Sourcing Investment Ideas

Quick Summary
1. Read what other investors are recommending and buying
2. Identify countries, industries and companies that are currently out of favor
3. Focus on your niche area of expertise
4. Run a quantitative screen to filter the investable universe down to a more manageable list
5. Maintain a watch list of companies that you would like to own at the right price

Introduction
Sourcing potential investment ideas is an initial step in the investment process. This involves generating a list of companies that are worth closer scrutiny. Potential ideas that make it past the initial screening require further research and analysis, but this stage is set aside exclusively for brainstorming.

1. Other Investors
Paying attention to the investment theses of other investors and analysts is often cited as the best resource for discovering new companies. Sources for finding investment ideas include blogs, magazines, newspapers, newsletters, investment forums, research publications, podcasts, conferences, television broadcasts, and personal contacts. An annotated list of relevant websites is included under the External Links section of this blog (here). Once you come across an idea you can read additional articles on the individual stock, listen to conference calls, and browse the annual reports to see if the company is still a candidate.

A related strategy is to closely follow the investments made by prominent equity investors, specifically those whose investment acumen you respect the most. The most successful money managers often communicate to clients what they are investing in through letters to investors. These can occasionally be accessed publicly on the firm’s website. You can also track what investors and hedge funds are holding by referring to 13F SEC filings. Sites like GuruFocus (here) and MarketFolly (here) do the legwork of scraping and organizing this data for you. The inherent disadvantage of this approach is that you’re a late herder into investment ideas.

2. Unpopular Companies
Looking for out of favor companies is another popular strategy for sourcing investment ideas, especially among value investors. Unloved companies are considered good hunting grounds for cheap bargains since their unpopularity can be a source of undervaluation. Temporary adversity can be caused by disappointing short-term results, legal proceedings, product recalls, health scares and the like.

Sometimes stocks in an entire industry or country may be priced very cheaply due to market disturbances. Investment opportunities may be hiding in these areas since healthy companies are often undervalued by association. The best opportunities often exist when there are behavioral reasons for the depressed sentiment.

Another method for locating unpopular companies is by referring to new low lists. These lists track companies that have dramatically fallen in price to the extent that they have reached a new low over the past 52 weeks. Popular sites for this information include Barchart (here) and GuruFocus (here).

3. Niche Areas of Expertise
Narrowing the investable universe down to a manageable short list of stocks is more easily done when you stay within your circle of competence. Experts in certain sectors and countries can leverage their understanding and knowledge of a subject to interpret how different events will impact the companies they follow. Such competence mainly comes from your education, experiences, occupation, business partners, etc. It is not uncommon to generate additional leads when performing due diligent research on companies by talking with competitors, suppliers and customers, also known as channel checks.

Investors might also understand a company very well because they have previously owned the stock. It is not uncommon to own the same company at different times – buying it when it’s cheap and selling it when it gets pricey. An industry development or a drop in the stock price might make a company interesting again. Due to your existing familiarity with the company it is easy to get up to speed with the latest developments and quickly reach an investment decision. Many analysts keep previously owned companies on their watch list for this reason.

Circles of competence should not be viewed as static. Investors should continuously expand their domain of expertise to encompass new companies, sectors and countries. Deciding which specific niche to focus on next can be facilitated through a top-down approach. This begins by looking at the current economic environment and thinking about what type of products and services are likely to be impacted based on your observations. You can then center your attention on specific sectors and companies that might benefit from the trends that you have identified.

Other investors become experts in usual areas and special situations. These can include spin-offs, recapitalizations, bankruptcies, mergers, SPACs, etc. It’s usually possible to find websites dedicated to these specific strategies, which often list qualifying candidates among their content.

4. Quantitative Screens
Well-known value investors like Warren Buffet and Benjamin Graham are famous for systematically reading from A to Z through every company listed in a Moody’s Manual or Value Line Investment Survey in order to identify good investment candidates. Advocates of this approach note that the best ideas often do not screen very well. One must therefore diligently trawl the market, or so the argument goes, briefly examining data on every company.

At the same time, investors are constrained by time. Stock screens can quickly scan a large database of information and filter thousands of stocks down to a dozen or so prime suspects. What is more, screening services have improved over time. It is possible to generate a suitable list of investment candidates based only on a few variables. Unfortunately the most capable stock screeners – like Capital IQ – come with a price tag.

One of the most common screening strategies is to search for cheap companies using market multiples, such as the price-to-earnings ratio. Of course companies are cheap for a reason. This means investors must still identify why a stock is cheap and what catalyst is going to cause the company not to be cheap in the future.

Other investors scan for companies by watching share repurchases and insider buying, which can indicate that the management team has great conviction in the company’s future. (There is listing of insider transactions on Barron’s website, here). Screens can also filter the universe of stocks by market capitalization and sector to match your particular circle of competence. While screening for investment ideas is regularly derided by investors, it should be considered one additional tool to reduce your workload of finding investment opportunities for further research.

5. Watch List
You will inevitably come across companies that you would like to own but are currently not at the right price when sourcing potential investment ideas. It is therefore recommended that you maintain a database populated with these companies and monitor them at regular intervals. Some investors suggest looking at the watch list weekly. Others recommend creating Google Alerts or setting up RSS feeds to stay informed of any company developments.

In the meantime as you wait patiently for an investment opportunity to materialize you should continue learning about the companies on your watch list. This will put you in a better position to respond when a stock drops in price. You can then quickly make an investment decision since you’ve already done most of the research on the company. In other words, you avoid starting from scratch when a company that meets your criteria is attractively priced.

Suggested Reading
The Manual of Ideas had queried a number of investment managers at one point about their strategies for generating investment ideas. Highlighted excerpts are available on Quora, here.

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