6/9/16

Financial planners, mutual funds, ETF 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...

Quantitative Screening

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, EV/EBITDA, FCF 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?

Thematic Investing

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.

Comments (90)

4/5/14

Good stuff, like the industry vertical stripping idea. +SB

4/5/14

Love it too.

"After you work on Wall Street it's a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side." - David Tepper

4/11/14

Overselling at industry conferences is to be expected. Got me thinking about next month's SALT.

4/6/14

Andy, home page it!

Snootchie Bootchies

4/6/14

Bondholm:

Andy, home page it!

My thoughts exactly.

4/7/14

2pm!

WSO's COO (Chief Operating Orangutan) | My story | My Linkedin

4/6/14

.

4/6/14

Awesome stuff, as usual.

This is going to sound incredibly sophomoric, but I usually spend at least a little time combing through the "biggest losers" and "biggest winners" over a given time period. This goes for individual companies and sectors/industries. It's definitely not the best means of sourcing ideas in my opinion, but I've found more than a few successful longs and shorts this way.

I often find myself combining thematic investing and "industry vertical stripping" too. Say I find a product/trend that I think can be huge, I will usually break down the value chain to determine the best way to monetize this trend. I think you kind of implied this in the write-up, but maybe it wasn't as obvious to some others. Or maybe I'm just way off base and have been doing it wrong haha.

patternfinder:

Of course, I would just buy in scales.

See my WSO Blog | my AMA

4/6/14

I'd rather just learn how to read lips, then hack into David Einhorn's webcam.

Is that a good idea?

4/7/14

Really appreciate the thread.

How does your idea generation process differ when you are trying to find shorts?

4/7/14

I would be interested in hearing a response to this as well. It seems to me shorts are better in industries that undergo more "out with the old and in with the new" business cycles, like tech, healthcare, and consumer discretionary as opposed to sectors like utilities or financials

Best Response
4/7/14

bmcrhino:

Really appreciate the thread.

How does your idea generation process differ when you are trying to find shorts?

Good question, since the process is markedly different for some analysts. With shorts, things are a bit strange since you basically have a shot clock on your investment and usually have visibility to some sort of catalyst that drives the idea. For the most obvious shorts (like someone below mentioned GME) the catalyst is also obvious, so those things are usually pretty crowded/weak ideas since everyone thinks of the same handful of companies when you sit back and think "so... which industries are dying?"

This is why I very rarely "go looking" for companies to short. The obvious ones are obvious, and the ones that aren't obvious are rarely going to show themselves to you in a time-effective way just by doing first-step diligence. In my experience, analysts who go looking for shorts will find them, whether it means actually finding good ones or convincing themselves something is a short when it really might be more of an "ignore." This is why I try to never do it.

Most of my short ideas tend to come from things I've learned or comments that have been made to me about a certain industry or business as part of the research effort on the long side. A good question I ask myself when I start getting pretty excited about a long is "who is this company going to take share from/displace?" A good example of stumbling on a short recently for me was after getting [ridiculously] bullish on QCOM. On the chip side, I was very upbeat about the direction handset makers were heading, and that vendors would eventually have to do away with discrete solutions in favor of system-on-a-chip. As mostly a discrete connectivity vendor, BRCM would be in the worst position of any of the major vendors if I was right.

I hate victims who respect their executioners

4/8/14

Interesting. I like that quite a bit. It sounds like your fund has a strong long-bias. How do L/S typically create the short side of the portfolio?

I hate to sidetrack the thread a bit, but I've been thinking about this a lot and at my current fund, we seem to take a somewhat macro view on where the markets are, and try to position ourselves accordingly. For example, if we are cautious about the equity markets (easy credit, tapering, tech valuations, etc.), we'll try to hit a certain net long (or short) percentage. While I understand the rationale behind this, I end up spending a lot of time trying to find shorts to hit that percentage range. Naturally I find it quite difficult to find shorts, and feel like I end up wasting a lot of time that I would rather spend finding really unique longs. If we can't find shorts we'll put on hedges via various index ETFs.

Is this a common approach? Or do funds just put on shorts as they come up organically? While the answer is most likely "it depends", I'd be curious to hear your thoughts regarding this.

4/7/14

I like Scott Adams approach. It's worked well for me so far when I have employed it.

