Financial planners, mutual funds,managers, and even Warren Buffet all say the same thing: the average investor is not capable of picking stocks and is better off investing passively. The debate of Active vs Passive investing and which is more efficient probably can't be won, so my opinion on that particular topic doesn't really matter. The argument is of course that the average investor has some other day job that makes educated stock selection too difficult, and even most actively-managed funds can't outperform the index on average. I tend to agree with this sentiment, but not for the academic reasons usually cited...
Whether it's mutual funds or hedge funds, the number of "closet indexers" out there is remarkably frightening. And the reason they're closet indexers - Believe it or not, an alarming number of managers (with similar strategies, of course) are looking at the same set of companies at a given time. Put simply, most analysts are incapable of consistently sourcing new ideas on their own.
While no idea can be truly original, being one of the first and/or one of the few to discover a drastically mispriced security, impending catalyst, etc. is how an analyst or firm can make a killing in a hurry. By the time your indexers (think asset managers, overly-diversified hedge funds, etc) and dumb money (momentum, retail investors) are in, the return potential is mostly behind them. What's left is often little more than just a market return.
Common Sources of New Ideas
Every buy-side analyst is taught what I'll call the basic, most popular ways of finding companies to research. In order of prevalence (or at least my best guess), along with the pros and cons of each method...
As the name suggests, this is simply the construction of a list of securities that fit your specified quantitative characteristics. These are used most often to filter for statistical cheapness on a P/E,/ , Yield, or other valuation metric, but can also be used to screen for companies of a certain quality based on margins, ROIC, ROE, etc. Especially with CapIQ, FactSet, and other data providers, this becomes an efficient way to build a watchlist of companies that appear very cheap while still having financial results within your specified parameters. The disadvantages to running screens are essentially the same as the advantages.
First, they're easy to run, so there's nothing particularly value-add from the analyst in using a screening tool to find potential new ideas. It's funny how often I'll hear from different analysts that they're looking at the same few names that we've all seen come up on valuation screens (think TNH, CA, MSFT, anyone?). Not an easy way to be original, that's for sure.
Second, there's always trouble with trailing numbers and screening based on financials in a single year can often be misleading. Every company is different, and even if something appears cheap on trailing (or forward) numbers, we may be missing something cyclical or a one-time event that makes the valuation less meaningful. Third, screens ignore catalysts, which is why (if anything) they are often more effective for long-only/buy-and-hold investors than for investors with a shorter horizon, like hedge funds. I can discuss more in the comments about why I don't like relying on this method for deciding what names to research, but this is high-level (and just one uneducated man's opinion).
Sell-Side / Word of Mouth
Most monkeys on WSO have probably heard enough stock pitches to know how common idea generation by word of mouth / idea sharing is in the industry. But here's the thing about other people's ideas: most analysts share ideas with more conviction than they'd have with their own money. There's no harm done in hearing the high-level thesis and both sides of the investment case, then deciding if it's interesting enough to do your own diligence... but when you're immediately presented with a conclusion and cherry-picked data points from a biased party, it can definitely affect the way you interpret things as you do your own research.
Another drawback is that by the time colleagues at other funds (or anyone publicly sharing an idea) are pitching a stock to you, the cat is probably out of the bag and you won't be getting a price nearly as good as the one they got. To state the obvious, David Einhorn isn't going to share an idea at a conference until he's fully invested in the name already. And let me reiterate - because even large portfolio managers are guilty of it - NEVER take someone else's word for it no matter how great the idea sounds. Always do your own work before you start pouring real money into someone else's idea, because I guarantee you they're overselling it.
The sell-side is another source of ideas, albeit a non-BlackHat approved one, since a buy rating isn't exactly worth the same amount coming from the brokers. Initiating reports can be very helpful in getting up to speed quickly on a business, and they tend to be much more objective in nature than most other reports you'll see from that analyst later on the business. Also, it's not uncommon for salespeople to spill the beans on trades other firms are making, as disgusting as it sounds, so I guess if that's your thing...
Public Disclosures: 13-Fs
Every public equity fund files their domestic long-only holdings 45 days after the quarter in the form of a 13-F. These are as much a goldmine of good ideas as they are of misinformation, so it's always important to filter them properly to holders with a long-term view that makes the 45 day lag time less meaningful. The benefit is of course the ability to get a snapshot of plenty of great investors' portfolios and see which are their top holdings, increased/decreased positions, new positions, and exits. I find these valuable to comb through in aggregate, taking note of the most frequent new positions and exits across a basket of funds that I respect.
Something to keep in mind when combing through 13-Fs is that plenty of funds like to "window dress" their portfolios at the end of the quarter to mask certain investments or appear to be holding names through the quarter that they really didn't have. Also, since short positions and international equities are not reported, you never quite know what's going on under the hood, even with the longs... for example, a popular play among Tiger Cubs when it was difficult to borrow TSLA was shorting the box (meaning they were short the stock while simultaneously holding it long elsewhere) and 13-Fs would misleadingly suggest they were all long TSLA in size. To state the obvious, 13-Fs aren't going to give you any indication of what the actual reason for holding a security is. This makes mutual funds and other long-only investors the most transparent filers and my favorite among 13-F reporters when thinking about new long-term ideas.
Abstract/Unorthodox Sourcing Techniques
Aside from the above methods that every analyst (or retail investor for that matter) is pretty much able to use, there are plenty of unique strategies to finding ideas that aren't as accessible to everyone. In my opinion, these are more effective in finding names that are off the beaten path, and thus better opportunities for outperformance. There's a countless number of tips and tricks that analysts develop over their careers, so I suggest picking everyone's brain when it comes to some of the unorthodox ways they discover new companies. I'll share two of the more common "uncommon" practices and one of my own methods, though I'd love to hear from you guys on yours in the comments as well.
