“Talent hits a target no one else can hit. Genius hits a target no one else can see.” –Arthur Schopenhauer
A position is an idea in practice. It’s the manifestation of a string of thoughts, which ultimately leads to a decision. That decision then becomes based on any available information, facts, predictions, assessment, all culminating into the formation of a valuation. “What’s this thing really worth?” Is the underlying question behind many of the greatest ideas and positions. Where do these ideas come from? They’re always out there. Knowing that can cause a lot of angst for the proactive investor, who’s eager to sprinkle in spectacular companies to her portfolio. Thankfully, there are repeatable methods for the idea generation process. This post deconstructs that process, and explores where many of the top value investors begin their hunt.
With approximately five or six thousand publicly traded companies listed on the U.S. exchanges alone, and thousands more globally, spotting the winners can feel a little like looking for the needle in the haystack. Fortunately, technology has significantly improved the way investors set parameters to help narrow down the potential pool of candidates. Back in the day, investors like Warren Buffett had to pour over the phonebook-sized Moody’s Manual, looking at earnings, calculating ratios, and investigating balance sheets. Now, all of this can be done digitally. No phone books required.
Screening has always been for ten years an important tool to me and it’s a great way to provide consistency into how you work. Consistency is extremely important in this job. You want to do the same thing day in and day out, you want to expand how well you think but you want to do the same thing basically, otherwise it’s too hard to just hop on the latest popularity train.
The most common screens include: Price/Book, Enterprise Value/Free Cash Flow, Average daily trading volume, P/E, Profit Margins, among others. Buffett has famously compared looking for value positions as elephant hunting. In 2011, he wrote in his annual letter, “We’re prepared. Our elephant gun has been reloaded, and my trigger finger is itchy.” In other words, he knows to wait for the fat pitch, but to do that requires that you recognize the signs of when the pitch is coming straight down the middle. Screens can help narrow your sights, and as Henrik Andersson of Didner & Gerge, discusses in the video interview above. Screens also provide consistency. Idea generation is very much a process, and you must commit to that process in order to see results.
“It is in Apple’s DNA that technology alone is not enough—it’s technology married with liberal arts, married with the humanities, that yields us the results that make our heart sing.” – Steve Jobs
The late Apple Inc., CEO Steve Jobs believed that the best ideas emerged from the intersection of technology and the humanities. The key word in that thought being, “intersection”. The Large Hadron Collider at CERN is another example of this; where discoveries are made at the points of collision. As particles are smashed together at near lightspeed, physicists can observe the carnage in search of new particles. The collision is what makes this possible. New ideas are generated in a very similar fashion. Only, ideas are less expensive and come from the collision of thought, rather than matter.
In our interview with Josh Brooks of Granite House Capital Management, he notes something we’ve written about before: ideas come from reading. Warren estimates that spends somewhere between five to six hours reading every day. Whether it’s annual reports, books, or his five daily newspapers, material like this is a well known part of his daily routine. It’s not that you have to be actively on the hunt either. Simply exposing the mind to different ideas and industries, creates the optimal environment for Eureka moments. New information brews in your subconscious, until at some seemingly random point, it just clicks.
Creating intersections doesn’t have to be limited to books. You can also reach out to other money managers, review their portfolios, talk with former employees of the company at interest, speak with analysts, and so on. The goal is to inspire curiosity, and once it’s there, use it like a journalist digging for information. Christian Olesen, of the Olesen Value Fund, says it’s really important to maintain a flexible mental state and keep your eyes and ears open.
Idea generation, the way I see, is really a balancing act between being opportunistic versus building on knowledge you already have. To me, there’s a high value to being opportunistic because it simply increases the universe of companies that you can invest in and that should lead to better results. And that is especially true if you are a generalist as opposed to a specialist and I would certainly consider myself a generalist. The way I view value investing is an approach that you can apply to virtually any security type, any industry, any market cap size, any country really. And it just makes a lot of sense that if that is your basic approach to investing to utilize it as much as possible by considering as many opportunities as you can and really maximizing your opportunity set.
Quantitative screens can help you narrow down the search of companies that already reflect value in their price or earnings. But sometimes, in order to spot the value before it’s reflected in the numbers, you must also look for qualitative inefficiencies. “Value” is the result of some discount on the intrinsic worth. Take for example, Amit Wadhwaney’s (Moerus Capital Management) idea of investigating disasters.
What things pique our interest? The obvious thing is for me, disasters, very obvious thing is disasters be it at the level of a company, be it at the level of an industry, be it across a number of geographies, a collection of industries that are affected by common factors or diverse factors. But disasters are one characteristic that attract us.
Sometimes, the game is a bit more subtle in that you see companies which are embedded in some sort of complex web organizational structure that people underappreciate, that may take a little bit extra digging, a little bit, you just lock yourself up in the room with a piece of paper and a pencil, and don’t come out until you figure this puzzle out, that kind, and there’s rewards to doing that. It seems rational to assume that for a company to look like a potential value target, there must be some catalyst for the discount..
Whether it’s the result of a disaster, or just frequently overlooked, Amit’s advice to look for catalysts of discount can be an excellent place to start when thinking about new opportunities. By definition, a really great investment opportunity is somewhat contrarian. It suggests that you know something, other investors don’t. Or, it means that you believe something more strongly than the other guy. Either way, you can generate plenty of new ideas by thinking inversely about commonly held truths.
There are a great number of new tools for the idea generation process at the disposal of the modern intelligent investor. Whether it’s weeding out thousands of companies via a few simple quantitative screens, or pouring over hundreds of newspapers; technology has certainly made the organization of massive amounts of information easier. It then becomes the duty of the money manager to make the best use of this information possible. History suggests that many of the best ideas result from a collision at the intersection of two seemingly unrelated thoughts. The more you expand your informational universe, the better the mental environment for these serendipitous idea explosions. Finally, you can find a great deal of value potential simply by looking for the catalysts of discount. It might not be reflected in the numbers just yet, so newly minted value opportunities can begin with qualitative inefficiencies.
At the end of the day, idea generation is just as much of a process as any other aspect of the practice of value investing. Additionally, it’s what you do with the idea that makes it valuable.
For more on idea generation, read exclusive insights by members of our global community.
[full-interview-for-registered h3heading=”Full Conversation with Josh Brooks” introsentence=”Watch our interview with Josh Brooks on investing better through pattern recognition.” url=”https://www.youtube.com/watch?v=Yfc2d-dYtp4″]