My Investment Research Process (Part 3a) – Stock Idea Generation

First of all, apologies for the lack of update. I have been recently too busy with my own personal commitment and my university mid terms was round the corner as well. And with the little time available, I reckon it will be best used to read on some of the stocks under my watch list. Nonetheless, the time was well spent and I managed to add another HK-listed stock into my portfolio. As a close-to-monopoly manufacturer, the fundamental of this company is of top-notch quality and I believe at my entry price, it is undervalued.

Moving on to my blog topic, I thought it will be good to continue on my investment research process after receiving an email which queried on my methods in picking good stocks. By no means do I advocate that my methods are the best but I thought it will be good to share my methodology and perhaps sharpen iron with iron among the fellow value investors in my blog sphere.

Stock Idea Generation

One of the failures in investing – whether value, technical, etc – is to silo yourself into becoming a “one-trick pony”. As the saying goes, “To the man with a hammer, every problem is a nail.” And unless one decides to be a part-time investor where new investment is made only rarely, then it is a basic pre-requisite to be able to identify potential stock investment through different means.

I remembered I started out investing by analysing only the balance sheet and with the limited skill, I thought I was well-versed in investing and every “less than 1x P/B ratio” looks like a potential ten-bagger to me. How naive I was back then! And slowly through my learning journey, I have come across different means of generating stock idea:

Stock Screening

By far the most basic way of generating stock idea is to create a stock screen of relevant filters. Stock screening can be executed either via a Bloomberg terminal or manual browsing of stock data provided in The Business Times (Singapore context). What stock screening basically does is to filter out (from a universe of stocks) a list of stocks that meet your basic filter requirement. Some of the filters which I normally used are low TTM P/E ratio (less than 6x) or low P/B ratio (less than 1x). Thereafter, I will select additional information such as market capitalisation, amount of net cash position and dividend yield. The main advantage of stock screening is mainly to reduce the searching process workload for an investor. Though that by itself is a huge benefit, the method of stock screening is not necessarily flawless. Sometimes, attractive stock can still be ‘missed’ by such stock screening. Consider a simple case of a stock trading at perhaps 7x P/E but it may be facing a very strong earning driver likelihood. Or maybe there might exist a stock which trades at 9x P/E but half of its market capitalisation is in fact net cash – this means it is trading at 4.5x P/E ex. net cash. Of course, one can simply readjust the filter requirement. However, allowing a more lax restriction will simply generate a larger list of stock, which generally defeat the main benefit of stock screening. Hence, using stock screening implies a trade-off of research workload reduction and the cost of missing attractive stocks which are not detected by such screens.

Blogs, forums & other websites

Investing websites such as blogs or forums can also be another good source of stock idea generation. The concept behind such is simply to ride (though not entirely) on the work of other investors. The financial market is a place of millions and millions of agents and each one of them is constantly searching for their next attractive stock buy. Some of them keep it to themselves while others may share it on their own investing blog or forums. And if you keep your eyes opened attentively to these website, there might be a chance of finding a good buy. As Monish Pabrai said in his book, “The Dhando Investor,” “It’s often better to be a copycat than an innovator.” Of course, as mentioned, the advantage is mainly on the free-ridership of searching for attractive stock but the disadvantages are plenty as well. For instance, there is a lack of due diligence if you rely fully on the work of others. You are also on the “mercy” of their disclosure if this method is your only means. In other words, there is nothing you can do but to wait for people to post their stock idea (if they are willing). Lastly, it is normally quite seldom before you can chanced upon a good buy. Hence, chances of obtaining good buys via this method are slim.

Exchange announcements

My current favourite. My frequent source of stock idea generation is via the daily corporate announcements of SGX and HKex. What this basically entails is that corporations are required to announce specific events such as huge corporate acquisition, quarterly results or changes in stake ownership of its substantial shareholders (SSH) where the last example is my common trigger for finding attractive buys. I normally keep an open eye to companies which announce open market purchases by its own SSH. These SSHs can be either its own management directors or investment funds who have taken a huge stake in the company. Again, the idea behind this is  to ride on the information that these people possessed. In other words, when SSHs made an open market purchase/sale, they are actually sending a signal to the public that they are confident/skeptical about the company’s performance and hence, have invested their own money into it. But this is not flawless as well. It is by no means that an investor can safely commit his capital to a stock simply because the management have invested in it as well. As Warren Buffett had mentioned before, management will always think that their stock is cheap. However, by keeping an eye to the above, chances are likely that you can stumbled upon an attractive stock.

Thematic plays

This, in my opinion, is the source which requires the most skill and knowledge in. Thematic plays are simply a combination of first top-bottom analysis and then a bottom-ups approach. Though this is one source which I have utilized the least, I have also come to recognize its effectiveness as well. This is so because thematic plays provide the relevant earning drivers to an industry (i.e. “Rising Tide” Theory), which means that there is a readied catalyst to realize your stock undervaluation. How this is done is simply to identify a theme and then to research on every stocks that might be affected by the theme. For instance, one may find that consumerism is a rising trend in China. Thus, with that theme, an investor will research on every possible consumerism stock that will likely to benefit from this theme. The main advantage of such thematic plays is from the effect of second level thinking (which has been very clearly explained by this blog post) where an investor does not simply look for easy-to-find thematic links but actually digs deeper into beneficial companies that are less likely to be recognized by the public eye. The disadvantage of thematic play is the constraint of time allowed for your research. Unless one is able to anticipate a favorable theme in the future, he/she will normally find that companies beneficial to favorable themes are often already traded to its fair value.

A-to-Z method

This is the most effective but yet most tedious method. As the name suggests, the approach is simply to run through the entire list of exchange-traded stock – from A to Z – and then picking out stocks which have favorable fundamental qualities. Perhaps, the assuring comfort from this method is that an investor will almost definitely find an attractive buy. However, the biggest disadvantage to this method is in the huge time commitment required. To estimate how tedious the process is, consider a part-time investor who will be devoting around 4 hours of his/her time each day to reading through every stock. In addition, assume that an investor will need around 8 hours to understand an average company. For a total list of 772 stocks under SGX, this will take at least 1544 days (around 4 years) to complete. Of course, one just simply skip a company if a simple glance can conclude its potential. But what I am driving at is that unless one is able to commit full-time to investing, this method is often very inefficient. By the time you reach a stock (in the latter alphabets) that might possess excellent business fundamentals, it may have already become fully too expensive to purchase.

Conclusion

The above list is not exhaustive and I am always on the midst of discovering new ways of generating stock idea. However, an investor should always acknowledge that stock idea generation is only the first of many further steps in concluding an investment decision. A wise investor will not commit his/her capital simply because the stock falls under a stock screen of certain metrics or have been purchased by SSHs. Instead, such means will trigger potential stocks to be research and a wise investor will conduct his own intensive due diligence before making an investment decision.

Next Post: An elaborate discussion on the next step: Business & Financial Analysis