"Invest in companies you hate"

http://online.wsj.com/news/articles/SB100014240527...

make it hard to spot the general by working like a soldier

4/7/14

Great post, thanks for sharing. I definitely find the Industry Vertical Stripping part interesting. Like you said, it's fairly easy, but not many people take the time to do the analysis.

"Give me a fucking beer", Anonymous Genius

4/7/14

When looking for shorts I usually look at four things: industry cycle, disruptive technology, future margin compression and stock price (expensive versus inexpensive). If the street already knows the stock is a short its cheap, walk away. Look at GME trading at 14 P/E. Two weeks ago earnings were a disappointment traded down 7% and then ran up 16% due to short coverage.

4/7/14

Thanks for the thread. To what degree do you use employees at your firm for idea generation? I assume ideas are bounced off of each other frequently but each analyst/pm has his/her own method which could deter/encourage otherwise good ideas.

4/7/14

+1 banana, pretty interesting read. I liked reading about your thought process through vertical stripping especially.

4/7/14

+sb

I love your realistic posts.

If the glove don't fit, you must acquit!

4/7/14

Thanks as always for the insight

4/7/14

I am usually cheap as shit with my bananas.....but have a banana!

4/7/14

Great post, thanks a lot.

Can you go into a little bit of detail as to how you approach "vertical stripping"?

I would imagine you could just comb through a succession of 10Ks, using the supplier and customer disclosures to point you adjacent links on the value chain, but was wondering if there was an easier way that you've found useful.

4/8/14

that was good bh. thanks.

4/8/14

@"BlackHat" such an asset to the community. Thanks for continuing to share your thoughts.

+1

4/8/14

Another way of getting ideas out of management is asking who they benchmark against, particularly if there are useful industry metrics. It gives you an idea of how they're comparing themselves against others in some objective way and is something you can come back to if/when you meet them again.

Another - and more direct way - is to ask the "if you could buy stock in a company in XYZ industry that wasn't your own, which one would it be and why". It works along similar lines as strategic acquisition, etc.

4/8/14

alman:

Another way of getting ideas out of management is asking who they benchmark against, particularly if there are useful industry metrics. It gives you an idea of how they're comparing themselves against others in some objective way and is something you can come back to if/when you meet them again.

Another - and more direct way - is to ask the "if you could buy stock in a company in XYZ industry that wasn't your own, which one would it be and why". It works along similar lines as strategic acquisition, etc.

I have a problem with the first portion of this (not in spirit, but in practice) because it's often (read: always) in management's best interest to pick a peer group they can consistently outperform on metrics, or one they would like to use to justify executive compensation. Either of these tends to result in a pretty distorted data set and to be frank, if you don't know the best companies to benchmark the company against yet... then you haven't adequately prepared yourself to speak to management in the first place.

On the second point, it's pretty unlikely you get an opinion from the question that you'd regard as valuable. Now if you know the manager is a fantastic steward of capital and truly understands shareholder value, then maybe that opinion carries more weight... but at the end of the day I've never found that asking explicitly what the best investment in his space (other than his company) would be is a data point I'd view as credible or have any effect on my opinion. I'd rather learn operational differences and draw my own conclusion on what the impact will be to the equity value in the long run.

I hate victims who respect their executioners

4/8/14

Nice, thanks for that write up. SB'd.

I'm talking about liquid. Rich enough to have your own jet. Rich enough not to waste time. Fifty, a hundred million dollars, buddy. A player. Or nothing.

See my Blog & AMA

4/8/14

thanks, interesting thoughts, Vertical Stripping especially. SB.

4/9/14

Great article!

Aircraft engine leasing could be an addition to your vertical stripping of the industry, if you don't already include it under aircraft leasing. Eg. (WLFC) Just to flesh it out some more!

4/9/14

Willis Lease Finance "severely underfollowed" came up on Seeking Alpha weeks ago also. - Link

4/10/14

Held it for last 4 months in my little paper portfolio! Cant read the article at the moment - do pro articles open up to everyone after a time period?

The real beauty in @"BlackHat" 's vertical stripping approach is uncovering parts of a supply chain that I didn't even realise exist like these guys and their engine leasing.

4/9/14

BlackHat:

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.

No, this, in fact, is not the argument that is made.

BlackHat:

Put simply, most analysts are incapable of consistently sourcing new ideas on their own.

