How Successful Investors Find Winning Ideas
A Compilation of Wisdom from Hundreds of Interviews
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Great ideas are the lifeblood of great investment performance. No matter the skill of a portfolio manager in controlling risk or holding on to winners, if he or she lacks access to great ideas, success is going to be elusive.
How do you find great ideas? What is your a process for feeding ideas into your research pipeline? How do you improve and refine the process?
Over nearly two decades, MOI Global has queried investment managers on their idea generation strategies. A common theme: investing is part science, part art. Granted, quantitative methods can generate lists of companies for consideration, based on criteria such as P/E, enterprise value to sales, or price to book value. However, massive outperformance has never been synonymous with picking the quantitatively cheapest companies.
Several issues arise with the use of purely quantitative methods. Screens often suffer from a “garbage in, garbage out” problem: One-time items such as non-recurring gains can inflate income, making a company seem cheaper than it is really. Even in the absence of one-time items, a cyclical business will report the highest earnings at the top of a cycle, just before income drops off a cliff. Finally, cheap companies are often “cheap for a reason”, with the most obvious that a company has low returns on capital, yet keeps reinvesting cash back into the business.
Every investor also faces a practical constraint: time. Without this constraint, idea generation strategies would be less important, as we could analyze all available ideas. Time limitations force us to prioritize. Quantitative screens are one way of prioritizing candidates for research. Another way, as David Einhorn points out, is looking for situations in which non-fundamental reasons exist for the mispricing of a security.
We are delighted to share insights from some of our conversations:
Bryan Lawrence, founder of Oakcliff Capital:
Voracious reading, talking to other investors, and looking for areas of disturbance in the markets… It has been interesting to study the records of the great investors, and see how they generated ideas. Often the great investor works alone much of the time, which makes sense given the difficulty that two people will agree on the best ten stocks to own. But it is smart to find a small number of other investors whom you respect and with whom you can share ideas. You do not have to agree on everything, and their different perspectives can enhance your own thinking. Oakcliff shares space with two other firms run by first-class people. I enjoy having a collegial environment in which to kick around an idea, but also the freedom to make my own decisions.
Mark Massey, founder and chief investment officer of AltaRock Partners:
It’s all qualitative stuff. We really don’t do screens. In fact, the only screen I find useful is one that spits out companies that have been buying back a high percentage of shares. This may be indicative of a well-aligned management team that has great conviction in the durability of its competitive moat… but it could be the opposite, too… so you always have to do a lot of work to get to the truth. I really think the key to our success has to do with our love for the game. We absolutely love coming to work every day. I literally spend almost all of my time reading. And while it, no doubt, makes me a bit of an oddball, my greatest pleasure is to be constantly searching for wonderful businesses that, for whatever reason, are mispriced. Having done this for nearly thirty years, I have built up a lot of knowledge and understanding about many different businesses, moats, and business models. The result is a long list of companies that we would like to own at the right price. And we know from experience that if we continue to be patient and disciplined, a few mouth-watering opportunities will eventually come our way.
Brian Bares, founder of Bares Capital Management:
We do exactly one computer screen on market cap that identifies our constituent investment universe. From that point it is old-fashioned hard work. Our research analysts are free to follow their intellectual curiosities. I want to foster a collegial environment where people are constantly exchanging ideas. If I constrain people to specific sectors, or task them to write up a specific idea, they may not go the extra mile to get an idea as polished as it can be. We have had ideas come to the table from researching competitors. Others have materialized by visiting management simply because we are in the area. And some have come to our attention through shared board members or founders. Anytime one of our research analysts comes up with an idea, it is presented in a formal process internally. The idea needs to meet our qualitative criteria for competitiveness and management capability. We also have a very important discussion about what our advantage is in researching a specific idea. We love it when there are behavioral reasons for pervasive contrary opinions.
