Three approaches I use to generate investment ideas
How to look for great investment ideas like professionals
“There are two kinds of people in the world. Ones that generate ideas, and others who work on them. To be successful, you should learn to be both..”
At the beginning of my career as a sell-side analyst, I was the blue-eyed star of the team because I was the only one who had the prestigious (quite rare in India in 2008) CFA badge with me. With my education and acumen, I was decent at building out valuation models and sector research frameworks on ideas generated by my senior colleagues.
However, several years later, longer than I wished for, I found myself doing quality work, but on someone else’s ideas. Soon I realized, I could analyze a company/ industry/ sector pretty well, but someone had to bring them to me. I did not have a framework or an approach to generate new ideas, and sadly there is not much literature/ guidance on the subject.
You could fill a library with books on how to analyze a business at hand, but very few on how to discover and prioritize ideas to work on. Sorry, starting with A’s on the list of all companies is not a viable option anymore.
In this post, I want to share the 3 approaches (and a bonus one) of how I filter and prioritize investment ideas for further study and eventual investment; something I wish someone had shared with me at the beginning of my career.
Thematic / Top-Down
In this approach, as the name suggests, we start from the top. Initially, Top meant a country or a region, however, as globalization advanced, this lost its meaning. Eg: If I was bullish on Chinese infrastructure built out in the 2000s, the best investment might have been in Vale, the Iron Ore manufacturer in Brazil. Instead, I consider the top layer as the universe in which we would select investments. That universe is mostly static, the definition of which comes from external factors. For example “Universe” might be defined by which country you as an individual or organization are allowed (or prohibited) to invest. A Shariah-compliant or Ethical Fund would not invest in liquor, tobacco, or gambling. A developed market fund would not invest in developing economies
Once the universe is decided we look for themes.
Themes can be defined as any medium to a long-term trend that you see developing in an industry, sector, or even global economy.
Below are examples of a few themes of past and present varying in size, scope, and duration:
Electrification of global energy as an off-shoot of climate change
Rise of AI, Robotics, and Automation
Growing adoption of Cloud and SAAS (Software As A Service) companies
Rise of organized retail in India
Underinvestment in fossil fuel (the antithesis of the first point)
Rising natural Gas prices
Rise of the METAVERSE (The most definitive definition can be found here )
We are introduced to such shape-shifting inescapable themes every single day through various media channels. We need to select themes that we believe to have higher probability to be true and still have a decent runway in front of them. Also, we must pick a theme where we believe, with the right amount of effort, we can gain information or analytical advantage over the average investor. Eg: A person working in retail knows far much more about retail than one who works in banking, and vice-versa. The key is to just pick one, and analyze it for what it is worth. Go to the next step if it is worth it, or else move on to the next theme.
If we find the theme interesting, we try to understand the structure of the industry, which section of the industry has the power to draw value, and finally which companies would be the likely winners.
For example, while working on the Climate Change theme, I learned that too much capital was being deployed on the wind and solar at very low and volatile returns. (Listen to this free podcast to shatter a lot of myths and misconceptions regarding renewable energy). Plus renewable became such an obvious choice, it was a very crowded trade. On the contrary, something that is the most economical and viable solution to energy transition was abused and misunderstood, namely Nuclear Power. I wrote an article on it in Feb -2021. That theme could have been played by investing in :
Nuclear Power Plants - But they were simply utilities have limited upside potential
Nuclear equipment and EPC (Engineering Procurement & Construction) players - but it was difficult to find pure-play Nuclear players. Companies like GE, Hitachi, Mitsubishi, and AREVA, all had different capabilities in Nuclear, but it was a small portion of the entire portfolio
Uranium Miners - I finally decided to invest in the miners as spot Uranium prices were below the marginal cost of production. Uranium miners were overlooked (and hated) stocks. Few large players controlled most of the market. A detailed argument is enlisted in the article.
Similarly, for every theme, we need to understand which part of the value chain would most stand to benefit. It can be the raw material producer, the processor, or someone who builds the final product. The theme just provides the tailwind, but all parts of the value chain do not benefit equally. More often the part of the value chain that has a bottleneck (Uranium miners in Nuclear’s case) or the ones who have the brand and pricing power prove to be eventual winners.
Once we have decided which part of the value chain would benefit, we need to pick the strongest company or a set of companies that have the best chance to succeed. There are nuances to every industry, sector, and company along with associated risks. I have many such stories to share, but, I don’t want this post to be a 10-hour read, hence would save them for future posts.
