Finding buy ideas in ten steps.
"Today's sound bite culture reinforces the popular impression that investing is easy, not rigorous and painstaking" - Seth Klarman
Investing is full of rules of thumb to help you pick the next winner: Look where others aren't; buy what's hated; allow a big margin of safety. The list goes on.
Most of them have more than a grain of good sense, but if you focus on them too much you risk underplaying the thoroughness that supports every good investment case.
Every time you buy a stock you're saying (or should be saying) that the market is undervaluing it - and to make that assessment, you need to understand very clearly how it makes its money, and whether it's likely to continue doing so.
That can take many hours of research into the business and its competitors, suppliers and customers. Your aim should be to understand the business like an owner - which, as a shareholder of course, you will be.
With that in mind, here's a 10-step guide that may help you find your next winner.
Step 1: Find a business
There are plenty of different places to look. Stock screeners, business media and discussions with other investors all provide fertile ground. Warren Buffett had a more simple approach - he got himself a list of all the stocks on the market and went through them from A to Z.
Step 2: Filter the business
We don't have time to look at everything out there. We're trying to find businesses that are underappreciated. That could be an average business going through a bad patch or a great business currently masquerading as merely good. But you need a reason to think the market is underestimating it.
Step 3: Understand the business
Many new stock ideas will fall at this hurdle. You need to recognise your circle of competence. If you don't think you'll be able to understand the business, then move on.
Step 4: Understand the industry and competitors
To understand how (and why) a company is able to make money, you need to understand where it fits in its industry value chain. Does it or its customers, suppliers or competitors add the most value? Who could be replaced by cheaper alternatives? Who calls the shots?
Most importantly, think about how things will look in the future. Is there a new technology that could disrupt the status quo? Michael Porter's 'five forces' provide a useful framework for thinking about these things. Scuttlebutt can also help: talk to suppliers, customers, employees.
Step 5: Evaluate management and culture
A cracking business with crooked management is a recipe for disaster. Look at management's track record; not only where they worked, but how they performed in those roles.
You want management that is capable, dedicated and acts in the interests of shareholders. The third of these is the most important because, as Warren Buffett has noted, without it the other two will kill you.
Culture can be even harder to assess from the outside, but there's a lot of truth in Tolstoy's observation that 'Happy families are all alike, but every unhappy family is unhappy in its own way'.
Great corporate cultures often show themselves by the absence of serious problems. Be wary of companies that have recently faced significant disruption, such as changes of ownership or major restructurings, or where there are signs of a disengaged workforce.
Above all, watch out for red flags. Too many of them and it might be wise to pass on by.
Step 6: Understand the financials and accounting methods
Comb through the notes to the accounts for each line item on the financial statements. It's important to know how the company accounts for things like revenue and assets. It can sometimes help you uncover value or risks that weren't immediately apparent - and that other analysts might miss.
Ask yourself if you would account for things in a similar way, and be prepared to make adjustments to the published numbers if it better reflects the underlying value.
Step 7: Make loose projections
Once you've looked through the accounts and the historical statements, you're in a position to make some projections.
It's better to be roughly right than precisely wrong, so don't try to get too specific. Often, it's better to come up with a range of projections; optimistic, pessimistic and base case scenarios, for example. Make sure the projections are realistic, and that you can justify any of the assumptions you've made.
Step 8: Select a valuation method
Here, you have a number of choices. Discounted cash flow method, the gordon growth model or taking the replacement value of the business are all valid options. The choice you make should match the characteristics of the business. Often it makes sense to use several different valuation methods to cross-check.
Step 9: Seek outside opinion
It's easy to get caught in a bubble going through this process. Find some smart people and test your ideas. Hopefully they'll highlight some things you hadn't considered. At Intelligent Investor, we do this through our Dragon's Den process.
Step 10: Find a place in your portfolio
If you've made it here, and the stock trades considerably below your valuation, congratulations. You've found a new buy idea.
The final step is to understand where it fits in your portfolio. How will it affect your overall balance of risk and reward and will it help you meet your goals. Consider the risk inherent in the individual stock and how it might combine with others to affect the risk of your portfolio.
If you're still keen to buy it and have the cash available, then you can go ahead and buy it; if not, then you'll first need to find something to sell. For that, it might help to look at our Guide to Selling Stocks.
For a more comprehensive guide to value investing, take a look at our book, Value.
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