Tim McElvaine, president of McElvaine Investment Management:
We don’t really have any market cap constraints. North American or Anglo-Saxon markets, as you might typically define them, would be preferred because of familiarity and governance. But the bigger the population you can select from, the better ideas you can have. I’d like to give you an example. When I worked with Peter [Cundill], or since I’ve had my own fund, I have always invested in and out of Japan — quite different culture with its own peculiarities, but we have always had very good experiences there, mostly because we were disciplined about the price we are paying. That is a market where a lot of people have negative comments, but we’re able to find stuff to do — [echoing] a recent book on Peter, “There’s Always Something to Do”.
Brian Boyle, president of Boyle Capital:
We really don’t have a rigid process or use screens to generate ideas. However, there is usually a common linkage among our investments. For example, Fairfax Financial has been a major holding for years, which led us to Sandridge Energy. We owned Canadian Oil Sands Trust in the past because of Seymour Schulich. Likewise, when he became a significant investor in Birchcliff Energy, we took notice. We also study the investments of other great investors. I have files on over 50 other investors we respect, so we look at what others have been doing to see if anything might be interesting. At the end of the day, you must do your own homework.
Drew Edwards, partner and portfolio manager at GMO:
The majority of our ideas come to us through screens. We run lots of different screens on different industries. What we’re looking for are the same core criteria. We are looking for companies that trade at attractive levels relative to their net asset value or their tangible book value; companies that have strong balance sheets, limited leverage, and have shown an ability to generate consistent operating profit through cycles. Those are the basic criteria, whether it’s a bank or a manufacturing company… At a tactical level, the way we handle this is: I run screens on a daily basis, I take the output of my screens, and I drop the tickers into an internal database we maintain. And we’re looking for situations where the company is triggering new criteria. There could be a company where we like the business fundamentals and the valuation, but we have concerns about the management team or the debt levels. We’re looking for those criteria to be triggered, and at that point we do additional research. Or alternatively, if the company has never populated our database, that’s an exciting situation because it’s an idea we haven’t researched before. We very quickly go and meet with management.
Massimo Fuggetta, chief investment officer of Bayes Investments:
I do unconstrained screens from a sectoral point of view. And what I look at is situations where the valuation metrics, P/E or price to book, or price to cash flow, are in sharp contradiction with the history of profitability… when I can relate the undervaluation in a particular situation to a change in management, a scandal, or something that has happened around the company—that becomes an opportunity.
Sahm Adrangi, founder of Kerrisdale Capital Management:
We’ve made some of our best investments by becoming experts in weird and unusual areas of the public markets, and using that deep understanding to our advantage. For instance, we generated strong returns on SPAC warrants in the second half of 2009, and accomplished that by becoming experts on how SPACs operated.
Barry Pasikov, managing member of Hazelton Capital Partners:
Originally, a majority of my ideas were generated by a screening tool using metrics like price/sales, revenue growth, margin expansion, cash on the balance sheet, debt reduction, 52-week lows, etc. The results were as you would expect: names of companies that met my criteria but frequently did not have the long-term results or earnings power I was looking for. My searches then began to progress from quantitative to qualitative valuations. Unfortunately, I don’t know of any screening tools that can search for a company with a sustainable competitive edge, operating in a niche industry with high barriers to entry, requiring little to no capital expenditure, and of course, is cheaply priced when you fully understand their business model. I found that the trick to finding these companies is not to search for them. Instead, study the types of industries where investment opportunities may be hiding; an industry that could conceal an unloved, abandoned, sometimes vilified company lacking sex appeal. I also do a fair amount of reading, and two of my favorite magazines are BusinessWeek and Fortune. I am not reading them for investment recommendations; I read them because both magazines do a great job of giving a quick and concise overview of different companies and their industries.
