I find it very ironic that new buy-side analysts are not responsible for generating stock idea on day one, but need to have an actionable stock idea before getting the job. However, we all want to land an offer so we put up with it. I do not know about you, but I had zero idea how to generate an actionable stock idea when I first started investing: Do I screen? Do I copy ideas from online write-ups? Where are the ideas?
This week I discuss the misconceptions about stock idea generation. To the extent possible, I share ways to improve idea generation skills. Disclaimer: There are many ways to make money, some apply exclusively to select styles, so I stopped trying to one size fits all long time ago.
You need to do the work
When I first started, I did not know my own investment style or which super investor to follow, so I relied on screening. Screening is quantitative, which is liked by novice investors because it’s formulaic. However, every experienced investor knows investing is more art than science and there is no secret formula. Some companies on the filtered list might be actionable while others are not. One cannot assess just looking at a few financial metrics.
You have to dig into each company: understand its past, recent trends, market expectation of its future and assess whether your view of the future differs from the expectation. Only the two views on the future materially differ, a stock is actionable.
Investing is never as straightforward as “oh, I found these 50 best businesses, they are all actionable.” or “these 50 stocks based on my screen are statistically cheap, they are all actionable.” No, the former set might have too high valuation and the latter could all be terrible businesses that deserve low valuation.
My observation probably applies to fields outside of investing, but generally many people are seeking shortcuts that don’t exist. I could be wrong, but I do not think there is really a shortcut in identifying actionable mispriced stock ideas. You have to turn over the rocks one by one (you do get more efficient over time.)
Not actionable != waste of time
Many ideas you work on might be not actionable at the time of your analysis. You might feel a waste of time but not really, because you always learn new things when analyzing another business and the situation at hand. That process becomes another pattern recognition that can help the next time a similar situation arises.
Professional investors make money in the same stock many times in their career. Knowing another company never hurts because the next big price movement can make its stock actionable.
What can we do to be more efficient on idea generation or more quickly assess whether something warrants a deeper dive?
Run the numbers
Put together a very simple model for the company and forecast what you think the business can become a few years out. Are you paying a reasonable multiple on the out-year earnings or free cash flow based on current stock price? Assess the risk reward based on your forecast on the range of outcomes. If the risk reward is good, dig into the situation deeply. This is what I work with my clients extensively.
Be a Specialist
Specialists who have been covering an industry for a long enough time see recurring patterns from time to time – Did another company have the same go-to-market issues in the past? How did it work out? How did the businesses do the last time this industry goes through cyclical downturn?
This time a stock tanked 30% after earnings for the same go-to-market issue that you believe is fixable, the light bulb should light up that this could be actionable.
Pod shop research analysts are made to be a specialist for this precise reason. It is very laborious, but an excellent way to follow an entire sector over time and see how competition changes and what moves stocks up and down to generate trade ideas on both long and short side frequently. You could consider covering a few stocks in the same industry to start out and “scale out” to other companies within the value chain – this approach has dual benefit of becoming an expert on that industry and uncovering actionable stock ideas in real-time.
A controversial one. Yes, a lot of portfolio managers are snooping around Value Investor Club, SumZero, Substack, Twitter, etc. I believe borrowing ideas are totally fine as long as you can gain the same level of conviction and know the business as well as the idea publisher. However, beware the idea publisher could have other motives: You will never know their true motive but just understand not all idea publishers want the readers to make money (eg. some are trying to promote the stock while selling the stock.)
Similarly, you can borrow ideas by tracking what mutual funds (Morningstar can help) or hedge funds (Whalewisdom / Dataroma) are buying / selling. Over time, you are probably following the Super Investors you respect which can be a source of ideas. It’s not 100% hit but nothing really is in this business.
Fund filings are tricky because a lot of funds “window dress” (ie. buying stocks that do well and selling stocks with large losses close to the quarter end.) For hedge funds, you could be mistakenly viewing a position as a buy when it’s a pair trade that’s used to hedge a short (as hedge funds don’t need to disclose their short positions publicly). So have a healthy dose of skepticism when viewing fund filings.
I have many buy-side connections as I was always networking aggressively to source job leads and meet mentors. Certainly becoming a social media person further helped. Today ideas just come to me from like-minded investors who are friends and/or mentors.
Friends are just another futile sources for ideas because of philosophical alignment.
The only thing I say (which warrants a standalone article) is: you need to have certain level of people skills to be building a professional network and cultivating these relationships. If you are transactional about sniffing out stock ideas from people you network with, first of all, people might be more reserved about giving you value and second of all, even if they throw you a bone, it will not be recurring which defeats the purpose of relationship building.
Remember the power of reciprocity: always lead with giving value to others first without expecting anything in return. Over time, your network is just a vast well of ideas that you don’t need to go out to find. Again, on reciprocity, once you have done the work, share the findings and your view with those who gave you the idea to return the favor.
Build the bullpen
For investors who are more focused on the underlying business, there are always enough businesses you can study thoroughly and then wait for the price to come to you. Always be a student of businesses and trends, what businesses are addressing the next big trend, why do you think they are the winner, at the price do you think they are actionable as stocks?
I don’t think there is shortcut to idea generation – it requires hard work. You should pay attention to big stock movements, study businesses and be willing to make a call when risk reward is attractive. Remember investing is not buying best businesses at any price or buying bad businesses at cheap prices: it's about identifying dislocation between the value of a business and the price of its stock.
If you are interested in learning more about professional equity investing (the "buy-side"), I have two other great articles for you:
Have trouble generating stock ideas? Want to learn about my stock idea buckets? I can help you. Let's meet!