The Scuttlebutt Advantage

In my previous column, Gaining an Investment Edge, I argued that the surest, safest way to investment outperformance is to have an edge -- preferably many edges -- because without it, "you're the proverbial sucker at the poker table [and] you're going to get creamed."

I highlighted many different types of edges, concluding with: "the best investors often have an information edge. They simply do more work, are more creative in collecting information -- often tapping into valuable 'scuttlebutt' -- and/or throw more resources into the research process such that they can occasionally gain some proprietary insights that can lead to big profits." Let's focus on scuttlebutt.

What is scuttlebutt?
Scuttlebutt can mean many different things, but to me it's information about a company or industry that's gathered via nontraditional means. So, reading a company's annual report and SEC filings, listening to a conference call, attending a management presentation, or even visiting the company are not examples of scuttlebutt. Every investor does (or at least should do!) these things, so they rarely provide an edge.

Scuttlebutt usually involves being creative and going the extra mile to gain proprietary insights about a company -- the type of insights that, on occasion, can lead to big profits.

Fisher on scuttlebutt
Investing legend Philip Fisher, in his classic book, first published in 1958, Common Stocks and Uncommon Profits, wrote extensively about scuttlebutt and his techniques for collecting it:

The business "grapevine" is a remarkable thing. It is amazing what an accurate picture of the relative points of strength and weakness of each company in an industry can be obtained from a representative cross-section of the opinions of those who in one way or another are concerned with any particular company. Most people, particularly if they feel sure there is no danger of their being quoted, like to talk about the field of work in which they are engaged and will talk rather freely about their competitors. Go to five companies in an industry, ask each of them intelligent questions about the points of strength and weakness of the other four, and nine times out of ten a surprisingly detailed and accurate picture of all five will emerge.

It is equally astonishing how much can be learned from both vendors and customers about the real nature of the people with whom they deal. Research scientists in universities, in government, and in competitive companies are another fertile source of worthwhile data. So are executives of trade associations.

Allow me to share a specific example where I made a lot of money by effectively gathering scuttlebutt.

CKE Restaurants
CKE Restaurants (Nasdaq: CKR  ) is the owner of the Carl's Jr., Hardee's, La Salsa Fresh Mexican Grill, and Green Burrito restaurant chains -- with 3,183 total restaurants. When I first purchased the stock, which I still own, in early 2003, it was just above $4. It had collapsed from above $12 in the previous year as both Carl's Jr. and Hardee's were hit hard by the economic downturn and burger wars between McDonald's (NYSE: MCD  ) and Burger King in 2002. The investment thesis was simple: The value of Carl's Jr. alone was worth the price of the stock, so an investor was getting a free call option on a potential turnaround of Hardee's.

Initially, I had little confidence that this call option was worth much -- Hardee's was one of the worst restaurant chains in America and was losing money -- so I only purchased a small amount of the stock. Management, however, to its credit, realized that Hardee's could never compete successfully with McDonald's and Burger King at the low end of the market, and identified a gaping hole in the fast food market for a thick, high-quality burger. There was a significant void between Wendy's (NYSE: WEN  ) and fast casual restaurants such as Applebee's (Nasdaq: APPB  ) , so CKE made a bold bet with Hardee's: It eliminated 40 items from the lunch and dinner menu and rebuilt the menu around "Thickburgers," which are big, juicy (and delicious!) Angus beef burgers with all the "fixins."

Shortly after making a small investment, another investor and I visited the company, learned more about the Thickburger strategy and rollout and -- this is key -- collected two critical pieces of scuttlebutt information.

First, we learned that in focus groups the company had commissioned, average Americans were going nuts over the new burger. This got us pretty excited, but we were a bit wary -- focus groups, especially company-sponsored ones, can be misleading -- so, second, we wanted to talk to restaurants and learn how the Thickburgers were actually selling in the 200 Hardee's restaurants (of roughly 2,000 total) that had converted to the new menu.

So, we asked the company for a list of these restaurants, which they gave to us, and we started smiling and dialing. Within a few days, we called over 30 Hardee's restaurants in six markets and also spoke with one of their largest franchisees, who owns over 100 restaurants. Almost everyone was willing to talk to us -- we told them exactly who we were -- and we heard a very consistent (and exciting) message.

The converted restaurants initially experienced a brief, mild sales decline as, for example, patrons who came in for fried chicken discovered that Hardee's didn't serve it anymore. Since the average price points are higher for the Thickburger, Hardee's lost many of its most price-sensitive (and least profitable) customers. Within weeks, however, even with no advertising support, sales rebounded as word got around that Hardee's had the best fast food burger in town. In some cases, sales then increased by 30% to 40% and margins were also rising substantially.

At this point, we were trembling with greed, as we realized that the call option on Hardee's that we were getting for free could be worth a lot, but the story gets even better. What do you think was happening to Hardee's same-store sales in early 2003, as hundreds of restaurants converted to the Thickburger menu? They were tanking, of course, as the restaurants suffered the initial sales decline associated with the new menu. In January 2003, Hardee's same store sales fell 8.3%, followed by a 5.3% decline in February.

Wall Street saw these dreadful numbers and dumped the stock, driving it down to nearly $3, but from our perspective, the worse the same-store sales figures were, the better, as it meant that Hardee's was rapidly converting its restaurants to the new menu (we were worried that some franchisees might resist the conversion). This is as close to investing nirvana as I've ever experienced. Thanks to a little bit of scuttlebutt research, I had unique insights into what was happening on the ground, which gave me the conviction to make this a big position right at the bottom.

Sure enough, the Thickburger was (and continues to be) a grand slam -- plus the economy improved, the burger wars ended, the company has continued to innovate and execute superbly, and restaurant stocks are back in favor, all of which translates into a stock price above $14 today. (I still own it, though I'm not recommending purchase at this price.)

Conclusion
In every investment I make, I seek an information edge. Sometimes I don't find one, yet still get comfortable with a stock for other reasons, but the most profitable investments in my career have been ones in which I've gathered scuttlebutt to gain proprietary insights about a company. It can be time-consuming and/or expensive to collect such information, but in many cases one simply has to ask the right questions and be willing to make a bunch of cold calls. So what are you waiting for?

Whitney Tilsonis a longtime guest columnist for The Motley Fool. He owned CKE Restaurants at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security.To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com. The Motley Fool isinvestors writing for investors.


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