You make it sound as if an analyst "sourcing a new idea" is somehow easy or that it should be easy. Analysts, if they wish to yield information that may potentially generate a supernormal return, have to "source new ideas" before insiders, industry experts/specialists and market-movers, and then they must disclose that information before other actors actually act on it.

BlackHat:

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.

Precisely. All of your tips essentially consist of methods, strategies and information that are regularly available to the public and therefore most likely won't yield alpha.

"Elections are a futures market for stolen property"

4/9/14

Esuric:

BlackHat:

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.

No, this, in fact, is not the argument that is made.

BlackHat:

Put simply, most analysts are incapable of consistently sourcing new ideas on their own.

You make it sound as if an analyst "sourcing a new idea" is somehow easy or that it should be easy. Analysts, if they wish to yield information that may potentially generate a supernormal return, have to "source new ideas" before insiders, industry experts/specialists and market-movers, and then they must disclose that information before other actors actually act on it.

BlackHat:

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.

Precisely. All of your tips essentially consist of methods, strategies and information that are regularly available to the public and therefore most likely won't yield alpha.

What? This makes no sense. If it's not available to the public, it's illegal to trade on it.

Admission to elite schools, employment with the best companies, selling your company for millions to google are all things that are "available" to the public; doesn't mean it doesn't take legwork to achieve them.

4/10/14

bonobochimp:

What? This makes no sense. If it's not available to the public, it's illegal to trade on it.

Ding. Try again.

Trading on nonpublic info in and of itself is not illegal...its legality is predicated on how material said info is perceived to be.

4/10/14

Going Concern:

bonobochimp:

What? This makes no sense. If it's not available to the public, it's illegal to trade on it.

Ding. Try again.

Trading on nonpublic info in and of itself is not illegal...its legality is predicated on how material said info is perceived to be.

Conceded - I wasn't aware of the legal technicalities, but if said nonpublic information impacts your decision to trade, is it not material by definition?

4/10/14

bonobochimp:

Going Concern:
bonobochimp:

What? This makes no sense. If it's not available to the public, it's illegal to trade on it.

Ding. Try again.

Trading on nonpublic info in and of itself is not illegal...its legality is predicated on how material said info is perceived to be.

Conceded - I wasn't aware of the legal technicalities, but if said nonpublic information impacts your decision to trade, is it not material by definition?

Not necessarily. Read up on Mosaic Theory.

http://en.wikipedia.org/wiki/Mosaic_theory_(investments)

4/10/14

Esuric:

BlackHat:

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.

No, this, in fact, is not the argument that is made.

BlackHat:

Put simply, most analysts are incapable of consistently sourcing new ideas on their own.

You make it sound as if an analyst "sourcing a new idea" is somehow easy or that it should be easy. Analysts, if they wish to yield information that may potentially generate a supernormal return, have to "source new ideas" before insiders, industry experts/specialists and market-movers, and then they must disclose that information before other actors actually act on it.

BlackHat:

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.

Precisely. All of your tips essentially consist of methods, strategies and information that are regularly available to the public and therefore most likely won't yield alpha.

Sounds like somebody is a big proponent of efficient markets! To each his own I suppose, but believe me - I never meant to (and hopefully didn't to too many others) give the impression idea generation is easy, hence the fairly long post about it.

And this is basically just a comment on efficient markets - and the validity of EMH isn't something I care to try and debate with anybody here - but to address the other point, I disagree with the notion that since all the information is public, you can't generate an above average return by using it correctly. First, plenty of information that is technically public is actually pretty difficult for the average person to dig up. But more importantly, even with all the information right in front of them, it's unlikely that everybody in the market would interpret and apply it in the perfect way to fully understand how it impacts every factor of the underlying business. So just because these aren't tips on how to act on inside information doesn't mean they can't help you find businesses that generate an abnormal return.

I hate victims who respect their executioners

4/11/14

BlackHat:

Esuric:
BlackHat:

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.

No, this, in fact, is not the argument that is made.

BlackHat:

Put simply, most analysts are incapable of consistently sourcing new ideas on their own.

You make it sound as if an analyst "sourcing a new idea" is somehow easy or that it should be easy. Analysts, if they wish to yield information that may potentially generate a supernormal return, have to "source new ideas" before insiders, industry experts/specialists and market-movers, and then they must disclose that information before other actors actually act on it.

