How to Generate Investment Ideas

🌾 Welcome to StableBread’s Newsletter!

As of December 2024, there are ~53,626 publicly traded companies worldwide. With so many options, how do you find stocks worth your money?

This post draws from Michael Shearn’s 2011 “The Investment Checklist: The Art of In-Depth Research” to explain how to systematically find great investment ideas - the foundation of any successful investment strategy.

The first thing to understand is that great investment opportunities are rare.

Shearn notes that Warren Buffett attributed his investment success to fewer than 20 ideas throughout his entire career.

However, this shouldn’t deter you from seeking great stocks. As Buffett once shared:

Buffett's punch card metaphor emphasizes quality over quantity in investing. If you knew you could only make 20 investment decisions in your lifetime, you'd research each one thoroughly and only invest when truly confident—leading to better returns through fewer but higher-conviction picks.

With this selective approach in mind, when should investors act?

The best opportunities typically emerge during market downturns when forced selling creates artificially low prices.

For instance, when the S&P 500 dropped 36% in 2008, many stocks were sold indiscriminately as money managers had to fund client redemptions. This created a rare chance to buy quality companies at bargain prices.

Shearn explains other scenarios that create opportunities:

• When stocks get removed from major indices. This happens when companies no longer meet minimum market cap requirements or other criteria for index inclusion, forcing index funds to sell shares.

• During spin-offs where institutional investors must sell. Many funds have specific mandates that prevent them from holding the smaller spun-off companies, creating automatic selling pressure.

• When uncertainty about litigation, accounting, or management causes panic selling.

In each case, investors assume the worst and sell quickly. This creates buying opportunities for those who can determine whether the problems are temporary or permanent.

Good companies often get sold alongside troubled ones during these panic periods. Often, once the reality sets in that the situation isn't as dire as feared, stock prices adjust upward.

Importance of Valuation

No matter how promising a business looks, the price you pay determines your returns. Successful investors maintain strict discipline on valuation.

Shearn shares the story of investment manager Brad Leonard, who generated 26.94% annual returns from 2004 to 2010 compared to just 3.87% for the S&P 500 during the same period.

Leonard achieved this by paying low prices for stocks, typically just three time enterprise value (EV) to EBITDA:

For instance, Leonard purchased home décor retailer Kirkland's ($KIRK ( 0.0% ) ) at $1.70 per share in 2007. During the market crash, the stock dropped to $0.70. As the company's results improved each quarter while the stock price remained depressed, he bought more aggressively.

The stock eventually recovered to $2 in 2008 and exceeded $20 per share by 2009.

When paying such low prices, investors don't need to make many assumptions in their analysis. The business simply needs to continue operating, and the investment will likely succeed as the market eventually recognizes its true value.

Where Not to Look

Just as important as finding undervalued companies is avoiding overvalued ones. Shearn warns about areas flooded with capital:

He points to historical examples like the conglomerate boom of the 1960s and the dotcom bubble of the late 1990s to show how exciting trends often become expensive fads.

To spot potential bubbles, Shearn suggests looking at the Forbes list of billionaires and noticing which industries are producing new wealth. For instance, in the early 1980s, the list was dominated by oil and gas industry figures, signaling potential overvaluation in that sector.

Another warning sign is when companies in hot sectors are valued based on revenue rather than earnings, and/or when they trade at unusually high multiples.

During bubbles, investors typically ignore traditional valuation metrics, justifying high prices with claims that "this time is different" or by focusing solely on growth potential.

Signs of market bubbles typically include:

• Abundant available capital.

• Higher levels of leverage.

• Decreased discipline from lenders.

• Loose lending terms for borrowers.

Recognizing these warning signs can help you avoid areas where prices have been pushed to unsustainable levels, saving you from potentially devastating losses when reality eventually catches up.

Stock Screening Tools

Stock screens filter companies using criteria like price, size, or financial ratios. These tools range from simple free websites to complex paid services.

Shearn cautions that these tools have a major limitation: they rely on GAAP accounting numbers that often don't reflect a company's true financial health.

