Finding investment ideas is the bane of many new investors’ existences. Sure, we can read all the investing books we have or know how to create a complicated discounted cash flow model, but it’s all worthless unless we have some ideas to act on.
In this post, I want to show you how I come up with investment ideas. I realize that these methods are not typical of all investors, and different methods will work for everyone. If you only take one thing away from this post, remember that every idea should be fully researched. Regardless of where you get the idea—from my methodology, from Mad Money, or from a friend in the financial industry—you must do your own homework. This is a key tenet of investing (especially value investing) that is echoed by almost every famous investor.
Having said that, I’ll break down idea generation into FOUR main categories: fundamental stock screens, 52-week lows, news ideas, and hedge fund idea sourcing.
Category One: Fundamental Stock Screens
Fundamental stock screens are one of the most old school methods of finding undervalued stocks that have gone unrecognized or else have been unduly hit by the market. They are especially great for value investors, because, as we learned with my ten rules of value investing, the market tends to reflect the true value of a company over the long run, yet can be inefficient in the short run.
That said, how do you identify them? You can use any metrics you want, but a few easy ones might be price-to-book ratio, return on assets, return on equity. One free stock screener that I use is from Yahoo Finance. This one is pretty in-depth and I’ve found some good ideas from it. If you click through that link, click “Launch Yahoo! Finance Stock Screener” and then you’ll see a screen that looks like this:
The screen is pretty simplistic, but you just have to use Boolean expressions (using the operators <,>,=, etc.) with your values. In the criteria field, you can enter such expressions. A good place to start is by setting Price-Book < 1 and Return on Assets > 15% or Return on Equity > 15%. You’ll definitely need to tweak it if that doesn’t produce any results, or if you want to broaden it. Play around with some of the different metrics, and if none of them make any sense to you, let me know and I’ll add them in to my investing terminology page.
Category Two: 52-week lows
The next way to find potential investment ideas is by searching for stocks that have recently hit their 52-week low. There are a lot of paid services that will show you a list of stocks here, but I use MSN Money to find mine. I saved the URL as a bookmark and would check it from time to time. It gives you a concise list with the market cap, but beyond that it is pretty sparse.
So why would this be useful? Often, it’s common that stocks that are on a downward trend continue past a reasonable point for a number of reasons. This is known as the concept of price momentum. First, current stockholders might panic and see that their portfolio is decreasing in value, so they sell shares to try and limit their downside. Or, some investors might have had stop-loss orders (which I’ll cover in a future post) to protect their downside, and as the stock is falling, these orders trigger and close out their positions. There are many other reasons, but for the most part, people act emotionally. This temporary imbalance in supply and demand for a stock pushes down the price, even if nothing has changed with the company’s earnings or outlook. As a result, this opens up a lot of opportunities for out of favor stocks to be picked up at a discount. However, you still ALWAYS want to do your research.
Category Three: News Ideas
A third possibility for finding investment ideas is simply by keeping up with the news. I know this sounds obvious, and despite the fact that there are millions of other investors reading the news each day too, you’d be surprised at how few people actually use ideas from it. I’m not talking specifically about a huge story that is talked about for years, as in the case of Google (GOOG) or Apple (AAPL) taking over the world. Most people probably will go out and buy a company if they hear about it for months on end.
I’m talking more about smaller, special situations that most people don’t see as an investment opportunity: things like spinoffs, corporate restructurings, and bankruptcies (if none of these terms makes sense, check out the post I wrote on this earlier). These areas seem risky and off limits to most investors, but the reality is that they actually tend to outperform the market over the long run. That’s why I like them.
Real life example:
Here’s one example of a company I’m invested in right now: Furiex Pharmaceuticals (FURX). I read about this on another niche investing blog, and checked it out for myself. It seemed like it had good potential as a company with 2-3 late stage clinical trial medicines, but apart from that it exhibited the good qualities of a spinoff: incentivized management, good cash balance, existing royalty streams, and small market cap (which meant institutional investors like mutual funds would not want to own it). As I looked at the chart for the stock since it was spun off, I saw the typical downward pressure initially. It then recovered and floated around $10.00 per share, and has since been on the rise. This has confirmed my initial feeling that the spun off stock was undervalued.
Category Four: Hedge Fund Idea Sourcing
The last idea I use for getting investment ideas is through following hedge funds. The logic here is that a) hedge fund managers tend to be the smartest investment minds around, and b) they are required to list their holdings both quarterly and if they acquire more than 5% of company’s outstanding shares. This is great news for us, because we get access to their best investment ideas on a regular basis, at which point we can evaluate them for ourselves and then decide whether to invest. The way I view it is that you are provided a list of great stocks, and then from that you get to pick the greatest ones.
So how do we find what these stocks are? Check out the post I wrote previously on how to track hedge funds for a good idea of how and where they file these holdings. In short, though, we can set up a system that follows a small number of hedge fund, and that is alerted via RSS whenever a new filing is available. We would then have to manually read through the filing itself, and can pull ideas from it!
See here for an example of a recent 13F filing from Pershing Square (Bill Ackman’s fund). If you scroll down a little bit you will see a list of companies that he currently has holdings in. Since his is a value/activist fund, he tends to hold onto the companies for quite some time, until a catalyst occurs or it reaches their intrinsic value calculation. Therefore, even though the 13F filing reflects positions that may be 3 months old, it’s usually not too late to buy!
There are many ways to find new investment ideas, but these are just four of the ones I use. There really is no excuse, if you’re serious, to not be able to find investable ideas. They are literally everywhere! But before you get overwhelmed with a massive list of candidates to choose from, just know that you only need one or two big hits to do well in any given year. Most companies will return about the same as the stock market, but occasionally, you will find a company whose stock grows 100% in a single year. Those are the ones we hope to identify.