BlackHat:

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.

Precisely. All of your tips essentially consist of methods, strategies and information that are regularly available to the public and therefore most likely won't yield alpha.

Sounds like somebody is a big proponent of efficient markets! To each his own I suppose, but believe me - I never meant to (and hopefully didn't to too many others) give the impression idea generation is easy, hence the fairly long post about it.

And this is basically just a comment on efficient markets - and the validity of EMH isn't something I care to try and debate with anybody here - but to address the other point, I disagree with the notion that since all the information is public, you can't generate an above average return by using it correctly. First, plenty of information that is technically public is actually pretty difficult for the average person to dig up. But more importantly, even with all the information right in front of them, it's unlikely that everybody in the market would interpret and apply it in the perfect way to fully understand how it impacts every factor of the underlying business. So just because these aren't tips on how to act on inside information doesn't mean they can't help you find businesses that generate an abnormal return.

I'd also add that a large portion of analysts don't consume the proper public information. Many analysts don't read 10Ks, 10Qs, or proxies. A lot of things are 'hidden in plain sight'. Further, many only have a base-line understanding of a business and don't do the deep dive necessary. Sometimes you don't need a differential insight from intelligence or understanding, you just need to dig deeper.

IMO.

4/11/14

Seriously? They don't read 10-k's? I'm not doubting you... but i'm not sure what i'd do if I didn't read that stuff. I guess go on sell side research reports?

4/11/14

I'm completely serious.

Other analysts have told me they're too busy to read them, read one a month, etc. They rely on conferences, sell-side research, discussions with management, and other analysts for idea generation and 'research'.

4/11/14

Value Sleuth:

I'm completely serious.

Other analysts have told me they're too busy to read them, read one a month, etc. They rely on conferences, sell-side research, discussions with management, and other analysts for idea generation and 'research'.

I've never met anyone who would openly admit to that. Maybe some macro fund who's just picking high-beta within a sector or something? Nobody in real life who actually picks individual stocks for a living...

I hate victims who respect their executioners

4/11/14

BlackHat:

Value Sleuth:

I'm completely serious.

Other analysts have told me they're too busy to read them, read one a month, etc. They rely on conferences, sell-side research, discussions with management, and other analysts for idea generation and 'research'.

I've never met anyone who would openly admit to that. Maybe some macro fund who's just picking high-beta within a sector or something? Nobody in real life who actually picks individual stocks for a living...

Really? I've met some who flaunt it with a sense of pride.

My boss doesn't read the whole thing - just the first half (doesn't read the notes) - and only reads them occasionally.

Drives me nuts.

4/11/14

Somebody at a conference I was at recently pitched AOL as their favorite long - I only read the 10k - and I asked them about their relationship with Google (which they derive ~16% of their revenue from) and he had no idea what I was talking about. It's disclosed on page 9 of the 10k.

4/11/14

How did you react?

I'm talking about liquid. Rich enough to have your own jet. Rich enough not to waste time. Fifty, a hundred million dollars, buddy. A player. Or nothing.

See my Blog & AMA

4/12/14

Matrick:

How did you react?

I was really too surprised to say anything. I told him that it was within the first 10 or so pages of the 10k and that it was something I'd want to look into if I were to do a deep dive.

My greater point is that due diligence on the Street is often quite shitty, even at buy side shops, and tremendous value can be added by actually doing work. I tend to focus on why something would be cheap and look there for idea generation (which markets are in chaos? why are they irrational?). But sometimes they'll be in plain sight - BlackHat's comments on Qualcomm illustrate this. Massive company, well-covered, but the quality of the business is/was unappreciated (I felt this way about Microsoft when it was at $24). Sometimes you can find great investments just by doing work.

4/12/14

Where does investing based on what you think changes in regulation are going to do to a group of stocks? (say, European Banks) Is that catalyst investing or thematic?

4/12/14

Catalyst.

4/13/14

I second the comment that some analyst do not read 10k's. I am familiar with one shop where analysts only screen stocks and rank them using CPMS. Then they pick top quartile stocks and read sell side research reports and pick 2-3 stocks to present to PM ...

4/14/14

Do you have any suggestions for idea generation in global macro?

4/16/14

There's actually firms making money off of this. http://www.knowledgeagency.com/content/enhanced-in...

