Think Differently

The Concept of Idea Inventory and Cheap Parts of the Market

I divide my time into two main areas: business development¬†(this includes networking, meetings, discussing ideas with prospective investors, etc… basically everything it takes to run my business) and investing.¬†In the latter category, the majority of my time is spent doing two things: idea generation (building watchlists, reading, screening, etc…) and researching (going through items I’ve placed on my watchlist in greater detail). So investing is a never ending interplay between getting ideas and researching ideas. I think of this general concept as “idea inventory”.

What I mean by this is that my watchlists naturally get larger as I find more ideas that might be potential investment opportunities. As the watchlist grows, I need to spend more time researching these ideas to determine if any of them should be placed into my portfolio. As I spend more time researching, the idea watchlists get smaller as some stocks either get placed into the portfolio or get removed (some stay on the lists if I think I might buy them at lower prices).

Balance Idea Inventory with Research

Just like an operating business, you need inventory in order to eventually sell goods and make profits. But you don’t want your inventory to pile up too high, or you’ll end up with too much product on your shelves that will need to get marked down (i.e. JC Penney). With idea inventory, you need to balance your time between finding ideas and researching ideas in order to efficiently make conclusions about which stocks you should buy.

I recall Buffett mentioning in his early partnership years that his “idea inventory” was always at least 10% ahead of his available capital to invest, which meant he was nearly always 100% invested. This is something to think about… I think that just about every individual investor, and the majority of small to medium sized professional fund managers would probably improve their results if they focused more on managing their idea inventory and less on trying to analyze the security markets, business cycles, and the macro picture.

I don’t have any problem with holding cash, but as I look through my idea lists, I’m finding lots of opportunities to invest in small undervalued companies that on balance, should provide safety of principal with adequate returns.

Where Might Some Bargains Be?

I’ll mention a few specific ideas as I find them interesting enough to post. But a few areas of the market worth looking at are:

  • For Profit Education (historically very good businesses… low fixed costs, high returns on capital, currently offered very cheap relative to cash flow)
  • Industrial Metals¬†(high costs, capital intensive businesses, but many are cheap relative to net assets)
  • Gold/Silver Miners (same)
  • Small Community Banks (there are still plenty of small banks selling for 70% of their tangible book values)
  • Insurance (there are parts of the insurance sector where numerous stocks are selling at 50-70% of tangible book despite experiencing consistent 10% annual growth of book values)

These are just a few small cheap pockets within the larger market (which is what I would call fairly to moderately overvalued). But even with the broader market looking somewhat expensive, there are still these parts of the market that look cheap. I just mentioned a few areas that look cheap. There are plenty of other random cheap stocks in other industries that may or may not be undervalued.

Notice how the list might make you feel when you look at it. Many investors hate these areas of the market. Even value investors might hate them…. i.e. for-profit education has all kinds of business problems and regulatory hurdles, metals are high cost businesses selling a commodity, ditto for the precious metal miners, community banks low ceilings for growth and are often very mediocre operating businesses, insurance stocks can’t seem to consistently produce underwriting profits and might be vulnerable to rising rates, etc…

There are all kinds of reasons to not like cheap stocks. But as I heard Steven Romick say in a recent interview “Good things happen to cheap stocks“. Walter Schloss made 21% a year for 47 years… looking at his list of stocks he owned, he bought a lot of low margin, high cost, ugly businesses that were backed by significant assets. He also owned a few compounders and a few great businesses, but on balance, he owned cheap stocks.

There are still cheap stocks in this market. One thing to always keep in mind is to “think differently“. Happy hunting…

4 thoughts on “The Concept of Idea Inventory and Cheap Parts of the Market

  1. I would agree with you that there are many bargains to be found in the mining sector, check out NSU.

    Small community banks also hold a lot of promise, check out SBFG.

    The “for profit” education industry holds a lot of peril for investors. There customer is the government. If the government turns off the student loan spigot, they are done, out of business. The default rate on their loans is TERRIBLE. It is also a tremendously damaging product for their students. I would probably stay well away from this industry.

    I’ve looked at insurance companies, and they are cheap from an asset perspective, but for the most part they just can’t earn good returns. What good is it to buy a company for 60% of book value if they can only earn a 5% ROE?

    The bulk shipping industry might offer some good opportunities if pricing ever comes back to normal. I think Diana Shipping (DSX) is the strongest.

    Great website! Keep up the good work.

    1. DTEJD, Thanks for the comment. I’ve studied the for profit ed sector and have come to many of the same general conclusions you have. However, one thing I would consider is the fact that these facts are well known and have been in the public domain for months, and that’s why many of these businesses have extremely high FCF yields. The businesses are also good businesses, at a very basic level… high returns on capital, low debt, low fixed costs, growth runways, etc… Many are also buying back their stock at these depressed levels. So the regulatory risks are well known (that doesn’t diminish the risks, it just means its priced in). I don’t see the government shutting off the spigot… there are a lot of lower to middle income people that attend and rely on these universities, and that would be a difficult political proposition. I could certainly see them increasing regulatory levels such as the 90/10 rule and maybe lowering the cohort default rate requirements…

      My initial approach to the industry was to take a basket approach, but I decided I really didn’t like a few of these. However, I may end up still owning a few others, but I did decide to take a position in STRA because I think it’s a well managed business with great fundamentals and single digit multiples to trough earnings. The company is managed by a former Berkshire subsidiary CEO, and is also well respected among regulators. Senator Harkins wrote a scathing report on the for profit eds, but complimented STRA.

      Something to consider… I many summarize my thoughts in a post.

      As for insurance companies… I like these a lot more than the for profit eds. Regarding your 5% ROE with discount to book example… I’ve thought about that in this way… many of these were priced at 50% of book (they’ve appreciated significantly in the last 6 months). So if you have 5% ROE at half of book, you’re getting 10% return on your investment (the equity is growing by 5%, but you’re paying half price). The basic thesis for the whole industry was mean reversion… many of these businesses historically achieve 8-10% ROE and sell at 1.0 to 1.2 times book. Some pay consistent dividends and buy back stock. You could potentially buy a basket at 50-70% of book, and you have a large margin of safety. If the business reverts to the historical averages, your P/B multiple gets revalued. If it doesn’t, you’re still getting positive returns on equity that you didn’t pay much for.

      These are usually the situations I like… if things get better (which they often do), you have potentially really good returns. Some of the businesses have grown their book values by 8-10% per year over long periods of time. If they currently sell at 70% of book, and book value goes from let’s say 100 to 130 over the next 3 years, your purchase price represents close to a 50% discount to future book value, implying close to 100% returns if the business gets revalued to book…

      Anyhow, insurance is a difficult, competitive business where many companies struggle to earn their cost of capital over time, and many lose money in underwriting. I look for the profitable underwriters, or at least average underwriters, and buy them at a discount to book. It’s all part of the undervalued portfolio, so we’ll see how it works out.

      I’ve learned that sometimes they do and sometimes they don’t, but if you buy assets cheap, often times you get pleasantly surprised.

      Anyhow, just some thoughts on those two. I actually like both those areas better than the miners, but the miners are cheap as well. I prefer the streaming businesses in that industry…

      There are a number of other unrelated stocks that I’ll make some comments on later as well.

      Thanks for reading. I appreciate the feedback and the ideas.

  2. Thanks for a great blog!

    I just came across your posts on Idea Generation and they gave me a great process to clone. Everything you write makes a great deal of sense and resonate well with what I have been reading by Greenblatt, Greenwald, Marks and so forth.

    This blog is a fantastic resource. With your process and knowledge I am sure that you are set for excellent long term absolute returns.

    Thanks

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