With approximately 41,000 listed equities globally, how can investors ever generate investment ideas that are both “early” and have attractive risk-reward potential?
In this article, we share the 4 easy ways to generate investment ideas. Additionally, we introduce the concept of crowdedness, a measure of how popular/unpopular a stock, using free and publicly available tools today. We summarized the article with a recent example of how we generated our latest stock idea on ATSG.
Investment idea generation made easy. Let’s start!
4 easy ways to generate investment ideas
Generating investment ideas are difficult enough, let alone a profitable one. Contrary to most investors, we find the idea generation part of the investment process much more interesting than the rigorous stock analysis itself!
Let’s go through the 4 easy ways we use to generate powerful and profitable stock ideas.
Building a strong knowledge base
“An investment in knowledge pays the best interest.” – Benjamin Franklin
Knowledge is never enough and we can all agree on that. Needless to say, it is extremely useful during the idea generation process. Curiosity about how the world works is key. For example, understanding how, why and what the current e-commerce trend is today alone can bring you countless stock ideas (see below). The goal here is to identify secular trends that will serve as the pillar (or one of the) of idea generation.
To elaborate, suppose you concluded that there is an increasing demand for corn in China. An immediate follow up question is what will happen to corn prices? Depending on your analysis, you may want to avoid or increase exposure to corn stocks.
Simple enough? To the contrary, most new investors today struggle to generate ideas. Ideas often start out by sounding “naïve”, before potentially transforming into something tangible and actionable in the market. Our rule is that if the idea doesn’t pass the “grandma test”, then it’s too complicated.
Finally, investors come from all walks of life and therefore should use and share their everyday life experience / knowledge to generate ideas. For example, an aviation pilot may have insights into how freighters work, how they generate money, key issues etc. Similarly, a restaurateur can apply his/hers knowledge about the food/retail sector to generate tangible investment ideas.
We have previously introduced the idea second-order thinking, which we think is a powerful tool to generate outsized risk-reward ratio (on the positive side of course!). Introduced by Howard Marks, the founder of Oak Tree Capital Management, second-order thinking involves the question “And then what?”, aka questioning everything.
To analyze the clear distinctions between first-order and second-order thinking, we use our previous example of the increasing demand for corn in China.
- “Increasing demand for corn in China.”
- “What will happen to corn prices?”
- “What corn by-products will be most affected?”
- “What about corn substitutes’ prices?”
- “How will USD/CNY affect supply and demand?”
It should be clear the second-order thinkers tend to differentiate themselves by delving deeper into the idea itself. What’s unique about this process is that it allows for new, unique and even isolated ideas to be researched in more detail. For example, assuming that soybean and corn are substitutes that are used primarily as feed, the increased demand in corn may imply decreased need for soybean. Now, does that mean that the soybean prices decline is imminent?
Pure play / isolated bets
Another way to generate ideas is through identifying pure plays or isolated bets. Pure plays are companies that are significantly geared towards or have a singular focus to a certain type of goods, products or trends. For example, Shake Shack Inc (SHAK) sells burger, full stop.
In our view, pure plays are the best way to isolate your bets and reflect your analysis in the stock market. By isolating your well-researched ideas, investors are able to limit unknown risks that are associated with other parts of the business that may dilute your idea/return. Of course, this comes at a greater risk, but, that’s why in-depth analysis is required to gain comfort before investing.
For instance, suppose you are convinced that the world will double its burger consumption in the next five years, then investing in Shake Shack would make more sense than say Yum Brands (because it doesn’t only sell burgers), all else being equal. Perhaps that can be argued both ways, but you get the idea. Consequently, we often find pure plays in the small to mid-cap space. This make sense given the structure and focus of the companies.
The concept crowdedness is often underappreciated by the market, especially retail investors, in our view. To put it simply, crowdedness is a measure of how popular the stock is. With big data and technology advances today, a quick and easy way to do is to search a company via Google Trends, search volume or the number of visits to its Wikipedia page etc.
From experience, following the crowd or herd mentality, more often than not produces mediocre returns at best (not to mention losses).
While we’re not advocating to stay away from popular stocks, we do think that investors should factor this into account before investing. Naturally, this boils down to a supply and demand issue. When too many investors are chasing after the same things (crowded), it not only creates a false impression that you are missing out, but also likely to encourage you to overpay for these stocks.
On the flip side, things can also get super interesting when some stocks are extremely disfavored by the market. Consequently, this sometimes create unique stock ideas. One way to identify these are to look at short interest, which is the amount of stocks that have been sold sort but not yet covered or closed out. As a result, stocks with high short interest indicates pessimism among market participants.
So, why would anyone look at stocks that are so hated by the market? Well, the rationale here is about your risk-reward potential. When stocks are heavily shorted, one can argue that the market may be overly pessimistic and risk-reward may actually work in your favor with appropriate research. For example, the stock may go down by 30% or up by 150%.
A great example here would be Ocado Plc, a British online grocery that prides itself on its cutting-edge technology and automation. The stock very much fell out of favor with the market, with short interest peaking at ~20% during the good part of 2015 to 2017. The signing with international grocery partners such as Kroger (KR), Casino Group (CO.PA) and Marks and Spencer (MKS.L) created the sharp turn in investor sentiment, ultimately delivering ~960% since the first deal was announced. It goes without saying that it was also assisted by the massive short squeeze.
Of course, this example is specifically selected to illustrate our point. The key takeaway here is that short interest data creates a source of idea generation.
A brief example of ATSG
Our idea on ATSG came about the continued momentum in the e-commerce trend. Based on our analysis, we remain constructive on e-commerce and view the shift away from traditional channels as being permanent, rather than temporary.
The only problem is that, most investors in the market have the same conclusion, which dilutes our risk-return profile. Hence, there’s little alpha to be made investing in Amazon (as an example) given our view.
Next, we considered what the relevant spillover effects are (second-level thinking) from a booming e-commerce industry. Our goal here is to identify which industry would benefit most from the secular trend.
Through this study, we examined the feasibility of various vertical industries of leading e-commerce including packaging companies, web-services companies, raw material suppliers and logistics companies.
Specifically, we found logistics companies to be straight forward, since its volume depends not only on e-commerce, but also benefit from the need to ship medical equipment, personal protective equipment (PPE) and possibly transportation of vaccine in the future. With the spike in demand, cargo rates would drastically increase.
This is where we stumbled across Air Transport Services Group (ATSG), a small cap air freighter based in Wilmington, Ohio, that counts U.S. Department of Defense, Amazon and DHL. In short, ATSG is an indirect bet and pure play on the e-commerce trend. ATSG flies under most investors’ radar given the size, with a market cap of <$2 billion.
For more on why we added the stock to our portfolio, see our write up here!
In our view, sourcing and generate investment ideas is key in creating odds that favor investors. With more than 41,000 listed stocks globally today, we need an effective method to generate ideas before deciding to do further research.
To summarize, here are 4 easy ways we like to use when generating profitable investment ideas:
- Building a strong knowledge base: Understand what, why and how things work is crucial to build ideas around it.
- Second-level thinking: Always question the obvious to uncover the unobvious.
- Pure plays / isolating bets: Isolating bets and investing in pure plays allows you to reflect your view with maximum impact in a controlled environment.
- Crowdedness: Identifying the extremes in the market often allows for unique stock ideas in the process.
We hope our idea generation framework is helpful to your investment process!