I'm talking about liquid. Rich enough to have your own jet. Rich enough not to waste time. Fifty, a hundred million dollars, buddy. A player. Or nothing.

See my Blog & AMA

4/16/14

My $0.02: Great ideas don't get shared until they are no longer great. If you have a great idea you invest in it, you dont sell it.

Doog37

4/16/14

Doog37:

My $0.02: Great ideas don't get shared until they are no longer great. If you have a great idea you invest in it, you dont sell it.

Negative. You invest in it and THEN sell it to drive the price up. Jim Cramer knows what I'm talking about.

4/16/14

I mean you don't sell while it is still a great idea. You don't need to sell it yourself (although you probably should) to have the price driven up. If something is a great idea you dont need to do anything.

Doog37

4/16/14

Great post BH, thanks.

Out of curiosity, would you/ do you guys ever use any "expert network" services? I had never known about them until recently. My understanding is that they're basically knowledge brokers where if you want to learn more about something before investing, they (for a price) go out and find you an expert on the topic to talk with. Seems like a pretty interesting idea.

4/16/14

Dr.Seuss:

Great post BH, thanks.

Out of curiosity, would you/ do you guys ever use any "expert network" services? I had never known about them until recently. My understanding is that they're basically knowledge brokers where if you want to learn more about something before investing, they (for a price) go out and find you an expert on the topic to talk with. Seems like a pretty interesting idea.

All the time. I don't remember if I mentioned it in the past but I could probably write an entire post just on how to use expert networks effectively. Once I decide to start getting serious with a name and doing a full-blown deep dive, I usually use networks like GLG, Guidepoint, and Coleman to find a good cross section of niche experts to help me build that mosaic when there's certain aspects of the business I can't comprehend on my own or where I need actual industry operators' opinions. It's a great concept and I think it's worth the money when used properly, but more and more funds are using the same networks (most people use GLG exclusively) and end up all speaking to the same few experts, so the information isn't as alpha-generating as it used to be.

I hate victims who respect their executioners

4/18/14

Very Informative

4/19/14

I was taught by my former experienced boss about the thematic investing. Pretty much he does what you have written up there.

Neat piece. Thank you for posting this, BH.

Fortes fortuna adiuvat.

4/20/14

https://doc.research-and-analytics.csfb.com/docVie...

MM's white paper covers a lot of the same topics as BH with some more in-depth analysis if any of you monkeys want a deeper dive.

4/25/14

kidflash:

https://doc.research-and-analytics.csfb.com/docVie...

MM's white paper covers a lot of the same topics as BH with some more in-depth analysis if any of you monkeys want a deeper dive.

I must say very good read! Nice find.

I'm talking about liquid. Rich enough to have your own jet. Rich enough not to waste time. Fifty, a hundred million dollars, buddy. A player. Or nothing.

See my Blog & AMA

4/25/14

ya. MM is brilliant regarding competitive advantages/strategic analysis.

4/24/14

solid write up

happy to give advice; no asking for referrals please

4/24/14

insightful stuff here

4/25/14

@blackhat

https://doc.research-and-analytics.csfb.com/docVie...

Industry mapping note from CS last year.

"After you work on Wall Street it's a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side." - David Tepper

4/25/14

lol great minds think alike.

4/25/14

kidflash:

lol great minds think alike.


haha, sorry, didn't see your comment.

"After you work on Wall Street it's a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side." - David Tepper

4/25/14

thanks BlackHat, this was a terrific read (+sb by the way). since my practice is less focused on absolute return and more on capital preservation, I always enjoy reading what the absolute return guys have to say.

quick question, how does your group view risk? do you view risk like Buffett does "risk comes from not knowing what you're doing," do you quantify it like std dev (or some other metric), or do you do something else? curious to hear your thoughts on this.

"The four most dangerous words in investing are: 'this time it's different.'" - Sir John Templeton

"The investor's chief problem - and even his worst enemy - is likely to be himself." - Benjamin Graham

4/25/14

thebrofessor:

thanks BlackHat, this was a terrific read (+sb by the way). since my practice is less focused on absolute return and more on capital preservation, I always enjoy reading what the absolute return guys have to say.

quick question, how does your group view risk? do you view risk like Buffett does "risk comes from not knowing what you're doing," do you quantify it like std dev (or some other metric), or do you do something else? curious to hear your thoughts on this.

