Investment Checklist I: Hunting for ideas

This is the first in a series of posts inspired by Michael Shearn's work The Investment Checklist. I'll be following a chapter-wise format as provided in the book. I will also follow up points made in the book with my own commentary of my understanding so far. For any examples provided in the book, I will use Indian examples for my own benefit (and hopefully for yours too).

This post deals with generation of investment ideas. Quite frankly, I am boggled with the multitude of options illustrated in investing literature on how to make money. The answer perhaps lies in developing your own strengths, learning about your biases and making informed and rational decisions with a long term perspective. Investment ideas can be qualitative or quantitative or both. Let's start with hunting grounds for investment ideas.

At the outset, Shearn warns his readers quite prophetically -

"You need to mentally prepare yourself in advance with the idea that you will not have many outstanding investments in your lifetime."

Are we indulging in intellectual masturbation here? What is the point of this all, if you're not going to get rich. No, no. I didn't say it. If you're a Munger fan and practice second-level thinking, you've probably already figured it out - most of your money will be made in just a handful of investments. So pull no punches when opportunity presents itself. But how many punches - if you're listening to Buffett, no more than 20!

Some places to seek new ideas:

1. Times of crisis undoubtedly present exceptional opportunities. Take for example the Asian crisis of 1997-98, the tech bubble of 2000 or the mortgage crisis of 2008. Most of the these opportunities arise out of forced selling. This happens when institutions must make good on large-scale client redemptions. Even though fund managers may have some inclining that the stocks they're dumping are intrinsically undervalued, they have no choice but to meet their mandates.
   
2. Other examples of forced selling include selling after a stock is dropped out of an index. This usually happens because stocks are ousted as index constituents based on some mathematical computation (such as market cap). Spin-offs may also present If such stocks are fundamentally sound, they may present good opportunities.
   
   Comment: In the Indian context, I am unaware of any academic study which checks the stock performance of stocks which dropped out of indices. But the exercise may be worthwhile. With regard to spin-offs too, I am not very well informed. In recent times, Syngene IPO and the run up in both its stock and that of its parent Biocon may be a worthwhile consideration [post forthcoming].
   
   

   

   Syngene and Biocon (after listing of Syngene)

3. Broad market sell-offs: look for sectors which are in greatest distress. In other words why is capital scarce in such sectors and why are investors fleeing? Invert and ask yourself, when the
   cycle reverses - which companies will stand to gain the most.
   
   Inversely, which sectors seem to have an abundance of capital? Which sectors have highly leveraged balance sheets and appear to be heading into bubble territory? These may the ones to avoid.
   
   Comment: As an illustration I compared the BSE Metal Index with the Sensex. Metals unde-performed the broader market for three years from 2012 to 2015, but staged an impressive comeback in 2016 during which time Sensex has been almost flat [post forthcoming].
   
   

   

   Sensex v/s Metals (2013-15)



Sensex v/s Metals (2016)

4. Stock-specific sell-off: When bad news hits a particular business, investors dump the stock quickly. This can be good hunting ground if you can make the distinction between permanent and temporary distress. Take for example, Buffett's investment into American Express after the Salad Oil Scandal.
   
   Comment: In the Indian context, think of the Maggi fiasco. Or more recently, the Welspun cotton-issue or promoters at VRL saying they will get into airlines. Are these investment bets for the future? I don't know. But if you do your homework and find the distress temporary and inconsequential to long term profitability for the companies, these may present good buying opportunities. [posts forthcoming]
   
5. Stock screens: Tools like screener.in are indispensable to retail investors. They help us quickly sort through a multitude of companies using financial indicators which are most important to us. But perhaps, screens are too simplistic. When the devil lies in the detail, some caution is warranted. A principal concern can be in the nature of accounting itself. One needs to look at real earnings [post forthcoming]. Also, if you're looking at earning multiples, a temporary loss can throw a company out of the screen. Most importantly, without the necessary tools build into a screen, it's difficult to investigate the qualitative aspects on an investment thesis such as management integrity.
   
   Comment: For example, Lycos Internet is always thrown up on my screen whenever I use return metrics for screening. But it's trading at PE of 0.88 currently! Surely something must be wrong here? Could this be a case of creative accounting? [post forthcoming].
   
6. Low lifes: It maybe worthwhile to investigate companies which are hitting 52 week lows. Some companies may be deservedly in the list, but some may be going through temporary distress. If you can connect the dots with point 4 related to stock specific sell-off, you may find good bargains.
   
   Comment: For example, look at Speciality Restaurants. The company has been hitting lows since its IPO. But they have no debt on their books and whenever I've been to Mainland China, I've always been pleasantly surprised with the quality of their service. A turnaround could augur well for shareholders. [post forthcoming]
   
7. Coat-tailing: Following investments of renowned investors and betting with them is called coat-tailing. It can be incredibly useful to hunt for investment bets. A word of caution is warranted here. Without an investment thesis, betting your money is akin to gambling. So while coat-tailing may be a good idea to discover companies, without independent research you cannot build conviction.
   
   Comment: Investments above a certain percentage of shareholding of the company or monetary value must be disclosed as Bulk/Block deals to the exchanges. These can be the mostly timely indicators of interest by seasoned investors. Annual reports also carry names of top ten shareholders besides promoters and management.
   
   
8.  Buying shares to track a business: Sometimes you need motivation to get things going. This involves buying small quantities of some companies which look interesting but where you've not completely formed your investment thesis. These holdings generally don't affect your overall portfolio (consequently, you can't expect to gain enormously if these do well too). Paul Sonkin of Hummingbird Value Fund calls this the grab bag. This idea maybe seem to be at odds with Warren Buffett's 20-punch rule, but examples like American Express come very infrequently. In most cases, conviction builds over time. The idea is to keep these holdings in your mind space and research in greater detail (even if valuations aren't very rosy). In the long run, when the iron is hot, you'll know where to strike.
   
   Comment: I've been guilty of indulging in some investments with this point of view. Consumer discretionary businesses like Wonderla Holidays and Mahindra Holidays present some examples.
   
9. Looking inside: Sometimes you already own the best ideas and don't need to go looking around. When valuations are favourable and your original investment thesis is still at play, you can buy more stocks of business you already own. Think in terms of opportunity costs.
   
10. Researching IPOs: Shaern points to something important - while researching IPOs, you don't have any prices to disrupt your valuation process. Without availability bias, you're likely to form an independent opinion of the company. Soon after listing, you can validate your valuation against the market quoted price. IPOs are inherently cyclical in nature (just look at the money raised in 2016 compared to previous years). In a bull market, valuations can be exaggerated. Having an independent opinion can save you from losses. Moreover, many IPOs are likely to be those of new-economy firms. Tracking changing industry trends in the market can serve in the long haul.

This list is obviously not exhaustive. To an amateur whose just starting off though, this list can be handy. To cut it short, ideas can be discovered anywhere. If you're a Peter Lynch follower you'd keep an eye for brands in the supermarket too.

Please note: I'm not a SEBI registered investment advisor and my discussion of stocks is not a recommendation to buy/sell/hold or transact in any way on the stock exchange. Please do your due diligence and make informed decisions.