Pablo Gonzalez, chief executive officer, Abaco Capital:
In many cases we find opportunities in companies we owned in the past, and we sold when they reached our intrinsic value. Occasionally we get the opportunity to invest in them again. This happens quite often in highly cyclical companies. We keep a list of companies we like to follow. It is formed by enterprises with outstanding businesses and strong competitive advantages whose shares aren’t cheap at the moment. We follow them on a quarterly basis, to make sure we are ready if the opportunity arises. Most of the companies in the list have already been part of our portfolio at some point. In other cases, we find ideas talking to other investors, who have a similar way of thinking and with whom we like to share opinions, we like to attend to events where we can learn and contribute with some of our experience. MOI is an excellent source of new ideas, too. Sometimes, being in touch with companies can be very helpful as well. We usually ask management teams about other enterprises in their industry, no matter if it is a competitor a supplier, or clients that have outstanding profiles and can be interesting to us. We also do this when studying the competitive dynamics of the industries, we don’t only focus on the company we are analyzing, we try to keep our eyes open when comparing it to its principal competitors, and other companies it works with. We are also attracted by stocks that have fallen sharply in the last three to twelve months in different markets. We look for cheap opportunities, so this is always a good reference to start.
Rahul Saraogi, managing director of Atyant Capital Advisors:
I use multiple methods to generate ideas. I do not, however, aspire to know every single thing about every single listed company, it is just not possible. Even if one’s analyst team does it, it doesn’t help the fund manager because he or she cannot internalize that much information effectively. The beauty of the investment business is that you don’t have to kiss all the girls. If one can find a few investment ideas that meet one’s investment criteria, one can do very well over time.
Scott Barbee, portfolio manager of the Aegis Value Fund:
We generate ideas in a multitude of different ways. Our primary methodology is a simple stock screen looking for companies trading at discounts to tangible book value. Additionally, we run screens in search of companies trading at low multiples of leverage-adjusted cash flow. Speaking with other similarly oriented fund managers, examining their regulatory filings, and reading industry-specific research are other channels through which good investments can be found. Additionally, we are all voracious consumers of business news, and we occasionally find gems through this general reading.
Sid Choraria, Asia-focused equities portfolio manager:
I like generating original ideas, companies that are off the beaten path and with potential to grow, but the underlying theme is always finding value. I look to source ideas constantly, through a variety of sources that keep me intellectually curious. Some of my ideas can come from just paying attention to companies in Asia in day-to-day life. I developed an exhaustive screening database that assists me for key factors I look for in a forensic way, quantitative and qualitative. These can include return on invested capital, quality of earnings and free cash flow, significant share repurchases, insider buying, brand, customer captivity, and pricing power. I also generate leads by asking companies “Which of your competitors do you fear the most?” Finally, I regularly read value-oriented publications. […] I also follow prominent value and private equity investors to see if they might be shareholders in a business. While their presence is not necessary, if the value discrepancy is large, it can be an advantage to have an informed investor engage in value creation.
Peter Kennan, managing partner of Black Crane Capital:
Our universe of companies is in Hong Kong, Singapore, Southeast Asia, Australia, New Zealand. That includes Taiwan. We look at enterprise value above $200 million. We don’t care how small the market cap is, so they can have a small market cap. That generates a screen, and then we scan out financials because we can’t get really comfortable with what assets are inside financial organizations. That results in about 1,800 companies in our universe and we then sort through those looking at various criteria. One of the key criteria for us actually is a big fall in share price, so we take a look at any company that has fallen more than 50% versus a 52-week high. It might be five minutes, it might be five hours, but we take a look at all of them almost without exception. We get used to screening things that are relatively lower quality businesses. We are looking for a quality business at the heart of it, but it can be pretty ugly in terms of leverage, corporate governance concerns, cyclical issues, etc. It can have lots of problems, but at the heart of it, it must be a core, good quality asset, which could be cash, properties, infrastructure, a strong cash flow business with a solid market position. We also look at things like a bigger portion of minority interests, which would be indicative of a large conglomerate, which might have a sum-of-the-parts discount and might have some activity to unlock that value. Big associate earnings — this is another thing the market will miss is that a lot of the earnings are coming through associates and are not in consolidated form. These are the things we look at.
Aaron Edelheit, chief executive officer of Mindset Capital:
Insider buying, spinoffs, turnarounds, restructurings, and reading what other really smart money managers are doing.