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How To Source Investment Ideas - Imitation Is The Sincerest Form Of Flattery

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During a recent investment forum on my blog, one topic dominated conversation: In a world of roughly 70,000 publicly traded companies, where should one begin their search for actionable investment ideas?

Unfortunately, there is no magic solution for finding good investments. The markets are perimutual, so obvious strategies and mispricings are arbitraged away quickly. I spend most of the hours in my day hunting for buried treasure in the markets, and usually end up digging a lot of dry holes. We read SEC filings, company press releases, proxies of announced corporate events, etc. For those who are more time constrained, perhaps there are methods to stream line?

One could alphabetize the list of publicly traded companies and go through them methodically. That is probably a waste of time, unless of course there are some phenomenal values to be found in businesses that start with the letter A. Quantitative value screens are a common tool that some investors use to find ideas, and are less arbitrary than alphabetizing. However, any tool that's easily accessible is probably also easily priced in to the stock.

Where does that leave us… How about imitation?

One should always do their own work on an idea, and never rely on a third party's premises or conclusion when making a decision. However, other investors' thoughts, opinions and ideas may offer an excellent place to start your own ideas list.

Through sources such as Seeking Alpha, there are hundreds of potential ideas posted every day. As an author and avid reader of investment ideas, I thought I would share my criteria for how to translate ideas into a useful form for potential consideration.

Tense Agreement

Convert any reference to stock price movement from present to past tense when reading any commentary about an investment idea. For example, "Tesla is going up" implies an urgency to get in now, but in reality the stock price already went up. The observed stock price move is in the past already. What is happening now or will happen in the future remains to be seen and should be viewed with a level of uncertainty. The more accurate description is "Tesla went up" and now one must prove whether or not it remains an attractive investment at the new price. Past tense is the grammatically correct tense and a reminder that the writer does not know what the stock price is doing or will do.

In the Press is in the Price

Two core questions to ask when reading any article are, i) what does the writer know that the market does not? and ii) how is this not already in the price? A variant perception will have something unique about the information source or the judgment applied to that information. Such sources probably took a long time, serious effort, and great expense to cultivate. If you don't know your edge, you probably don't have one.

Is it Prospectively Actionable?

There is nothing inherently wrong with someone telling you war stories, but they should do it at night and in person so that you can buy them a drink. An investment idea should involve a security that you can buy at a market price that is worth paying.

There Are Things in Life More Important than Money

But there is nothing in investing more important than money. Your investments don't care about you; they don't even know who you are. So, your relationship should be utterly transactional and devoid of any sense of loyalty to a given investment conclusion. Many investment ideas are presented with the conclusion implicit within the premises. Watch for that, and try to eliminate these biases from your own process.

Incentives Matter

I read psychology and history and apply game theory to the capital markets; I know that human nature is massively impacted by incentives. I try to remain skeptical at all times. About once a month or so, I still find myself thinking "incentives really matter!" having been insufficiently wary of how incentive structures can cause people to believe anything, say anything, and do anything that is consistent with their own interests.

When researching an investment and speaking with management, industry competitors, or analysts, consider how they are incentivized. When reading an article, ask who is the writer: an owner, seller, management, or a high priced helper of one variety or another? You are almost always being manipulated; it is unavoidable. But you can recognize it and partially neutralize the impact by knowing how a given writer is motivated.

Stories are for Children at Bedtime

You know what happened this one time in the market? Anything. Everything. There has probably been at least one permutation of nearly every conceivable phenomenon. Who cares? The past does not necessarily forecast the future, and the recent past certainly does not. Markets mislead and they are unpredictable.

If It Can't Be 100% Wrong, It is 100% Useless

If it can't be wrong, it can't be right for an investor. Investment ideas should be quantified: the upside value in dollars per security, the downside value in dollars per security, the probability of success, and the date. One key part of the definition of science is falsifiability. The reader needs to know how and when a thesis is wrong. If there is no catalyst or standard to judge that catalyst, the thesis is outside of science. If it is an article of faith, you can say, "amen", but you shouldn't ever say "buy" or "sell".

Where Does that Leave You?

Hopefully, with a much smaller list of ideas to research. Over 99% of investment articles fail these most basic standards. But, one in every few hundred is a real idea. Then what? If it is able to define a value, point to a price at a significant discount to that value, and can identify a flaw in the price system that confirms that the mispricing is real, then you can act. More frequently, articles contain useful but incomplete factoids that can be tucked away and used in conjunction with other sources.

Regardless of how good the article, we always start from scratch, redo the analysis, read primary sources and come up with our own premises and conclusions. Typically, we find that although the article meets many of the criteria, the security itself is not meaningfully mispriced. This is where I find it very useful to create an alert list, so that I can reengage at a price I've determined to be attractive. I have found many a mediocre investment thesis that becomes a terrific investment 25% lower. The key is to be patient and avoid mediocre investments, so that you don't have to lose that 25% before the investment becomes terrific. Professional investment managers have activity bias and outside investors to pressure them to act, principals have a great advantage in that they can avoid those pressures and wait for the best ideas to come along.