How to Improve Results

How I Filter Investment Ideas

My investment process can be divided into two main categories:

  • Idea generation
  • Investment research and due diligence

These are the two areas that I spend the vast majority of my investment time (portfolio management and execution is a distant third).

There is a lot of information in the value investing public domain on how to determine the quality or degree of undervaluation of various securities. There isn’t as much information on how to think about the actual search process. In other words, before spending a lot of time going through the process of due diligence on a specific security, you need to filter through many ideas (presumably) that don’t make the cut.

It can get overwhelming when coming up with ideas. It’s easy to float from idea to idea, gaining a cursory understanding of many ideas, but never putting yourself in a position to make an educated and informed decision.

So how do you go about simplifying the search process?

I’m not sure I have a great answer to that question, as I tend to want to cover a lot of investment ground myself. But I can share a few ideas that have helped me simplify my process, making it more methodical and systematic.

Where to Find Ideas

Investing is part art, and part science. The art part enters in various phases of portfolio management, valuation, position sizing, and selling, among other topics… The science part comes into play (in my opinion) in the search process. There might be some subjectivity here too, but for the most part, I’ve tried to refine the investment search/filter process down to a science.

I’ve discussed my search process before. Basically, to broadly summarize… the places I often look for investment ideas are:

  • Reading, Reading, Reading (Newspapers, Blogs, Google news alerts, etc…)
  • Value Line (I try to flip through each issue each week, which sometimes uncovers an idea or two)
  • 13-F’s
  • Screens

These are the basic areas I look for ideas. Pretty straightforward and routine. Reading generates the most interesting ideas typically and 13-F’s are a reliable way to keep abreast of what the best value investors are thinking about.

The Science of Filtering Ideas

Setting up a search routine is helpful, but you still need a method to filter ideas. I think of the search process as a conveyor belt that brings me idea after idea. One after another… the ideas keep coming so I need to have a systematic way of filtering these quickly and efficiently.

I’ve come up with a few quick questions to ask myself in order to quickly qualify an idea. These are very general questions that are only designed to disqualify ideas, rather than decide if they might be good ideas. Here are the questions I ask as ideas come past me on the conveyor belt:

  • Do I understand the idea?
  • Is it cheap?
  • Are there any catalysts? Insiders?
  • What are the risks?
  • Will it double?

These are very basic, but they help me quickly determine if I should remove the idea from the conveyor belt and save it for further evaluation. Understanding simply means that I have a basic idea of the business and understand why it might be undervalued. It doesn’t necessarily mean in depth understanding at that moment. Being able to tell if it’s cheap should be quite easy. If this is difficult to explain, it might not be worth moving forward. Complex situations sometimes provide hidden opportunities, but most of my great investments have all been quite simple, and sometimes even obvious.

Risks are important to consider. I divide risks into three broad categories to think about:

  • Valuation
  • Leverage
  • Business

I want to decide right away if I am taking on valuation or leverage risk. Usually if there are risks in either of these categories, I will pass. Business risk is harder to quantify, and sometimes takes more analysis. If I understand the idea, I’m willing to give this some room for further evaluation.

The last question “will it double?” seems too basic, even somewhat frivolous… but I like to ask myself this question to remind myself that a good investment has upside potential. A 95 cent dollar might have very little risk, but the risk it does have might not warrant the 5 cent upside potential. I’m looking for low risk 50 cent dollars, hence the question: “will it double?” It’s just another way of asking: “Is this a 50 cent dollar?” I usually don’t know the answer to this question when the idea first arrives on the “conveyor belt”, but I want to ask it right away. I want to begin thinking about the risk as well as the upside, and how those two relate to each other as soon as possible. An idea with lots of upside but too much risk needs to be disqualified. A very low risk idea with not much upside similarly needs to get disqualified.

I’m fond of the saying: “Take care of the downside and the upside takes care of itself”. I live by these words, but there has to be upside available if it is going to take care of itself. This is important to remember.

So I might not know if the idea is a low risk 50 cent dollar up front (chances are I won’t), but sometimes I can quickly identify that it isn’t a 50 cent dollar. In other words, I might not be able to confirm that the stock has 100% upside, but often times I can quickly identify the ones that don’t have that upside, at least not without undue risk.

So this last question just reminds myself to think in these terms, right from the outset.

