Review & Outlook

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Where Do Good Investment Ideas Come From?

1 March, 2016 by Ben O'Brien in Commentary

Where do good investment ideas come from? Do great investors crunch numbers and analyze data as a scientist would, or do they find sudden bursts of almost other-worldly inspiration like a poet or a painter?

There is a lot of difference of opinion on this question, and there is no one right answer. Some investors have been successful with extensive, data-driven stock screening, while others tend to read widely or follow the moves of other respected investors or simply draw ideas from everyday experience or general macroeconomic trends—more like a poet than a scientist.

There is a long standing division in the business world between the qualitative and quantitative, left brain and right. In fact, one of the leading websites for information on pursuing an MBA degree is called “Poets and Quants”.

The Switzerland-based value investor and newsletter author John Mihaljevic recently explored this question in an article that compiled an extensive list of value-oriented investment managers describing their methods for coming up with new ideas.

I have included excerpts of the first two entries in Mihajevic’s article below, which I thought were particularly good. (I added the bold):

Allan Mecham, founder of Arlington Value Management [source]:

[I generate ideas] mainly by reading a lot. I don’t have a scientific model to generate ideas. I’m weary of most screens. The one screen I’ve done in the past was by market cap, then I started alphabetically. Companies and industries that are out of favor tend to attract my interest. Over the past 13+ years, I’ve built up a base of companies that I understand well and would like to own at the right price. We tend to stay within this small circle of companies, owning the same names multiple times. It’s rare for us to buy a company we haven’t researched and followed for a number of years — we like to stick to what we know. That’s the beauty of the public markets: If you can be patient, there’s a good chance the volatility of the marketplace will give you the chance to own companies on your watch list. The average stock price fluctuates by roughly 80% annually (when comparing 52-week high to 52-week low). Certainly, the underlying value of a business doesn’t fluctuate that much on an annual basis, so the public markets are a fantastic arena to buy businesses if you can sit still without growing tired of sitting still.

Charles de Vaulx, chief investment officer of International Value Advisers [source]:

Compared to many of our peers, it would be fair to say that we may rely a lot less on screens. It would be easy every week to run screens globally about stocks that trade at low price to book, high dividend yield, low enterprise value to sales, enterprise value to operating income, and so forth. Generally speaking, a lot of our value competitors begin the investment process —by that I mean the search for ideas—by trying to identify cheap-looking stocks. Sometimes using screen devices they look for cheap-looking stocks and once they have identified a list of cheap-looking stocks, then they decide to, one at a time, do the work and investigate each of these companies. The pitfall with that approach is typically those cheap looking stocks that you’ve identified will typically fall in two categories. Either stocks that are of companies that operate in overly competitive industries or overly regulated industries where the regulator may not always be a friendly regulator. So you may find steel companies, or some retail companies, or the insurance industry in many parts of the world is notorious for its overcapacity and lack of barriers to entry. So, either you’ll find companies in overly competitive businesses where it’s hard, or even worse, you’ll find typically some of the lousiest competitors in their respective industry. If you had run a screen a day before a company went bankrupt, the stock probably looked cheap on maybe a practical basis or probably enterprise value to sales basis. The problem with these cheap-looking stocks of both categories is that it’s going to be hard for these stocks to see their intrinsic value go up over time. If anything, especially in the second category, the worst competitor type category, some of these companies may actually see intrinsic value go down over time.

Conversely, what piques our curiosity, what makes us want to investigate an investment idea is not that it looks cheap at first sight. It’s rather that the business looks neat or that the company seems uniquely good and well positioned in what they do, and then we hope and pray that, for one reason or another, the stock happens to be cheap.

. . .

Oftentimes, we will study over the years great businesses, whether it’s a Google, an Expeditors International [EXPD], 3M [MMM], and we keep them in mind and we have a tentative intrinsic value estimate, and sometimes there could be a crash. There can be a crisis like ’08, something happens and sometimes these stocks fall enough that we revisit them. I talked about these great businesses that are cyclical, the temporary staffing companies, most of the time they’re too expensive for us to catch, but once in a while, especially during an economic downturn, we’re able to buy them. Even L’Oreal [Paris: OR], the French-based yet global cosmetics company, a few times in the past during an economic downturn, sales slowed down and the growth guys that typically own the stock don’t want to own it, because the growth rate is not there. So they dump it. It still optically looks too expensive for the deep value guys. In other words, instead of staying at six, seven, eight times EBIT, it may still trade at nine, ten, eleven times EBIT. So the growth guys don’t want it, the deep value guys don’t want it. It sits in limbo, and that’s when we’re able to get those things. So it’s not much in the way of screening. It’s just the analysts, based on the sector they follow, and because some of us have been in this business for a long time – myself, over 25 years and Chuck [de Lardemelle] and Simon [Fenwick] and Thibault [Pizenberg] for many years – and because we’ve looked at tiny companies and huge ones, we have a pretty good idea of what the best businesses and companies are out there in the world, and we keep them in mind and try to revisit them when there’s a crisis or a big economic downturn.

Two things struck me about the way these two investors come up with ideas. First of all, data-driven screening, they say, is not all that reliable because it tends to produce cheap-looking stocks rather than truly cheap stocks. Screening tends to rely on valuation ratios that are a form of relative rather than absolute valuation. While I’ve found screens to be useful at times, I generally agree. For Mecham and de Vaulx, qualitative analysis tends to go first, and is then followed by a more quantitative valuation in order to identify a good entry point.

Secondly, while value investors tend to focus primarily on stocks that are currently trading at a substantial discount to intrinsic value, Charles de Vaulx points out that you still want a stock whose intrinsic value is going to increase over time. If the business is not growing and improving it is probably not worth owning at any price, unless perhaps you have a special expertise in investing in distressed companies.

Whether you use a more scientific screening method or create a mainly quality-driven watch list and wait patiently for a good entry point, like Mecham and de Vaulx, the important thing ultimately is, as Peter Lynch has said, that you turn over as many stones as possible in looking for ideas.