systems on new cars, so the demand for cars running on new LPG and CNG is better than for diesel cars.

Ciao, la domanda da noi installatori è un disastro, se ne fanno pochi purtroppo ci sono i concessionari di auto che regalano gli impianti sulle vetture nuove, la richiesta di macchine a GPL e GNC nuove è migliore delle vetture a gasolio.

distinti Saluti”

This meant that the cost of a new car with a BRC system was the same as a new car with a gasoline engine, a no-brainer for the consumer. If the aftermarket conversions and installers were struggling due to growing conversions at the dealer level, BRC was just moving demand from one channel to another. So if BRC’s OEM sales were growing enough to offset the collapse in retail installations, my client’s short position was at risk.

Then there was the moving target of government incentives for engine conversions and the higher incentives for buying new cars and trucks with CNG and LPG engines:

“Italy spurs new car sales:

Italy announces stimulus package for buying vehicles, household appliances

People trading in old cars for new hybrids to get 3,000 euros cash incentive

As part of the plan car plants will be maintained in Italy

Italy’s car industry about 11.4 percent of GDP, employs about 1 million people”

The cash for 10 year old (or more) clunkers scheme gave 1500 euros more for hybrids, CNG and LPG vehicles traded in at the dealer vs a smaller amount for simple conversions done at the retail level. Italy’s auto industry was 11% of GDP and employed one million people. Government policy seemed to be cannibalizing retail installer conversions in favor of OEM and dealer sales, according to data from one distributor:

“Now it’s the new car market which is driving the LPG and CNG systems due to the lower fuel cost and pollution they cause. For those who already have a car and want to convert it now the state’s contribution depends on the pollution rating it has (Euro 0/1/2 = €500 for LPG/€650 for CNG — Euro 3/4/5 = €350 for LPG/€500 for CNG). But the government is in the process of approving an amendment which will give an incentive of €500 for all LPG and €650 for all CNG systems. Now that petrol prices have gradually risen demand has increased a little, but having more funds from the state for the system can encourage people (to convert). In any case there’s been a drop since last year. At your disposal for other information.”

We had to measure the incentives’ impact because drivers who converted their engines to less polluting CNG and LPG fuels would be exempt from alternate day odd-even number license plate driving restrictions imposed in many Italian cities. Milan, Turin, Florence, Rome and Naples were among Europe’s most polluted cities.

But BRC sales to OEMs were less profitable: 1200–1500 euros per system for sales to installers vs 800 euros per system sold to OEMs.

By calling over 60 distributors in most of Italy’s regions I could construct for the client a detailed spreadsheet with data about the number of engine conversions and installation prices and the number of installations done quarter by quarter or month by month in the half year before and during the crash and correlate them to oil prices.

What has to go right: the Trade Setup

We had a known catalyst and the date it would go public: the next earnings announcement in mid-February that would incorporate the on the ground reality BRC’s distributors had revealed before Mr. Market knew about it. The Thursday before the announcement I asked my client if I could do the trade with options. When told yes I bought five 22.50 strike puts on FSYS for $2.60 each that would expire the following Friday. I should have bought more, but invested only what I thought I could afford to lose. Some trading errors are made for the right reasons. If the drop in FSYS’ earnings was insufficient to trigger a big drop immediately, I’d lose the entire $1300 bet. But the gap between market expectations and business reality was big enough. The following Tuesday FSYS dropped from 27.50 to 14 after the close and to as low as 12 on Wednesday. I sold the puts for $8.30 each on Wednesday.

After the trade I asked my client’s analyst how often he see a case like FSYS — a known catalyst with a fixed trigger date that Mr. Market doesn’t see coming. “Almost never”. I had begun my three year channel checking stint as a random black swan of success, a case of first short fortune. We tried to replicate this first case, with both long and short bets on FSYS, but never succeeded to the same degree.

Once the information was out the market focused on Italian car sales as a catalyst for FSYS’ share price. The market exhibited weak form efficiency — emh in small letters, eugene fama & co. properly resized.

Followup Research: Micro vs Macro Catalysts

After the first trade, the next step was to track overall Italian car sales since BRC’s sales to distributors for conversions and installations were dependent and highly correlated with this figure. FSYS’ share price was highly sensitive to this figure, at the time highly volatile due to the ongoing financial crisis combined with strong government incentives for the automotive industry.

The car sales figures were gathered from dealers by UNRAE, the foreign car automotive trade association and sales for the previous month announced by the fifth day of each month. But, Italy being Italy, partial sales figures of Fiat cars for the current month were available by about the 27th of each month from another source: the statistician at the Fiat Dealers Association. The association never announced these figures publicly, but made them freely available to dealers, automotive journalists, economists…..and a NY channel check researcher. That meant my client had found the holy grail of channel check research: publicly available and compliant information that no other investor had. (He checked with his compliance advisor; it was legal to use the info.)

For the next year I’d check with my statistician friend at the Fiat Dealers Association in Turin around the 27th of each month. I had learned Italian in a hillside suburb of Turin in the house of a university professor and wine chemist, floating into the Italian language and culture on a lago di vino (it was divino). So for my source, I was like a local and the only one outside the industry who ever called her about this data. My client’s compliance officer had me verify with the statistician that this very material information was indeed publicly available, though clearly unknown to the wider market at the earlier date that I obtained it. This compliance check was no laughing matter, as is clear from:

Has the “channel check” become a criminal act?

Wall Street analysts have been left bewildered in recent days, as federal prosecutors begin to home in on insider-trading cases that appear to involve routinely published information about public-company supply chains….”Insider trading basically comes down to where you know or ought to know that the person from whom you’re getting this information has a duty to someone else to keep it confidential,” said former Securities and Exchange Commissioner Paul Atkins in a video interview with The Wall Street Journal. “If you go in and pay the mail clerk to give you special information, that’s not proper.” (https://www.wsj.com/articles/SB10001424052748703730304575633173086330184)

We had to check if my Turin statistician was like the mail clerk. In this case, no foul, no felony — all clear.

Conclusions

The Fuel Systems Solutions case, by it very rarity, illustrates some key points about information-based alpha:

It’s rare and fleeting. EMH struck out once or twice, but not more often. Look for the signal nobody else has, can find or can interpret as better than noise. Language is only one barrier. Industry experts whose names can be found in trade magazines or trade associations are another. They’re often happy to be helpful; most of us want our work to be more significant than just a paycheck. Channel checking costs a lot of time, but beats the information most investors can more easily access from expert networks like Gerson-Lehman precisely because it’s harder and more costly to obtain (see #4 at the top).

Have I since been dumb money, burned by information or signals I couldn’t obtain or misunderstood? Certainly. All of The Great Humiliator’s lessons are constantly being relearned.

Historic macro bets with forex Mr. Market misinterprets are another, very different story, which I’ll write about in another piece.

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