The Four Sources of Investment Ideas
/Looking for new investment ideas is such an intuitive part of an experienced investor’s research that it is often an afterthought. But it is a necessary part of the investment process. Even if you’ve been right every time, the curse of “yesterday’s winners” means that what was good in the past might not be appropriate for the future. Technology investors are painfully aware of this fact, but it’s common for “old economy” companies too. As an industry matures, or as a business becomes bigger, it will naturally slow down. These types of changes make it essential to continue looking for something new. And this is also true for investments that were made outside the basis of business growth—stocks that were purchased because they were cheap will not always be cheap.
When thinking about what to do next, there are a few ways to continue searching (and a good investor will always be searching). My preferred methods, in order of effectiveness, are reading, screening, talking, and watching. All of these methods could be described as “wandering” that is driven by curiosity. And they were borrowed from other investors.
Reading is probably the most powerful way of finding new investments. The best sources are company financial statements and reports, books, magazines, newspapers, investment directories, transcripts of company conference calls, industry reports, interviews with executives… the list goes on. Even something as little as a paragraph describing an industry can spark a desire to investigate further.
Warren Buffett, the CEO of Berkshire Hathaway, is the most well-known investor using this approach. Buffett has famously read periodicals for decades that only produced one new investment idea, and he often credits his early success with a willingness to read an entire Moody’s manual. (How can you do that? Whenever someone asks that question, he always says to “start with the A’s.”) [1] It is an investment in time that might be more important than money—even if there is nothing obviously new in the moment, making a consistent effort will pay off eventually. The main idea is to learn as much as possible and keep everything that might be useful.
Screening is a shortcut to reading. Using a financial checklist can help an investor start with companies that already match their financial standards. In most cases, this means using a quick financial screen that encourages further research. Within the past year, some screening tools have also adopted AI enhancements that enable a more refined search beyond simple financial metrics.
One of the most popular starting points for financial screens is what Joel Greenblatt, the founder of Gotham Capital who has an enviable investment record, calls the “Magic Formula.” This strategy looks for companies that earn a high return on capital (a good business) with a high earnings yield (a relatively cheap stock).[2] But it’s only a starting point. More sophisticated screens can include other metrics such as debt and growth. And after screening—if you’re doing your research—you’ll still be reading.
Talking—sometimes called “scuttlebutt”[3]—is another effective complement to reading. As a routine part of their research, big investors often talk to management, but that’s usually not intended to find anything new. The best “talking” source of a new investment idea is through customers who are excited about a product or service. Other sources can be people who work in an industry, or even other investors. Trade shows can also be a valuable source of new information.
This concept was made famous by Peter Lynch, the former manager of the famous Magellan Fund at Fidelity, who looked for what he called “10-baggers” (stocks that have the potential to become 10 times bigger). His view was that an investor could do better by asking their family what new products they are using. The next hot stock might already be in your own living room.[4]
Watching is a variation of talking. It’s when a potential investment idea comes from recognizing a product or service that you use yourself, and you decide to watch the company or the industry. It can also come from the observation of consumers or other investors, without talking to them directly. It’s all about stumbling on trends and opportunities.
Investors with similar styles may find stocks that you don’t know about yet. Monish Pabrai, a well-known value investor, often talks about “spying” on other investors by looking through their 13F filings to see what they own. Observations that come from a more physical investigation can also be useful. This could be as simple as watching what sells at a supermarket. [5]
The search continued…
There are obviously other ways to find new investment ideas, but I believe that almost all of them would fit into one of those four categories. In a broad perspective, the best place to find a new investment idea is “anywhere,” but I have found most of my ideas by starting with financial screens.[6] It accelerates the research process because it provides a list of companies that already match something that I’m looking for. But finding most of my ideas this way does not mean that my best ideas have come from this source. The most encouraging signal is when a company comes to my attention in multiple ways.
From my experience, the most surprising results have come from looking at my own experience with an industry (usually as a customer), or from talking to people involved with an industry (also usually as a customer, but sometimes industry insiders or other investors). The companies that I find this way are often outside of my very conservative financial screens, so the only way that I would see them is from another source. Relaxing those financial standards in exchange for a bigger opportunity has generally paid off, although that compromise is more often about paying a higher price than accepting a lower quality company—a minimum standard of quality is still essential! And I have to accept that no company can be perfect.
As the search continues, there are also a few things worth noting about doing research this way:
A fundamental style of investor will be able to find new ideas for any strategy by using these methods. But in the end, a fundamental investor will always be required to read something after making a new discovery.
Having something show up in multiple ways can serve as an attractive foundation for further investigation.
Timing is not as important as it seems. The time from learning about a business to making an investment can be days or decades.
Finding new ideas is relatively easy. Finding good ideas is a never-ending challenge. Curiosity keeps it going.
Andrew Wagner
Chief Investment Officer
Wagner Road Capital Management
[1] One of the most comprehensive books about Buffett’s investment style is The Warren Buffett Way by Robert Hagstrom.
[2] Joel Greenblatt’s book, The Little Book That Beats the Market, has a good introduction to fundamental style investing and an explanation of the Magic Formula.
[3] The term scuttlebutt was popularized in Common Stocks and Uncommon Profits, an excellent book by Phil Fisher.
[4] Peter Lynch’s book, One Up on Wall Street, has great insights on his investment style and research process.
[5] The Sleuth Investor by Avner Mandelman has an interesting take on discovering new investment ideas by watching how people behave.
[6] I wrote about the financial screen that prefer in a blog published in the first quarter of 2021. As part of a description on why I don’t make certain types of investments, I included the financial metrics that I like to look for.
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