Source: Barron's Chinese
Author: Kenneth Jeffrey Marshall
Good investments do not have friends like bad news does.
Mature investors, after developing investment philosophies and analytical methods, still require investment ideas—clues and hints about which companies are worth spending time researching. Given the vast number of companies in the market, it is impossible to study them all, so priorities and focus areas must be established.
Kenneth Jeffrey Marshall, author of 'Value Investing: The Art of Buying Undervalued Stocks,' summarizes seven sources of investment ideas, with the most intriguing being the first source: bad news rather than good news. This is because people's reactions to bad news are often excessive, creating investment opportunities. This excerpt is from Chapter Nineteen, 'Sources of Investment Ideas.'
The value investing model requires stock investment ideas to function effectively. These ideas come from various places, some more productive than others. I believe there are seven distinct sources of investment ideas.
The first source of investment ideas is bad news.
Stories about companies often emphasize extreme elements within a given event. These extreme elements are magnified in headlines, driving human actions that sometimes go too far. This can lead to significant fluctuations in stock prices, whereas a calmer consideration of facts might result in less volatility.
Overreactions stem not only from retail investors but also from professional fund managers. For instance, hedge funds reporting their holdings at quarter-end may avoid holding stakes in well-performing companies that have faced embarrassing moments, fearing limited partners might be scared away.
Sometimes, stock prices may fall due to news coverage but drop excessively. Take Anheuser-Busch, producer of Budweiser beer, as an example. In 2005, newspaper articles seemed to suggest that beer's golden days were over, as alternative beverages like vodka mixed with Red Bull gained popularity among younger consumers. My analysis of Anheuser-Busch revealed its core business remained strong, yet its stock price fell regardless.
While I was reflecting on this repeatedly, my father invited me to watch a baseball game in San Francisco. I lost count of which team was visiting and who won the match, but I clearly remember what I observed at the stadium: people were drinking a lot of beer.
My observation can hardly be considered advanced market research, and this took place at a baseball field in the United States, where people naturally drink beer in such an environment. However, it was a real scene that illustrated that the good times for beer were not over. Not long after, I purchased shares of Anheuser-Busch at $45 per share.
By November 2008, three and a half years after I bought the stock, Anheuser-Busch was acquired at $70 per share. This investment, including dividends, yielded me an annualized return of approximately 15%. I neither sought new stocks nor liked acquisitions (on this point, I have clearly explained in Chapter 17). However, paying taxes on realized gains is one of the most welcome forms of pain for investors in the financial world.
At other times, stock price declines influenced by news are entirely justified. For instance, in September 2015, as the Volkswagen emissions scandal came to light, the company's stock price immediately dropped. Although the situation was still ongoing at the time of my writing, Volkswagen had systematically evaded regulatory requirements, which was unacceptable. Moreover, even before the crisis, Volkswagen was considered a poorly managed company, with its return on invested capital leaving much to be desired. For intelligent investors planning to hold stocks for decades, such a company could hardly be regarded as an investment opportunity.
In some rare instances, stock price movements influenced by news are entirely unjustified. This may occur when a story affecting one company causes trading in another company’s stock. For example, when Twitter prepared for its initial public offering in November 2013 using the stock ticker TWTR, it led to a dramatic surge followed by a sharp collapse in TWTRQ, which was the trading code for Tweeter Home Entertainment Group's common stock, a bankrupt electronics retailer.
Bad news often includes genuine tragedies. Security breaches jeopardize privacy, train accidents cause injuries, and foodborne bacteria lead to illnesses. Conscientious investors do not wish for these unfortunate events to occur.
However, sensational reports can trigger irrational panic. The gap between price and value widens further. Intelligent investors aim to bridge this gap. Good investments do not have friends like bad news.
The second source of investment ideas is spin-offs.
A spin-off refers to the separation of a subsidiary company that was previously part of a publicly listed parent company, resulting in the subsidiary also becoming a publicly traded entity. The spin-off process typically begins with a stock distribution, where shares of the parent company are distributed to shareholders as a dividend, forming a newly independent subsidiary. Subsequently, these new shares begin trading on the market.
Typically, the original shareholders of the parent company are institutional investors. When the spun-off shares start trading, they may sell them automatically because the new shares fail to meet their formal investment thresholds, such as minimum market capitalization. This forced selling may depress the stock prices of both the parent and subsidiary companies if they are otherwise understandable, well-managed, and worthy of investment.
The third source of investment ideas is regulatory filings.
Many national governments require investors with substantial shareholdings to periodically report their holdings. These reports are publicly disclosed. By comparing reports across different periods, one can ascertain which stocks have been purchased by talented professionals.
