How do Warren Buffett, Seth Klarman, Mohnish Pabrai, and other great value investors of today determine which company, of all the companies out there, to invest in? Well, they've become so influential they have businesses knocking down their doors pleading to invest with them.
But at some point, they weren't. These greats were like you and me, small time individual investors seeking great companies to buy in order to produce great returns. So let's examine a few strategies to generate excellent ideas.
- Being efficient at creating your own investment ideas allows you to beat the market and not get bogged down with too much information.
- Before you begin researching it's important to narrow the field. This means knowing the business, start with industries, and have a customized checklist.
- There are several ways to generate ideas including paying attention to your surroundings, reading credible websites, following professional investors, and utilizing stock screeners.
Importance of Idea Creation
The process of generating stock ideas is important for a couple of reasons. One, you simply cannot invest in mutual funds or index funds and expect to beat the market, as shown here. You have to invest in specific companies that are both undervalued and financially healthy (value investing). You can't rely on stocks your neighbor says is going to grow through the roof or one your sibling promises will crush the market. Hell, you can't rely on the stock picks most advisers rattle off to you. You have to be independent and vigilant, which is why the process is so important.
Second, many people never invest by themselves because they believe it's just too much work. They simply don't have enough time to pick through the entire stock market and select a handful of stocks that will produce great returns. The main problem is they don't have a defined, thorough, and simple process to generate ideas worth investing in. Without this, it's easy to see how people get watered down and feel the task is too daunting. Which leads me to the next section...
Narrow Your Search and Increase Efficiency
Warren Buffett said that back when he started his investing career he learned about every public company. He went on to say that bank of knowledge served him very well. His advice... “start with the A's.” Now, if you're like me, there is no way you're going to sift through every company that's publicly traded. Your time is too valuable and I'm too lazy. We need to narrow our search. I have a few general rules I like to follow when I'm researching stocks:
- Know the business
- If you're going to own a slice of a business, it's important to be familiar with what it does. You'll have a leg up on other investors because you'll have a better understanding of the industry. For instance, I'm a pharmacist. I enjoy researching different biotech companies and I have an advantage over someone who has no idea about the field of medicine, or at least I hope. This doesn't mean you need to know a business inside and out, but it's helpful to have an idea about what they do and why.
- Study industries, then companies
- I try to focus my research on industries first, and then move to the companies within. Look for strong companies within weak industries. For instance, the energy sector has been hit hard recently. Screen for companies with strong balance sheets and solid growth potential. You can also search for companies within industries you know something about. In my case, biotechnology. Analyzing industries is a great place to begin researching and can narrow your scope significantly.
- Create a specific checklist
- This rule has more to do with the actual analysis rather than the search, but it can still save you plenty of time. When you begin your search, you'll probably find several companies you will be interested in. Instead of obsessing over every minute detail on every single company, concentrate on key elements that will give you a good idea if you should research further. Is the business growing sales and earnings? Are they generating healthy cash flow? Make yourself a customized checklist regarding fundamentals important to you... or use the YourPortfolio Software
5 Ways I Generate Stock Ideas
There are several ways to find great companies without getting bogged down in numbers and statistics. In fact, the great Peter Lynch said one of his best investments of all time came from his wife's affinity for L'eggs pantyhose. So you never know where you'll find your next idea. Here are some of the ways I recommend:
- Pay attention - This is the easiest way to obtain great ideas. Simply pay attention to your everyday life. What products do you use and love? Which stores do you shop at? What foods do you eat? These are all questions that you can ask yourself consistently throughout the day. Check to see which stores are always packed, or brands that are always sold out. There's a good probability they might be doing good business. If you tend to like the product, chances are other people do as well. For instance, Apple is a brand that's everywhere. From phones to laptops to watches, you can see one of their products several times a day. Not to say you should invest in Apple, but it might be a good idea to research the company.
- Read a lot - Individual investors like us do have one distinct advantage over the greats of yesteryear... technology. There are solid websites out there where you can find fantastic content, ideas, and analysis. But with great power, comes great responsibility. 90% of the articles you read should go in one ear and out the other. That being said, some of the websites I have found to be value-minded and credible are Seeking Alpha, Motley Fool, GuruFocus, and Morningstar. When you stumble upon a good idea go research it for yourself and come to your own conclusion.
- Follow the best investors - The simplest way to find stocks is to follow the pros. Mohnish Pabrai has stated he is an unabashed copycat. He routinely follows great investors, namely Warren Buffett, and invests in the same businesses. In reality, many of the great value investors have significant influence and should be monitored routinely anyways. GuruFocus and Dataroma are my personal favorites for this task. Dataroma is a lesser known site, but it's totally FREE and offers the simplest interface in my opinion.
- Use stock screeners - Stock screeners are excellent tools that can crunch a ton of data. While I don't really care for the ready-made screeners - mainly because I don't know why they spit out the stocks they do most of the time - the Google Finance and the FINVIZ Screener can be very helpful. The trick is toeing the line between being too narrow and too broad. I recommend using around 7-8 metrics for screening stocks. Criteria I always include are Return on Equity (>15%), 5yr sales and EPS growth (>15%), Return on Capital (>15%), Current ratio (>2), and Debt-to-Equity ratio (<0.5).
- Properly utilize the business media - Generally it's a good idea to avoid most business journals, TV analysts, and other media outlets when it comes to stocks. But there is some quality information to be found. For example, I monitor two sections in particular on the Forbes website - America's Best Small Companies and World's Most Innovative Companies. When you're listening to, or reading, the business media try to focus on business-specific information and tune out macroeconomic news.