Management or Industry Referrals
This one could almost fit into the category of being a common source of new ideas, but in my experience there's really an art to it, and simply asking an executive something like "who do you like/hate" is often a waste of time. No CEO wants to sit around and talk about someone else's company, and the best way to "mine" a manager for interesting companies in the space isn't to explicitly ask them for a list anyway. My favorite way to go about it is to dance around the conversation of the company's competitive position and see if they mention any specific businesses (on their own) as a leader or laggard in segments where they compete.
To put it another way - if you ask Google what their opinion of Microsoft is, you're going to get a scripted, politically-correct answer. If you ask them who scares them the most in the enterprise business and they say it's Microsoft, now you have a free avenue to start talking specifically about what MSFT does well and what advantages they have over everyone else. (At the end of the day, most of this is common sense in social interaction...) Other questions I like to ask: is the industry entirely rational, or is there anyone you think is throwing the industry out of whack? Is there anyone you would consider a good fit with your business, either to acquire or as a strategic partner? Is there a certain manager in the industry you respect (or dislike) most? Who else is taking share and why?
A lot of people like this, a lot of others hate it... but it's hard to deny the knee-jerk "who makes those?" question when you stumble upon a product everyone's buying or a fad you think could be dying soon. Buying a stock on anecdotal evidence like seeing a crowded Apple store or a few positive product reviews is pretty foolish, but identifying high-level themes is useful in at least pointing to a certain sector or subsector where you can snoop around. From there, due diligence on the subsector as a whole should get you down to one or two names that are particularly interesting one way or another.
The most current example I can think of to describe this is the insanity surrounding firearms and ammunition since the beginning of the Obama administration, and accelerated by Sandy Hook and other mass-shootings. The theme in this case was obvious: certain types of ammunition and "assault rifles" were going to be under heavy scrutiny and began flying off the shelves at any dealer you could think of. The tough part isn't identifying the validity of the theme - this one was actually very easy to validate - but picking apart the sector to find the best way to invest in it.
There's the gun manufacturers, but there's a lot of them and no real way to build confidence in just one or two, so after some research it became clear that wasn't how I wanted to play it. Ammunition was a bit more intriguing, given the weapons and types of ammo used in these tragedies was widely publicized, the "who makes this stuff?" question actually becomes very valuable and ultimately led to us investing in ATK, owner of the Bushmaster line of firearms and ammunition. To this day ammo continues to be a scarcity (and a fantastic investment in and of itself) and ATK, along with the gun makers and other ammo producers, has had a ridiculous run... but ATK was able to outperform the theme itself, and that's where I argue that identifying valid themes isn't enough (unless you want to buy the entire sector, like some thematic investing funds which actually do this exclusively) and traditional research takes over from that point when it comes to finding the company in the best position to benefit from it.
Industry Vertical Stripping
This is a personal favorite of mine since it's easy, it's obvious, yet nobody takes the time to really do it. Along with a colleague, we've become enamored with our own version of what we call "vertical stripping," the process of simply mapping out, in as much detail as possible, the value chain of an industry from the most basic supplier to the end user, in order to identify all the companies along the way, with the objective of - in the case of looking for long investments - finding where all the margin is going.
Our favorite example is the airline industry: it's been around forever yet is known as being a terribly competitive and unreliable business... despite the fact that we continue to pay higher and higher airfare for basically the exact same service! So where's all the margin going? [If I could upload a picture of a napkin drawing, this would be the place I do it] Well, at the top there's the aircraft OEMs (BA, EADSY) operating a duopoly, and even above them the engine manufacturers who are highly consolidated with only 3 major players (GE, UTX, RR) and a duopoly above that in investment castings (AA, PCP). Most of these businesses earn very strong returns on capital, and we've already found a decent number of advantaged businesses worth learning about. Moving below the plane makers we have to start thinking about how aircraft are bought and placed among the airlines. Are there wholesalers, brokers, or what? Well there actually is something similar to a wholesaler... another strange business that doesn't get a whole lot of attention - aircraft leasing (AL, FLY, AER).
Moving on... Once the airlines actually have the planes, there's other ancillary businesses to consider - things like fueling (INT) and even infotainment (WIFI). You could spend a lot of time mapping out ancillaries, but in terms of major rungs on the ladder, the next one down would be the distribution network through which customers find their desired routes and make a purchase. This includes travel agencies, particularly online (EXPE, OWW), and the intermediaries between the TAs and airlines: the relatively obscure Global Distribution Systems (AMADY, Travelport). These businesses have absurd returns on capital and until recently, free cash yields in the mid-teens. At the travel agency level we can finish the exercise by including some ancillary businesses surrounding the actual reasons for travel, including hotel accommodation vendors (PCLN) and review sites (TRIP), not to mention things like rental cars (HTZ, CAR) and the actual hotels themselves (HOT, MAR). I bet a portfolio of all these tickers would look pretty impressive over the past 5 years, but hindsight is 20/20.
So which of these ideas is "the one" worth my time?
Unfortunately, I don't know the answer because that depends on your strategy, which aspects of the stock you value most (i.e. valuation vs quality/opportunity, catalyst, etc), and your opportunity set. It also depends on how many new names at once you are capable of effectively initiating... and thus what level of diligence you plan on doing. That number is going to vary wildly depending on your level of concentration, size, etc.
Keep in mind there's an unlimited number of ways to generate new ideas, no single method being uniformly better than another. Also keep in mind that my methods and personal preferences when it comes to research/analysis carry no more weight than yours, so don't force anything on your process that doesn't naturally fit on its own. With that being said, I'll be happy to field questions - related or otherwise. Let's hear how you find your winners!
Mod Note: Best of WSO, this was originally posted December 2014.