What's a 'Channel Check,' Anyway?

If you traffic in technology news or shares, you've undoubtedly heard about "channel checks." They are how analysts try to find out if Apple (or Adobe or Microsoft) are selling more or less of a given product than the market thinks. Basically, analysts go out and talk to people in the companies' supply chains and try to piece together what that means for the overall business. They're in the news today because, according to the Wall Street Journal, channel checks are one of the activities coming under SEC scrutiny.

So, what is a channel check? I did some years ago and here's how I think about them. If you're an investment analyst, you have a big spreadsheet. That spreadsheet tries to model how a company like Apple makes money. Everyone starts out with roughly the same information: how many iPads are selling at what profit margin, how many iPhones, how many Macs, etc., etc. Apple releases a lot of that information in their financial filings.

The real game, then, is predicting what those numbers are going to be in the next quarter or two. You want to know if Apple is going to sell more iPhones than everyone else thinks they're going to.

So, how could you figure that out? You can't actually ask anyone at Apple because that would be insider trading. But you can go out to the people who manufacture components for Apple products and ask them, "So, buddy, how many doodads that are needed for the iPhone 4 are you making this quarter? Is that more or less than expected?" You can also call up Best Buy middle managers and say, "So, how are iPod sales looking?" If you get enough of the right kinds of answers, you can start to make the bull or bear case for a stock.

It might not be the most elegant investing strategy, but if you've got a good (virtual) Rolodex, it can work. Is it insider trading? In most cases, probably not. It's just solid analysis.

But here's the tricky thing: if in the course of doing your channel checks at a hedge fund, say, you come across a bit of "material" information -- info that would be likely to impact a stock's price if it was widely known -- you can't trade on that inside information. However, sometimes it's hard to tell which bits of information are "material" and which are just "really awesome." That is to say, the very best channel check info comes right up to the materiality line without crossing it. The gray area is vast.

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