How Do You Find Value Investment Ideas?

by: David Tuzzolino, CFA

Summary

It’s easy to drown while trying to drink from the fire hose of information that is the stock market.

After 25+ years of value investing successes and failures, I've come up with my 11 favorite shortcuts to finding promising companies.

Did I miss any shortcuts? How do you find value investment ideas?

I've got the fire roaring, eggnog in hand, enjoying some downtime during the hectic holiday season. The New Year is approaching, which inevitably has me looking back over the investment year that was. There were some successes and, as always, there were some failures. I still flinch while thinking about my ill-timed "deworsification" into the Russian stock market.

One question I always try to answer is, "How exactly did I find my best ideas?" Value investing is for investors with a long-term outlook and simply looking back over the last year is not going to be very informative. The sample size is too small and not enough time has elapsed to let investment themes play out. So instead of just looking at the past year, I decided to go back a little further.

During my investment career, I have spent a substantial amount of time searching for excellent value ideas. But finding that one gem in the ocean of possible alternatives can be overwhelming. It's easy to drown while trying to drink from the fire hose of information that is the stock market. So over time, I have unearthed many useful tools that have helped me to discover great ideas. Some of these shortcuts started off extremely useful and continue to be powerful, but some simply didn't pan out or lost their efficacy.

I went back over the last 25+ years of my investing career and tried to recall how I first stumbled across each successful investment idea. I then narrowed this list down to the top 11 ways to find new ideas that I have found most useful. The list progresses from least to most valuable.

Traditional Media - I wasn't sure if I should include media on this list as it can really be more of the delivery mechanism for the other criteria below, but I have been spurred to look closely at a company because of information I've gathered through various media outlets, including newspapers, television and business websites. I tend to find investable concepts more than individual stock picks using traditional media, and there is a ton of noise, but there's a lot of good information out there if you look hard enough.

Removal From an Index - Obviously, when a stock is dropped from an index, there is forced selling by index funds that hold the name. However, the index sponsors also try to game the system. Companies that are added to an index tend to be sexy and on an upward trajectory, while companies that are dropped from an index tend to be stodgy and are often out of favor. The oversold cast-offs can be an attractive place to discover value investments.

New CEOs - This really depends on the specific situation. If a company's CEO is retiring after being named Time Magazine's "Person of the Year", when the company's stock price is at an all-time high, it's not going to attract my attention. If a CEO is pushed out by the board after failing miserably, now we're talking! A new CEO can make a huge difference in the right situation. Companies that tend to benefit the most from a change at the top tend to have a smaller market cap, a manageable debt load and strong free cash flow.

Biggest Percentage Losers - I check the biggest losers list every day. Most of these stocks deserve the sell-off, but every so often a great idea can be salvaged from this discard pile. When bad news comes out, many investors sell first and ask questions later, if ever. I've worked as an equity analyst and I have seen this first hand. The thought of going into a client meeting with a dog that dropped 40% makes investment professionals cringe. Stocks that drop dramatically often sail right past true value.

52 Week Lows - This is another list that I check every day. What's on the list? Why? It's a fantastic way to spot industry trends as well as to find individual companies that have been left for dead. It's a fantastic list to use to find bargains, but just because a stock is at a 52-week low, it doesn't mean it's undervalued.

Exiting Bankruptcy - Companies that are overlooked with a checkered past can often lead to very attractive gains. Bondholders often receive equity when a company emerges from bankruptcy and many times they sell it quickly, depressing the company's share price. Organizations that are exiting bankruptcy often have smaller debt loads and have shed unattractive businesses during their reorganization, yet are still covered in the taint of failure. If you feel your nose wrinkling as your face contorts into a look of disgust upon hearing the name of a company that imploded into bankruptcy, but is now emerging, you may be on to a great investment idea.

Insider Buying - A sizeable open market purchase by an individual with intimate knowledge of a business can be a fantastic buy signal. However, there can be a lot of noise. Ignore small, insignificant purchases and stock acquired through options. Pay more attention to open-market purchases by company management with a good track record of buying and selling stock, especially when there is size to their trades.

Gurus - Do you have a team of 20 well-paid, remarkably intelligent and highly-trained analysts at your disposal? No? Neither do I, but many successful value managers have this and much more. So why not utilize their resources? I don't tend to get too excited when I see that 40 hedge fund managers own Apple, but when a highly-respected value manager purchases 5% of a $100 million company, then I tend to take notice. Always pay attention to the type of manager you follow as some trade frequently and utilizing their public filings is not advisable. However, there is an extended list of value managers with long-term time horizons and superior track records that trade infrequently.

Untraditional Media - I would include blogs and newsletters in this category, including Seeking Alpha. Ideas from untraditional media can be hit or miss, but I've cultivated a small group of analysts/investors that I genuinely trust and rely on. Unlike many of the other resources I use to find investment ideas, I can assume that the ideas presented by this trusted group will be well-thought-out and worth a second look. I'm always searching for smart investors that share the same value investing methodology as myself.

Sentiment - As a value investor, I want to see high negative sentiment. The more hated and despised a company is, then the more interested I become. When everyone is negative, the slightest positive news can start to move a stock upward. I have always viewed traditional academic value screens as a measure of sentiment. The reason most companies are trading in the bottom decile of book value is that they are hated. Some of my favorite valuation screens include price/book, price/sales and EV/EBITDA. If these metrics are depressed, you likely have a company with very poor sentiment.

Spin-offs - I know. I'm sure many of you are cringing, wondering why you should sit through another narrative on why spin-offs are so great. I agree…but they still work. I won't go through all of the reasons that spin-offs tend to outperform as the information is freely available across the internet. If the information is so freely available, shouldn't the strategy stop working? Yes, it should. But when going back through my investing career, I have used the strategy to consistently find huge winners. I imagine that spin-offs will lose their ability to outperform eventually, but I don't believe we are at that point just yet. Index funds still dump spin-offs that are not in their index and individuals still dump the 25 share position that has magically appeared on their brokerage statement. Although investors need to be more selective when investing in spin-offs today, especially when many savvy investors are familiar with the strategy, there are still excellent opportunities available.

Hopefully I've been able to outline a strategy or two that readers will find helpful. Undoubtedly, there are many more strategies that successful investors use to uncover great value ideas that I have missed. I'd love to hear from the Seeking Alpha community.

How do you find value investment ideas?

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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