Idea generation in investing

I still remember that moment three years ago, when I was still a novice investor reading Berkshire Hathaway’s annual report with full of excitement and enthusiasm, I was clearly amazed by the spectacular returns of Buffett and Munger over the last 50 years in the stock market. Their early investment in well-known companies nowadays such as GEICO, See’s candy and Coca-Cola are investment classics that should be included in the textbooks in business schools. Nevertheless, what I was wondering at that moment was: How did Buffet manage to unearth those hidden treasure when they are still relatively small and was not in the public limelight? Are good investment ideas that easy to stumble upon? Definitely not. After three years of experience in the stock market and accumulation of knowledge, I finally have some answers for the question I’d asked myself three years ago. My idea generation process often takes place in four forms.

1. Screening

Screening softwares and services are provided by various financial data and software companies such as Bloomberg Terminal, Capital IQ and Factset. For individuals that may not want to spend such a hefty amount on financial softwares, there are also many stock screening tools on the web offered by Morningstar and Yahoo Finance. Most importantly, it’s free! Screens enable us to filter stocks based on different metrics such as a minimum Return on Invested Capital, Debt to Equity Ratio and the free cash flow of the company. Stock screening definitely does a great job in helping us to weed out those stocks that don’t meet our requirements and focus on the instruments that are within the user-defined metrics. However, it is not enough to discover great companies that can last for many years merely by picking stocks based on the results of our screening process. We must have the ability to see the big picture from the numbers that are screened. For example, a higher than average debt-to-equity ratio doesn’t implies that the company is a rotten apple. It may indicates that the company needs massive capital to fund its growth and expand market share. It might have a bright future ahead of it, making it the next Google or Amazon. Likewise, a low debt-to-equity ratio doesn’t make a company a ‘quality-guaranteed’ company. On the other hand, investors should have additional filters to really get down to something interesting from a long list of companies that appear on the screen. The filter includes qualities and traits that should exist in a well-managed company such as candid management, healthy cash flow and a healthy amount of debt. There are too many qualities in a company that should be taken into consideration so I will not list them out one by one here. (That would probably cost my entire school holiday!). In short, stock screening is a very useful tool to generate ideas in a short time span but it must be used judiciously, coupled with your own analysis and filters.

2. Other investors

You can get some fantastic ideas from other investors occasionally, ranging from institutional investors such as David Einhorn and David Tepper in investment conferences, to people around you which share the same passion towards investing with you. For me, my friends and pals are still concentrating in their video games and social network. Hence, my only source of investment ideas from people are my father and professional investors that share their ideas. I feel the need and commitment here to make a point that getting ideas from your friends and other people doesn’t mean that you should buy in their idea and just follow their decision without doing any due diligence and thinking. This will only make you invest like a headless chicken and end up in red. What you should do is trying to understand the underlying reason of their decisions, their investment analysis process and think of disconfirming evidence to challenge their view. If after you did your research and analysis to come to a conclusion that the particular company is an attractive one, then congratulations! you earned yourself a great company from other people. However, if you think that the company is overvalued and thus not worth investing, at least you get to improve your thought process and obtain a different perspective from the others. This is a heads-I-win, tail-I-win situation!

3. Look and Observe

I began reading about Peter Lynch and his investment concepts before I really began studying Buffett. His common sense approach stroke me hard and I still think that it is a really great approach to find out interesting ideas that are not known by anyone. Looking and observing at the things that is happening around the world is one of the best investment I could’ve ever made. You will soon start to realise that many of the things around us pretty much contributes to an investment idea. I never like to go the market with my mother because I’ll need to wake up really early. One morning my mother dragged me out of bed and without any other choice, I would need to follow her to the morning market. While my mother was buying eggs, she was complaining about the sky-rocketing egg price recently. Two months later, the largest egg company in Malaysia, Teo Seng announced its earnings, with profit exceeding the consensus by a large margin. Since then, I was always prepared to wake up early and follow my mother to the market. Quoting another example from the book One Up on Wall Street, Peter Lynch has always bought his children Disney films and toys and his children were never tired of watching them over and over again. The rest is history. He still regretted missing this huge opportunity until today. However, the quote ‘Invest in What You Know’ made popular by Peter Lynch is being misunderstood by the public. Some 25 years after his retirement from running Magellan Fund, Mr. Lynch clarifies that he never said, ‘If you go to a mall, see a Starbucks and say it’s good coffee, you should call Fidelity brokerage and buy the stock,’ ”. 

Every investor should keep in mind that however good is the product of the company or however confident your friend seems when he recommend an idea to you, you should conduct enough due diligence and analysis before making your investment in a company. Never let the herd guide your thinking and don’t let their mind make decisions for you. As Mr.Buffet would have put it,

“Don’t think of buying stocks, think of buying businesses”