We are, perhaps too much so, oblivious to the typical portfolio management metrics and the sort of risk gauges you think of in an academic sense. I know we keep track of this stuff for investors who care, but as far as our analysts and portfolio managers go, we follow that value-esque mantra of "risk is what happens when you pick bad businesses." I don't know what our beta is, what our standard deviation is, our drawdown, or whatever else people look at... Sharpe ratio, that's another one. Never factors into our decisions. The idea is that as long as we're picking good companies with limited downside and buying them with a margin of safety, "risk" takes care of itself. Everyone's different though, and nobody's more right than someone else. And it's certainly important to look not only at a manager's returns, but how they achieved them. A repeatable process is essential but that doesn't always show up in portfolio risk management metrics. Perhaps it would be a different story if we used leverage or had a more diversified portfolio, less sticky capital, or something else.

I hate victims who respect their executioners

4/29/14

great post

"A man travels the world over in search of what he needs and returns home to find it." ~George Moore

5/17/14

Yes I really like this forum. The industry stripping and supply chain analysis is especially provocative. If you are not an aspiring investment banker or professional who seeks to make this entire professional to industry interaction a complex quantitative endeavor, then try picking apart the domestic oil and natural gas industries---lots of juicy lucrative returns. Follow the upstream companies to the midstream transporters and refineries all the way down the supply chain to the downstream deliverers and POS stores. The ancillaries are the contractors and engineering firms who design and construct the pipelines and refineries.

12/26/14

Love it +SB for you sir

Strength & Honour
Lads pass exams

12/28/14

Damn. Great post

12/28/14

Awesome post deconstructing the herd mentality to idea generation. I can see it when I run quant screens on selected metrics then compare it to our sell-side coverage and 8-9/10 are overweights.. Screening is a good start point to define your universe but it shouldn't be the sole determinant of where client capital ultimately is deployed.

"Go for a business that any idiot can run - because sooner or later, any idiot is probably going to run it." - Peter Lynch

12/29/14

Because it's not hard, the market is basically random. Sure, you can pick a good company--but you have no idea how that company will be 20 years down the road. You can say buying McDonald's is not gambling, because it's probable they'll do well ten years from now. However, if you sell ten years down the road at a lower price, it's "oops, you made a bad investment." At least with trading I know the odds and can manage my risk. Passive investing is often fruitless. Don't forget to wake up at 4 AM EST to sell on FDA approval.

4/8/15

Franklin:
It's about something that gets me pretty hard and excited to wake up every day morning.

huh?

Moving on...

I think it would be helpful for you to know that companies that go into the portfolio are either

1) Things that have been research in the past and now are trading at an attractive valuation
2) Screened and added to the portfolio (this is what your post relates too)

At my shop, in addition to the typical screen we look at every single bankruptcy or spin-off/spin-out that hits the Street.

On top of that, I would say that the best ideas typically come-up organically.

For instance, my friends were recently buying a new couch. We found that the company that manufacturers it is publicly traded, based in Italy (so the stock is beat-up) but its single largest end-market is the U.S., and it trading for near cash value.

Follow me on Twitter: https://twitter.com/KarateBoy

4/8/15

Good idea on the spin-off, indeed a good starting place for more leads. A quick Google search brought me to this: http://www.rocketfinancial.com/spinoffs/ but I'm guessing there are more outthere--Are there any particular websites you look at for this?

I see what you mean when you say best ideas come up organically; I remember seeing Crocs being sold at my high school store and everyone around me started wearing them (or at least claims they own a pair or bashes it relentlessly). Too bad I didn't dabble in the market back then. Vibram five-fingers was another example, but this time around they are not public.

The reason why I raise the question (and thanks for your answer) is because doing research is time consuming, and given I am working full-time I want to maximize the effect of my effort.

4/8/15

KarateBoy:
For instance, my friends were recently buying a new couch. We found that the company that manufacturers it is publicly traded, based in Italy (so the stock is beat-up) but its single largest end-market is the U.S., and it trading for near cash value.

name?

4/8/15

MMmonkey:
KarateBoy:
For instance, my friends were recently buying a new couch. We found that the company that manufacturers it is publicly traded, based in Italy (so the stock is beat-up) but its single largest end-market is the U.S., and it trading for near cash value.

name?