In the United States, regulatory authorities mandate that fund managers overseeing assets exceeding 100 million U.S. dollars must report their holdings in U.S. companies quarterly (with some exceptions that do not require disclosure). This type of report is known as Form 13F and must be submitted within 45 days after the end of each quarter, subsequently being published on the U.S. Securities and Exchange Commission’s website. Regulatory reviews occur mid-February, May, August, and November.
There are numerous limitations in delving into the details of Form 13F reports. However, understanding the content of these reports can help investment strategies become more effective.
The first limitation is that one must know which professionals are worth following. It is relatively easy to identify fund managers of standout mutual funds from the reports since their performance records are publicly available. However, private equity fund managers may only share their records with clients. Moreover, professionals managing portfolios within larger corporations (even publicly traded ones) might never disclose detailed information about their past investment performance.
Without understanding a professional's track record, it is impossible to truly determine whether they are worth following. Fame is not synonymous with performance. I am often astonished to find that individuals with consistently lagging performance over the years maintain high-profile public personas, while some genuine investment stars remain largely unknown.
The second limitation is that Form 13F reports only disclose long positions and do not include short positions. As such, these reports are rendered useless when analyzing fund managers who match long and short positions in single, effective bets. Mistaking the long position in such a bet for the entirety of the wager (due to ignoring the short position) can be highly risky.
The third limitation is that Form 13F reports do not disclose the purchase price of the stocks. Although one can study the low prices during a specific quarter and conservatively conclude that the purchase price would not be lower than the lowest price of that quarter, no further details are provided in the reports.
The fourth limitation is the time lag. Stocks that were just purchased may have already been sold 45 days after the end of the quarter. Similarly, sold positions may have already been replaced by newly acquired ones.
The fifth limitation is that the report itself may drive up stock prices. When a well-known professional purchases a particular stock, many may blindly follow suit, eliminating the once-attractive lower price that initially signaled the stock’s value.
The sixth limitation is that stocks appearing for the first time in a Form 13F report may not actually have been purchased. They might have been acquired during a subsidiary asset spin-off. Additionally, fund managers may even begin selling the stock between the date of receipt and the reporting date. Such scenarios could be entirely contrary to what might have seemed like a promising investment idea.
The seventh limitation is that authoritative bias may lead to blind imitation. Investors who are psychologically unable to adhere to discipline might thoughtlessly mimic a certain guru. However, gurus can make mistakes too. It is best to treat the first appearance of a stock in a 13F report as an 'invitation' to conduct a thorough analysis from scratch.
A different cognitive bias may prevent you from reading 13F reports: the uniqueness bias. This bias might make you feel that delving into 13F reports seems like following the crowd, but this is incorrect. Consider the following analogy.
Imagine a restaurant owner who has opened a restaurant in the downtown area. Every quarter, the restaurant owner receives a letter from a trusted authority, disclosing some major actions taken by the most successful restaurants across the country. In one quarter, the letter reveals that the most successful restaurants have raised the price of soft drinks by 5%. In the next quarter, the most successful restaurants purchased a fryer, and so on.
Would the restaurant owner receiving these letters dismiss them as useless junk and throw them away without a glance? Of course not. These letters are rich in accurate information and may even contain beneficial investment ideas, akin to the best trading magazine you could imagine, but they are free and contain no errors. Moreover, simply by carefully reading these letters, the restaurant owner can optimize and upgrade the restaurant's services without any additional obligations.
Investors who ignore 13F reports are like restaurant owners who throw these letters away as junk. This is a strange and limiting behavior. A better approach is to thoroughly examine 13F reports while fully aware of their flaws and limitations, ensuring that the knowledge gained does not compromise your own decision-making autonomy. No one is requiring us to replicate the trades of a particular authority figure, nor is anyone mandating that a restaurant owner must buy a new fryer. Disclosure is not prescriptive.
The fourth source of investment ideas is reorganization.
Reorganization refers to transformative events within a company, such as an acquisition, a significant change in capital structure, or the sale of a major division. These events often involve complex issues that only investors familiar with such intricacies would be interested in resolving.
Other complexities may deter many people. This limits the breadth of potential buyers and could result in a decline in stock prices.
The fifth source of investment ideas is small-capitalization stocks, also known as small-caps.
These stocks typically have a market capitalization below $2 billion. Institutional investors may find it difficult to purchase shares of such small-scale companies for two reasons. First, the institution’s charter may prohibit the purchase of stocks with a market value below a certain threshold. Second, even if institutional investors are permitted to buy small-cap stocks, doing so may not necessarily be beneficial.
Imagine a mutual fund with assets of 50 billion USD that identifies a company with a market capitalization of 500 million USD as having strong growth potential. Even if the fund purchases 10% of the latter's shares and the share price doubles, the overall performance of the mutual fund would hardly be affected. The gains might barely reach one-tenth of 1% of the fund’s total value.
