Investment Idea Generation Part 2

So, a little later than I expected, I’m pleased to publish the next article in my series about Investment Idea Generation. In the first article in this series, I wrote about the topic of selecting investment goals, different types of assets and asset classes, and the different investment vehicles available to investors looking for alternatives to selecting individual holdings.

Investment Idea Generation can feel a bit overwhelming at first; an investor has thousands upon thousands of potential options for investment – the key is to keep things simple and to have a methodical approach to identifying good ideas. Most investors are overconfident when they begin; they believe that every idea they have is bound to make them money. As such, most investors rush into the process, piling money into the markets in every random idea that pops into their head, with little research or understanding of exactly what they’re investing in, and no game plan about what they’re going to do with the investment once they’ve made it.

Unfortunately, I’m yet to meet a person whose every idea is correct. Most of us fall foul of emotions; suffer from logical fallacies; make rash and impulsive decisions and come to incorrect conclusions based on incomplete information. If we accept this to be true in general life, then it should be no different with our investments. The goal, therefore, is to slow down the decision-making process and ensure there are as many checks and balances between your capital and investing it in a bad investment idea.

Macro vs. Micro and Qualitative vs. Quantitative

Broadly speaking, investment research falls along with one of two spectrums. Investors can consider the big ‘world view’ of economics, macroanalysis, or individual companies and sectors, microanalysis. Likewise, they can focus on quantitative performance, only considering the numbers behind a company or a more qualitative approach that relies on intuition and gut feel.

To illustrate this idea, I’ll explain my own research style. Personally, I use a combination of bottom-up and top-down research. Initially, I consider the societal trends and business concepts I encounter. An easy and commonly used example is online shopping. If I believe online shopping is likely to be a common and popular feature of future life (which I do), I next consider what businesses provide online shopping and what they need to do. Briefly, these would be things such as logistics suppliers, such as automated warehousing, reliable and secure online portals for processing orders, the ability to provide goods that a customer would want, and an ability to deliver those goods safely and quickly to the customer.

I then begin to look for companies that provide these services; warehousing owners, AI and picking technology developers, logistics providers, cybersecurity and e-commerce companies. This provides me with a list of companies to begin my ‘bottom up’ research.

Long-term readers of this site will recall that I wrote a series of articles about analysing individual companies and these articles are a good companion to this series on investment idea generation. Essentially, bottom-up research helps me to evaluate businesses as an ongoing concern and to identify ones that I hope will perform better in the future than other businesses.

The thinking behind this process is simply that share prices generally reflect the economic performance of the underlying asset. If a company grows its profits year after year, then the company will increase in value as investors recognise it as an increasingly productive asset. Likewise, if a company is persistently loss-making but the company is highly-priced, the price will generally fall over time to reflect the fact that owners in the business are losing money every year that they own it.

This second part of the research process is where I spend a significant portion of my time before making an investment. I use a tool called Stockopedia to review a company’s return on equity, profit margins, PE & PEG ratios, levels of debt and assets, revenue growth, and so on to identify companies that I feel have a sufficient track record of success to be likely to continue to do so in the future. In a nutshell, I believe that most winners will keep on winning (at least in the short-mid term)

I also have a preference for value investments i.e. making investments into companies that I feel the wider market has overlooked. I strongly agreed with Warren Buffet when he said “any investment is a bad one at the wrong price”. As such, the price I pay for a company is critical. I usually look for assets whose price is lower than my calculation of current fair value – I’m much less interested in buying companies who are cheap today “if they grow at X% for the next ten years” as frankly, I don’t know exactly what they’re going to do over the next ten years.

My method, of course, is not the only way to generate investment ideas. Below, I have listed further examples of research strategies;

  • Event-Driven investors make investments based on corporate events such as restructurings, mergers or shareholder activism. These investors are waiting for ‘events’ to trigger buy or sell action and are responding to momentum expectations.
  • Growth investors tend to be “bottom-up” investors and are primarily focused on the ability of the company to grow its business (both revenues and profits). They believe that the business is undervalued relative to the growth prospects of the business.
  • Management Analyst investors attempted to find quality managers in businesses and undertake significant industry research to understand a business, it’s industry, and the wider economy. These investors believe that capable management are able to generate high revenues and maintain more significant profit margins for a business in the long-term. In some cases, an investment will be made solely based on the past performance of a management team, or made based on their willingness to invest in their own company through share ownership.

Tips and Tricks for Idea Generation

Once you have an idea, undertake some research to try and verify it. Read some industry journals and academic research papers. Explore corporate blogs in the sector and thought leadership articles. Keep an open mind and look for genuine data that either supports or discredits your theory.

Don’t be wholly reliant on secondary sources. Perhaps market analysts are correct but they’re just as likely to have made an error or to be presenting a biased opinion. Some sources – particularly on the sell-side of investing – can be incredibly unreliable. Instead of these, try to focus on original sources, peer reviewed academic papers, and of course, your own analytic tools and processes.

Consider other avenues for generating investment ideas outside of our own area of expertise. Consider the lenses of different disciplines to inform your work. Novel and unconventional investment ideas often arise by joining dots that few other people have seen.

Take every opportunity to consider how conversations and news items you encounter could be point the way to new investment ideas. The more often you work at trying to generate investment ideas, the better you will get!