The Search Process – Some Members Discuss Their Approaches by CSInvesting
There's more than one way to skin a cat, so I'm curious how others decide on where to focus their initial research efforts.
Do you start with an industry you're familiar with or have an interest in? Do you go off of recent news? Do you look at 52 week lows and go from there? Do you look at insider trades first and go from there?
Many of the most well-known hedge fund managers in the world engage in philanthropy, and in doing so, they often reveal their favorite hedge funds through a review of their foundation's public filings. Bill Ackman's Pershing Square Foundation invested in several hedge funds during the fiscal years that ended in September 2019 and September 2020.
This is a great question. I'm an amateur (who hopes to someday go pro!). I usually get my initial ideas from other investors. I spend a lot of time reading investment theses. If I like the company and its competitive position, I add it to my watch-list, then perform my own regular research updates. Blogs, investment pitches for conferences, podcasts, magazine articles - all are great resources to discover new companies which have attractive economic characteristics.
An example is Input Capital, a canola streaming company based in Canada. I initially heard about the company from reading a blog article, approximately 18 months ago. The article piqued my interest, and from there I begun to conduct my own research. Over the course of the 18 months, I gained an understanding for the business and drivers of value. Then, in Nov. 2015, the price dropped over 40% in one day when it was revealed that 3 contracts were defaulted upon. I updated my research over the weekend, talked to management, then made it my largest position.
The danger of sourcing ideas on other's work is that you may not do your own. But I think it can be a greater starting point for sourcing ideas, especially smaller, boring companies with little news or analyst coverage. Just make sure you resist the temptation to get lazy. I've gotten burned on that when I began investing in companies and not just ETFs. It was JC Penny. My investment was based on reading far too much into Ackman's thesis and doing far too little of my own research. I made the mistake of confusing the number of slides with the quality of research. Not once did I, or Ackman for that matter, ask if JC Penny's customers LIKED used coupons and buying items on sales. Neither of us did the necessary "scuttlebutt" of actually *GASP* talking to JCP customers. Lesson learnt: retail investing is a lot like political campaigning, it's all about the ground game.
This is a great thread. I do a lot of what Ian talked about, but recently have started feeling that just reading investment pitches all day long isn't the best idea. Not saying it shouldn't be a serious tool in your arsenal, just I feel I need more balance. The old fashion way of just researching companies and industries where one can remain unbiased by outside opinion helps me recalibrate. Being able to maintain independence of thought is critical in investing. This might be obvious to some, but I figured I'd put it out there to see what the group thought.
We also need to a thread on investment process, a subject that is really fascinating to me. It's an very individualized process that still can be honed by ideas from other investors.
Mr. Munger/Mr. Buffett would suggest that you start with the A's and white knuckle yourself through the 2,500 companies in value-line and small cap value line. Any major library in the USA should have it online. Better yet, page through the hard copy at the library.
You can eliminate (with practice) many within seconds, but you will:
- find unusual opportunities that may not be picked up by screens.
- build a wish list. I would love to buy BCPC (Balchem) 35% lower. Ditto with CFX
- you build up a knowledge base in your head of various industries and the general financial metrics to compare.
- You can come up with your own investment ideas vs. being a late herder into ideas.
How you search is only limited by your process and creativity. For example, you may be a collector of companies with regional economies of scale so you look at rock quarries or trash hauling. You may seek specialized assets that can’t be easily duplicated for zoning and environmental reasons like Copart’s salvage yard (CPRT). I like the economics of Uranium so I want a company with leverage to a higher uranium price but a strong enough balance sheet and variable cost structure to survive a few years of low prices. I saw insider buying and a deep value investor, Cannell Capital has owned the company at twice the price, and the company has a unique asset—1 (The White Mesa Mill) of 4 permitted uranium mills in the US. Energy Fuels, Inc. (UUUU), but I hope to buy near or under $2.00. It is valued at ½ the price of uranium explorers but it is already producing and has lots of organic growth if uranium prices rise. Not a rec. but several elements combine for my search process—industry, asset quality, balance sheet, insider buying, ownership.
How can I find stocks that are undervalued?
The stock market has gone up so much recently it seems like there aren't any good buys. I'm tempted to just keep my money in a bank account and wait for the next market crash.