These two factors lead most firms in the asset management industry to avoid investing in small-cap stocks. This could potentially suppress the prices of these stocks, making them worthy of attention for institutions and individual investors managing smaller amounts of capital.
Investing in small-cap stocks can exhibit certain characteristics of shareholder activism, which advocates for reform in companies where equity is held. There are two reasons why investing in small-cap stocks is worth considering. First, it is sometimes necessary. Management teams of low market capitalization companies may exploit the absence of large institutional investors to engage in activities they would not undertake under stricter oversight. Second, it is feasible. Executives of small companies may be more accessible or easier to reach compared to those of larger corporations. It is not uncommon for the president of a small firm to respond quickly to emails. In short, small-cap stock investments allow investors to become more deeply involved in the affairs of their portfolio companies, an approach favored by astute investors.
The sixth source of investment ideas is stock screeners.
Stock screeners are internet-based tools used to filter stocks according to specific quantitative parameters. They are typically based on valuation metrics. For instance, one can rank stocks by their price-to-book ratio to generate a list.
Investment ideas derived from stock screeners are not my favorite. Long-term investors prioritize understanding a business first and observing whether it operates well. Starting with valuation seems to reverse the natural order. Furthermore, stock screeners may shift focus to companies operating on the periphery of financial environments, which might fail to attract those committed to lifetime investing. Nevertheless, many powerful investors excel at leveraging stock screeners to generate investment ideas.
The seventh source of investment ideas is serendipity.
Serendipity involves a mindset prepared to gain insights from everyday life, requiring interaction with the world. While luck plays a role, it does not occur randomly; instead, it favors open minds.
My initial interest in Clas Ohlson, a Swedish company, was sparked by serendipity. It is a home improvement chain, and every time I walked into its hardware store in Stockholm, there always seemed to be many customers making substantial purchases. After analyzing the company, I found it to be well-managed. Had I dismissed the spontaneous thoughts that came to mind, I might have overlooked this company.
Incidentally, this particular discovery was not perfect. In my view, the stock price never became low enough to attract me to buy. Moreover, I was somewhat overly enthusiastic in my search for uncertain evidence.
During my trip to Sweden, I often hurriedly entered the stores of the Clas Ohlson chain to confirm that its appeal was not limited to Stockholm. Indeed, it was not; all stores had customers. Later, on a weekend afternoon, I walked into one of the company's stores located in Helsingborg, on a major pedestrian street. The store was completely empty. It dawned on me. As I peered down the aisles to make sure I hadn’t missed anyone, a woman emerged from behind the counter and said to me, “Sorry, we are already closed.”
Serendipitous discoveries also help us draw conclusions about alternative companies. In 2012, I was analyzing Tesco, a British grocery chain. Investors whom I admired had purchased shares in this company. Additionally, I was impressed by the countless convenience stores on Monk Street in London. Tesco had everything I wanted, meeting all my expectations.
The following month, after returning to California, serendipity struck again. I noticed an advertisement for a new supermarket chain called Fresh & Easy. I discovered that this chain was owned by Tesco. I visited the nearest store to my home in Mountain View. The quality of the products was excellent, the prices were very reasonable, and the staff was courteous.
Of course, the staff were polite because I was the only customer in the store. I ceased my analysis. Since then, Tesco’s stock price has plummeted, partly due to declines in same-store sales, with the nearby Fresh & Easy store certainly contributing to that trend. Today, that convenience store has closed.
Serendipitous discoveries are particularly helpful when searching for companies in customer-facing industries such as retail. These companies are highly exposed to public view. However, individuals may possess deep familiarity with less visible industries because they work in those sectors or have substantial knowledge of their backgrounds. Serendipitous discoveries play an equally significant role in those fields.
Serendipitous discoveries also produce a delightful effect: enhancing relevance within ordinary environments. Everything becomes evident. The logos on people’s shoes, the number of passengers on airplanes, the brands of dilapidated elevators—all these details allow us to better assess what people buy, what products companies manufacture, and which products are popular. This does not force one to live in a state of heightened vigilance; instead, it provides a framework for intelligent investors to manage their thinking.
These seven sources of investment ideas merely serve as inspiration for the value investing model. None of them grants preferential treatment to any particular idea as it passes through the value investing model. In fact, once an investment idea is input into the model, it is best to forget how it originated.
The advantage of this approach is clear. When we forget whether we focused on a company because it was spinning off subsidiary assets, because a top-performing investor had invested in it, or because its stock price had plummeted, we can eliminate numerous cognitive biases. We obtain raw materials worth processing, along with the clear-headedness required to process them effectively.
Looking to pick stocks or analyze them? Want to know the opportunities and risks in your portfolio? For all your investment-related questions,just ask Futubull AI!
Editor/Rice