So as ideas come across the conveyor belt, I quickly use these questions to determine if they should be saved for further analysis. When I find an idea worth evaluation, I leave the conveyor belt and head to my office where I begin doing more detailed research which involves further reading, 10-k’s, reports, etc…

This process helps me focus on the task at hand. When I’m done researching an idea, I’ll go back to the conveyor belt (reading, screens, 13-f’s, etc…) and inspect new ideas as they come by. The process is a balancing act between idea generation and more detailed research.

And of central importance is the ability to quickly filter ideas.

Soon I’ll write a post on some thoughts on how Buffett filtered investment ideas, which is an incredible case study in and of itself. Buffett’s ability to filter ideas quickly was, in my opinion, one of his most underrated skills as a risk manager.

4 thoughts on “How I Filter Investment Ideas

  1. Jon,
    Always a good read, how about starting with the Letter A (using Russell 2000 or 3000). It may be boring, but it certainly is a structured way. I feel like if I start with the As and just go through the companies, then I control the process. When I am getting ideas from the news, etc., they are coming at me like a fire hydrant, with so many sources, I just can’t keep up (For example, on 13Fs, which investors do you decide not to follow, Einhorn vs. Loeb, what’s the cut off?). Instead, I think it helps to drive the process yourself and turn off all other sources. Just my two cents. If I recall correctly, I believe Buffett just used the Moody’s Investment Manual with all the listed companies and started at the beginning.

    1. Thanks for the comment Matt. Yes, that’s a great way to do it. I think anything that simplifies and/or mechanizes your process to make it easier and more efficient is a good thing to do…

      I love Buffett’s Moody’s example. I recently heard an interview with Alice Schroeder that I might comment on… she talks about the vast knowledge Buffett built into his “mental filing cabinet” simply by spending a lot of time studying financials and company reports.

      One thing I will say about the A to Z method: I think there is tremendous learning there, but I don’t necessarily think it’s the most efficient. It’s simply one way among many to go about completing the same task: which is finding undervalued businesses at reasonable prices. I think the A-Z method is outstanding, and is very beneficial, but for me, I’d prefer to begin my hunting grounds in areas that might have a higher probability of being fertile, thus my reasoning for looking at 13-f’s and other investors ideas. Or instead of A-Z, focus in on a list of businesses that have grown net worth by 10% or more over the past 10 years, or have been FCF positive in each of the past 10 years, etc… some way to improve the odds that your research efforts are being done on companies that actually may end up being a possible investment.

      I think if Buffett had screening capabilities, he may have focused his efforts in a manner like this, although I’m not sure about that.

      But I hear you on the fire hose problem… there is a lot of info out there… tough to keep up. So whatever works for you is the best thing to do. Another idea might be looking at specific industries and going through the ones with pessimistic or negative outlooks A-Z. Would be a smaller subset and might provide faster compounding of knowledge, and again-might improve the odds of finding something valuable since you’d be fishing in contrarian waters in that example.

      I’m sort of doing that with community banks right now…

      One thing I do work on daily that is similar to your A-Z idea is going through Value Line. It’s not A-Z, but it’s 3500 or so stocks that you can go through once a quarter just flipping pages. I enjoy doing it, and I learn a lot. And I’ve developed a google sheet to track what I consider the best companies in Value Line, so I can study them more closely as their prices come down to levels I consider to be fair.

      I think of my idea generation as all kinds of random hooks in the water trying to catch different kinds of fish. I’m never sure where ideas will come from next, but I have enough hooks in the water that there is usually always something to work on. Many ideas get left behind, but the good news is all you need are a few that work out, and you’ll do very well over time.

      So my idea generation is mostly reading all sorts of things, and building watchlists, and then researching one idea at a time in more depth. I always try to track businesses I’ve researched, since I prefer to focus on those companies I know well. That way, inevitably, the price drops at some point and I can cherry pick the ones I perceive to be most undervalued. It’s kind of like doing prep work up front and then waiting.

      The search process is fascinating. I have a post ready on Buffett and how he simplified it… he looked at major risk first, and eliminated ideas immediately before wasting time. I think there is something to really take away from that… I’ll post my comments tomorrow.

      Anyhow, this comment is getting into post-like length, but it’s always an interesting topic. Maybe we’ll save it for our next phone conversation. Talk soon…

      Thanks again for your comment. You brought up a really good point and something I spend a fair amount thinking about. Keep sharing!

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