John Mihaljevic, CFA, editor, The Manual of Ideas
Idea generation is both art and science. In investing, various quantitative methods can throw up many “names” for consideration, based on criteria such as price to earnings, enterprise value to sales, or price to tangible book value. On the surface, the companies with the lowest ratios will be the cheapest publicly traded companies at the moment. However, if investing was as simple as picking the quantitatively cheapest companies and earning a market-beating return, then investment success might not be as elusive as it is actually.
Several issues arise with the use of purely quantitative methods. First, quantitative screens suffer from a version of the “garbage in, garbage out” problem: One-time items, such as a non-recurring gain on the sale of subsidiary, can inflate reported income, making a company seems cheaper on a the basis of P/E than it would be if the one-time gain was excluded. Second, even in the absence of one-time items, a cyclical business will report the highest earnings at the top of a cycle, right before income is about to decline. Third, cheap companies are often “cheap for a reason”, with the most obvious reason being that the company in question is a terrible business with low returns on capital. If a company trades at a low P/E multiple but retains earnings and reinvests them at a low rate of return, long-term shareholders are unlikely to earn a high return. Over time, shareholder returns converge with the return on capital at companies that retain the vast majority of earnings.
Every investor faces a practical constraint: limited time. If an investor had no time constraints, idea generation strategies would be much less important, as we could analyze every available idea. Time limitations force us to prioritize. Quantitative screens are one way of prioritizing companies for further research. Conversely, David Einhorn, founder of Greenlight Capital, has talked about looking not for statistically cheap companies but scouting for situations in which non-fundamental reasons may lead to the mispricing of a security.
Over the past seven years, The Manual of Ideas has queried a number of thought-leading investment managers about their idea generation strategies. We highlight some of their insights below.
The following excerpts have been edited for space and clarity.
Allan Mecham, founder of Arlington Value Management:
[I generate ideas] mainly by reading a lot. I don’t have a scientific model to generate ideas. I’m weary of most screens. The one screen I’ve done in the past was by market cap, then I started alphabetically. Companies and industries that are out of favor tend to attract my interest. Over the past 13+ years, I’ve built up a base of companies that I understand well and would like to own at the right price. We tend to stay within this small circle of companies, owning the same names multiple times. It’s rare for us to buy a company we haven’t researched and followed for a number of years — we like to stick to what we know. That’s the beauty of the public markets: If you can be patient, there’s a good chance the volatility of the marketplace will give you the chance to own companies on your watch list. The average stock price fluctuates by roughly 80% annually (when comparing 52-week high to 52-week low). Certainly, the underlying value of a business doesn’t fluctuate that much on an annual basis, so the public markets are a fantastic arena to buy businesses if you can sit still without growing tired of sitting still.
Charles de Vaulx, chief investment officer of International Value Advisers:
Compared to many of our peers, it would be fair to say that we may rely a lot less on screens. It would be easy every week to run screens globally about stocks that trade at low price to book, high dividend yield, low enterprise value to sales, enterprise value to operating income, and so forth. Generally speaking, a lot of our value competitors begin the investment process —by that I mean the search for ideas—by trying to identify cheap-looking stocks. Sometimes using screen devices they look for cheap-looking stocks and once they have identified a list of cheap-looking stocks, then they decide to, one at a time, do the work and investigate each of these companies. The pitfall with that approach is typically those cheap looking stocks that you’ve identified will typically fall in two categories. Either stocks that are of companies that operate in overly competitive industries or overly regulated industries where the regulator may not always be a friendly regulator. So you may find steel companies, or some retail companies, or the insurance industry in many parts of the world is notorious for its overcapacity and lack of barriers to entry. So, either you’ll find companies in overly competitive businesses where it’s hard, or even worse, you’ll find typically some of the lousiest competitors in their respective industry. If you had run a screen a day before a company went bankrupt, the stock probably looked cheap on maybe a practical basis or probably enterprise value to sales basis. The problem with these cheap-looking stocks of both categories is that it’s going to be hard for these stocks to see their intrinsic value go up over time. If anything, especially in the second category, the worst competitor type category, some of these companies may actually see intrinsic value go down over time.
Search Process - Image Source: Pixabay
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