Screener / Bottom-Up
Bottom-Up is directionally inverse of the Top-Down approach. In the Bottom-Up approach, we start with a company either based on its financial performance and valuation, and then climb up the ladder to the sector to see if the sector/industry has enough tailwinds, what is the competitive intensity, and its probability to excel. Finally up to the top layer, i.e the economy or political environment in which it operates.
Note: For a company to succeed, it does not necessarily need the sector or economy to grow. When we look at sector/industry/ economy, we are thinking of how much the pie is growing. But many companies succeed by taking a much larger share of a static pie. Amazon’s growth did not depend on the growth of the overall retail industry. Uber’s growth did not require growth in the cab industry. Sector, industry, and economic growth are neither sufficient nor necessary conditions for a company to succeed. This is one of the main reasons why top-down investors miss out on several great investment opportunities.
To share one of the many investment mistakes I made, around 2013-14, a colleague shared an idea about a company that makes off-highway tires in India and exports it to the world. Its major clients were mining and farm equipment manufacturers (Caterpillar, JCB, John Deere, etc). As a top-down investor, I was bearish on commodities as I saw China slowing down. I was right about China and the commodity cycle and general mining activity but failed miserably to realize the said company’s ability to gain market share on replacement markets due to better unit economics. That company is Balkrishna Industries. Its revenues in past 10 yrs have grown to 2.8x, Net Profit 5.3x, and share price ~16x (Yes I missed a 16-bagger or 32% p.a compounder).
Back to the Bottom-up process. Besides accidentally discovering a company whose product/service you like, the most reliable way of finding such companies is to run screeners. Screening has two parts:
Filtering - Most screener tools would allow you to filter based on factors like size, growth, financial ratios, etc. I like to use the following filters:
Market Cap
Revenue Growth
Cash From Operations Growth
Return on Equity
I normally do not include valuation in the filtering stage, unless I am looking for deep-value stocks overlooked by markets. (which more often than not turn out to be value traps)
Ranking / Sorting - Once we have the list of filtered stocks, we would ideally want to rank them based on certain metrics. My ideal choice is a 5-year average Return on Equity (ROE). I have also developed a Quick-DCF method which acts like a composite rank to sort the companies. I run a quick and generic DCF on all companies in the list using formulas and sort them based on how far their current price is from this Quick-DCF price. Remember, I use this just to sort and prioritize the list. A DCF without company-specific inputs is useless for final valuation.
Once we have the filtered list, sorted based on our ranking metric, we can start skimming through companies to shortlist ones that we should take up for further study. There are several screening tools available. I use the professional Refinitiv Eikon product. However, Finviz is very powerful and free for US stocks (Screener.in for Indian stocks )
Cloning
We as humans have been trained to be unique, and differentiated and respect originality. So much so that copying is considered sub-par or beneath most people. However, our entire life and civilization are built on copying and improving on the greats before us. Monish Pabrai, one of the greatest investors of our time, claims to be a “Shameless Cloner”. By cloning, I do not mean picking your heroes and turning them into demigods, buying even on the rumor that they might be buying a certain stock. But by cloning I mean we could build upon and internalize ideas from luminaries in our field and see if it is suitable for us as well.
Most of the large and influential investors need to report their holdings periodically. Their holdings can give us a starting list to study, filter, and eventually own stocks that we rationally feel are good investments for us. Two sites that are very valuable for this (besides regulatory filings) would be Dataroma and tikr.
Bonus - Give Serendipity a chance
The last one is not a defined approach, but a confluence of two or more of the approaches mentioned above. Most of my investment ideas have come through serendipity. I would be researching a theme or a sector, but then leave it as it was not interesting, and then suddenly see fantastic results of a company in that sector, and BAM!! For example, I subscribe to an awesome Podcast called Macro Voices. The podcast had a Uranium ETF (URNM) as a sponsor for 6 months on their show. In all their podcasts, I would hear the brief sales pitch on the virtues of Uranium investing every week, but who would be interested in Uranium!! But when I started researching Energy Transition and read about the need for Nuclear Energy, I was able to connect, and DOUBLE BAM!! That investment is still up ~50% in a year or so while the market is where it is. A similar interesting story happened with my Oil and Gas investments, but that is a story for some other time. Subscribe for future posts if you want to hear this and many more such stories.