How To Find Investment Ideas

Posted on 21/10/2010

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Aside from following investment tips in newspapers, newsletters, from sell-side analysts and on online stock market forums – all of which are often-used but also relatively low-quality information sources – where can investors discover equity investment opportunities?   In this article I discuss some of my favoured methods, which are listed in no particular order.

Plagiarism.  Unlike most other walks of life, plagiarising the investment ideas of others is certainly not illegal and is often actively encouraged, as exemplified by the recent Value Investing Congress where a group of leading investment managers shared their ideas with the public. There are many sources of information, but the most comprehensive are the SEC EDGAR database (look for forms 13-D and 13-F) and the UK’s Regulatory News Service. More readable sources include websites such as Gurufocus and Marketfolly, while managers of public investment funds often list their top holdings on their company website. The risks of copying others are that their position may be part of a hedge (ie. offset by a short elsewhere) or that they are seeking to take an activist role to forces changes on the company that may not be in your interests as a minority shareholder.

Quantitative Screens.  By using websites such as Google Finance, Digital Look, ADVFN or the Financial Times, it is possible to search for companies that meet certain financial characteristics. Such characteristics could include: a high dividend yield, low indebtedness, a low price-earnings ratio, high return on equity, high historical earnings growth, etc. I have previously discussed some of the pitfalls of using quantitative screens and have already applied Benjamin Graham’s large-capitalisation to European companies. Expect more stock screen examples in the future.

Your Own Knowledge.  As a consumer and as a company employee you are on a daily basis coming into contact with hundreds of products and services. You may notice a particularly successful new product launch or a company that appears to be growing market share at the expense of its competitors. You can use this knowledge to further investigate the companies in question to discover whether they are worthwhile investments. For example, Apple Inc launched the iPod in October 2001, something that was heavily marketed to consumers the world over. Someone investing at that point would have returned 33x their initial investment (48% per annum).

52-week Lows. Investing in underperforming companies often entails higher risks than companies that are showing positive performance (and therefore unlikely to be hitting new share price lows). However, given how stock market investors show regular mood swings from exuberance to pessimism, this can often be a way of identifying attractive businesses that have been over-looked or are simply out of favour with the sell-side analyst community. Stockpickr provides a handy list of companies hitting 52-week lows in the US and Morningstar provides a similar service in the UK.

Director Buying. Company directors know their businesses better than are external investors, so their buys and sells should contain important information for investors. Because of this, company directors have to disclose their purchases and sales to the stock market in most developed markets. The pitfalls of taking this approach is that a director may simply be buying as he exercises an option grant, buying/selling a small amount relative to his overall wealth, or selling for personal reasons (eg. to fund a divorce settlement). Empirical research has found that directors’ share trades in smaller companies have a much greater predictive ability than those in larger ones. Directors Deals offers quality information in this area, though much is subscription only. Digital Look is a source of free information in the UK, while Morningstar provides such information in the US.

Temporary Bad News.  While it is often difficult to separate temporary set-backs from permanent ones given potential long-tail costs such as legal liabilities and customer refund costs, markets often dramatically over-react to bad news, giving investors the opportunity to buy shares in fundamentally strong companies at unusually attractive prices. Examples of this include recent incidents at BP plc and Toyota Motor Corporation. Since the Mercando oil spill reached its worst point, the share price has returned 42%. For Toyota, although the issues surrounding the January 2010 recall have dissipated without a significant impact on the company’s US car sales, the strength of the Yen in recent months has prevented the company’s share price from recovering. This also highlights how even when you as an investor correctly identify a situation (in this case the temporary nature of the recalls), other factors can intervene to offset your investment case.

Picks and Shovels.  It it said of the 1848-55 California gold rush that the men who made the profits were not the prospectors themselves but instead the men who sold the picks and shovels.  Indeed, one of the richest men in California at the time was Samuel Brannan, a promoter of the gold rush and owner of a number of mining supply stores.  The same principle applies to investing today.  Where a boom or growth industry has been identified, the best investment may not be the shares of the company that provides the end product, but instead one that provides a particular input, as the input supplier may have a stronger competitive position than the company that produces the end product.

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Posted in: Investment Ideas