I guess since I pitched the stock during my interview process and we don't know own it I can be explicit:

http://finviz.com/quote.ashx?t=ntz

Follow me on Twitter: https://twitter.com/KarateBoy

4/8/15

KarateBoy:
MMmonkey:
KarateBoy:
For instance, my friends were recently buying a new couch. We found that the company that manufacturers it is publicly traded, based in Italy (so the stock is beat-up) but its single largest end-market is the U.S., and it trading for near cash value.

name?

I guess since I pitched the stock during my interview process and we don't know own it I can be explicit:

http://finviz.com/quote.ashx?t=ntz[/quote]

Did the issue of trading volume come up in your interviews? If so, would really be interested to hear how you addressed it.

4/8/15

The advice I always give people on this is pretty vague but here it is, for what it's worth. Look around for an industry that you are interested in, specifically one that's been around for a long time. Sit down and chart out how that industry's product or service gets from the most basic supplier to the end consumer. You might think it's very simple to do but for every industry that's been around a long time, even/especially ones that seem to not be profitable for most participants on the outside (e.g. autos, airlines), but there's always way more going on than we first think when we start researching an idea or an industry. Somebody in there has to be making money, right? The further off the beaten path you get the better, and sometimes you end up stumbling upon some odd extremity of an industry that you never knew existed and is actually really profitable (and if obscure, hopefully cheap).

I hate victims who respect their executioners

4/8/15

BlackHat:
The advice I always give people on this is pretty vague but here it is, for what it's worth. Look around for an industry that you are interested in, specifically one that's been around for a long time. Sit down and chart out how that industry's product or service gets from the most basic supplier to the end consumer. You might think it's very simple to do but for every industry that's been around a long time, even/especially ones that seem to not be profitable for most participants on the outside (e.g. autos, airlines), but there's always way more going on than we first think when we start researching an idea or an industry. Somebody in there has to be making money, right? The further off the beaten path you get the better, and sometimes you end up stumbling upon some odd extremity of an industry that you never knew existed and is actually really profitable (and if obscure, hopefully cheap).

For many different industries have you done this for?

I think it's a great idea but your PM has to be aware that this is a pretty time-consuming process.

Or is this something you build upon in the background?

Follow me on Twitter: https://twitter.com/KarateBoy

4/8/15

KarateBoy:
BlackHat:
The advice I always give people on this is pretty vague but here it is, for what it's worth. Look around for an industry that you are interested in, specifically one that's been around for a long time. Sit down and chart out how that industry's product or service gets from the most basic supplier to the end consumer. You might think it's very simple to do but for every industry that's been around a long time, even/especially ones that seem to not be profitable for most participants on the outside (e.g. autos, airlines), but there's always way more going on than we first think when we start researching an idea or an industry. Somebody in there has to be making money, right? The further off the beaten path you get the better, and sometimes you end up stumbling upon some odd extremity of an industry that you never knew existed and is actually really profitable (and if obscure, hopefully cheap).

For many different industries have you done this for?

I think it's a great idea but your PM has to be aware that this is a pretty time-consuming process.

Or is this something you build upon in the background?

Plenty of industries. And ya, it definitely takes time but good ideas always do. But definitely becomes more of a thing where you just start knowing a couple industries really well and things tangentially split off of that as you do research on something. It's just hard starting at first.

I hate victims who respect their executioners

4/8/15

Thank you. It's time to dig.

4/8/15

BlackHat:
The advice I always give people on this is pretty vague but here it is, for what it's worth. Look around for an industry that you are interested in, specifically one that's been around for a long time. Sit down and chart out how that industry's product or service gets from the most basic supplier to the end consumer. You might think it's very simple to do but for every industry that's been around a long time, even/especially ones that seem to not be profitable for most participants on the outside (e.g. autos, airlines), but there's always way more going on than we first think when we start researching an idea or an industry. Somebody in there has to be making money, right? The further off the beaten path you get the better, and sometimes you end up stumbling upon some odd extremity of an industry that you never knew existed and is actually really profitable (and if obscure, hopefully cheap).

Seconded. Bloomberg function SPLC is a decent starting point.

4/8/15

Franklin:

seeking alpha

I'd be very skeptical of Seeking Alpha. Half of the contributors are college kids or failed industry vets that fold quickly when challenged.

4/8/15

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I hate victims who respect their executioners

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