Scuttlebutt research: how we diligence private companies

We review dozens of business acquisition opportunities every week. Many of these businesses are in familiar sectors, but often in niche’s that we never knew existed. 

For example, we recently learned about a small business that specialises in footpath trip hazard removal. It’s a pretty simple business - they grind down uneven concrete footpaths so people don’t trip over them! You’d never think a business like this would exist, but it makes sense why it does.

Unearthing these businesses is part of the fun for us. I imagine it’s akin to goldpanners spending hours sifting through silt to unearth nuggets of gold. You never know what you’ll find.

Part of the challenge of researching and analysing niche, private businesses is that there’s only so much desktop research you can do. 

In public market investing there's a tonne of information you can find about a company - publicly available financial reports, industry reports, broker reports etc.

In some older private companies, you’d be lucky to find a website!

This requires us to use other methods to research and diligence companies.

We do this via the scuttlebutt method.

What is scuttlebutt research?

Scuttlebutt research is a term popularized by investment guru Philip Fisher in his book "Common Stocks and Uncommon Profits"

Basically, it’s an informal method of due diligence where you speak with customers, employees (current & former), competitors, and other people that are associated with the company.

You can gather valuable insight, anecdotes, and other information that will help you evaluate the company.  Things that you couldn’t otherwise find on the internet.

Scuttlebutt is meant to be supplemental to the usual due diligence stuff (financials, product, legals, etc). It seeks to uncover the "ground truth" that may not be evident in financial statements or analyst reports.

Warren Buffett religiously practices the scuttlebutt method in his investment decisions.

My favourite example was his investment in American Express during the “Salad Oil Scandal” in the 1960’s.

Back in the 1960’s American Express (AMEX) wasn’t just a financial services company. It had a tiny division called ‘Warehousing Operations’. This division had a business in certifying the value of the inventory of other businesses. The business owners would then use the certificates issued as bank collateral.

The Salad Oil scandal came about with a dodgy customer - the Allied Crude Vegetable Oil Refining Corporation. Allied was in the business of vegetable oil and used its tanks of oil as collateral to secure loans. The company fraudulently inflated it’s oil inventory by filling the tanks mostly with water, with only a thin layer of oil on top to deceive the AMEX inspectors. The company was hence able to get loans and advances from multiple companies, including AMEX, which issued loans for the oil. 

When the fraud was uncovered, banks and other financial institutions found themselves holding worthless certificates. Millions of dollars of loans were secured against tanks of water. AMEX was suddenly facing massive financial liabilities due to the fraudulent activities of its warehousing operations division.

The result was a sharp decline in its stock price and a crisis of confidence among its customers and investors. The market feared the company was facing bankruptcy. 

A young and enterprising Warren Buffett (35 y/o at the time), known for buying great businesses at bargain prices, looked closer at the issue.

Buffett set out to establish whether the scandal really would affect the entire AMEX business - which at the time had a fast growing consumer finance business in travellers cheques and credit cards.

He did his own scuttlebutt research by simply talking to people:

Whilst the scandal made headlines in financial media, Buffett concluded that the vast majority of AMEX’s consumer customers had no idea about the scandal and would have no impact to the brand.

This insight gave him conviction that the Salad Oil Scandal was overhyped, and that AMEX would be fine. Accordingly, he poured most of his cash into buying shares in the company.

His bet paid off: within a year the stock price rose more than 40% and compounded at high rates thereafter.

Here’s some further insight into Buffett’s scuttlebutt process:

At Arbor Permanent Owners, scuttlebutt is a part of our research and due diligence process. Whilst, as an acquirer, we often can’t speak directly with customers and employees until much deeper into the deal process, we use some other unique techniques that suffice as scuttlebutt research. 

It’s remarkable what you can learn about a company through informal channels.

About Arbor Permanent Owners

Arbor Permanent Owners is a Serial Acquirer holding company that acquires and invests in exceptional, private businesses, deliberately built for long-term success. Our goal is to be the long-term custodian and permanent home of Great Australian Small and Medium Enterprises (SMMEs).

We are actively looking for businesses with the following characteristics:

• Business Model: B2B industrials: manufacturing and mission critical services

• Business Size: $3 to $6 Million of EBITDA

• Business Profile: Sticky B2B customer base

• Business HQ: Australia

We are backed by a small group of co-investors, collectively on a mission to preserve the legacy of Great Australian SMMEs.

Whether you’re a business owner interested in working with us, or an intermediary with a deal to share, I’d love to hear from you. Please email us at [email protected]