For example, a company might take a one-time restructuring charge that temporarily reduces earnings, making its price-to-earnings (P/E) ratio appear much higher on a stock screen than it should be.

Similarly, asset write-downs or goodwill impairments can distort book values and price-to-book (P/B) ratios.

Because of these accounting issues, many great investments might appear expensive on standard screens. In these cases, investors need to adjust the GAAP numbers to understand a business's real earning power.

The best approach is to use screens as a starting point, then dig deeper into the financial realities of promising companies.

New-Lows Lists

Following stocks hitting 52-week lows can reveal opportunities. Financial websites such as WSJ regularly publish these lists, highlighting stocks that have experienced significant price drops.

Shearn quotes Paul Sonkin, manager of a micro-cap fund, who explains how to properly use these 52-week low lists:

Sonkin recommends running these lists weekly and focusing specifically on new additions. This approach helps you identify companies facing temporary problems rather than those with ongoing issues, potentially spotting bargains where the market has overreacted.

Business Press and Financial Publications

Regularly reading publications like Barron's, Wall Street Journal, Financial Times, Forbes, and Fortune can help you find investment ideas you might miss with stock screening.

Shearn recommends this approach, suggesting you focus on articles about troubled companies rather than success stories, since distressed situations often create better buying opportunities.

Trade journals for specific industries you're interested in can also be valuable. For instance, American Banker might give you unique insights if you're looking at financial service stocks.

Value Line is particularly useful because it presents 10 years of financial data on a single page, including sales trends, operating margins, return on capital, debt levels, and shareholder equity. Each weekly issue highlights a different industry group.

Following Charlie Munger's approach, Shearn reads every issue cover to cover, gradually building knowledge about different businesses and industries.

Following Other Investors

Many investors try to find ideas by tracking what successful investment managers are buying. Shearn explains that there's always a popular group of investors whose moves are closely followed and reported by financial media.

Large investment managers (managing over $100M) must file quarterly SEC 13-F forms disclosing their holdings, making it relatively easy to see what they're buying and selling.

However, Shearn identifies several key problems with this strategy. He begins with this fundamental issue:

Even the best investment managers make mistakes that you might unknowingly follow. You also won't know their real reasons for trading - they might sell good companies simply because they face redemptions and need cash.

Shearn points to how investors questioned Buffett when he avoided internet stocks in 1999 as an example of how managers fall in and out of favor. Ironically, when they're out of favor is often the best time to follow their moves.

From his early career, Shearn warns that excitement about seeing a respected manager's new position can lead to overconfidence and shortcuts in your own research—perhaps the biggest risk of this approach.

Tracking Your Existing Portfolio

Many investors overlook opportunities already in their portfolio. During market crashes, consider increasing positions in quality companies you already understand well instead of scrambling to research new ones.

This approach builds on your existing knowledge and may generate better returns than starting from scratch with unfamiliar companies.

Other Potential Sources

Small investments can help you track interesting companies. By owning shares, you'll receive shareholder communications, voting materials, and annual reports that provide additional insights about companies you're tracking.

Researching upcoming IPOs, spin-offs, and companies exiting bankruptcy can also reveal opportunities. These situations often create temporary price dislocations as investors adjust to new market conditions.

With so many potential investments, you need a system to filter them efficiently. Shearn recommends establishing clear criteria for the types of businesses you want to own.

In his book, Shearn provides this sample criteria checklist that evaluates companies across ten important characteristics:

This scoring system helps you compare different businesses and see their strengths and weaknesses clearly. Moreover, setting a minimum threshold (like 7 out of 10) helps you focus only on the most promising candidates.

Ultimately, the more criteria a business meets, the lower your risk. This is why Shearn strongly cautions against making exceptions:

Such stretching happens when you compromise on key factors - like buying a stock with poor management because it seems cheap, or investing in a popular company despite its sky-high price.

Once you've identified businesses that meet your criteria, Shearn recommends creating a spreadsheet to monitor them over time. This formal watch list serves several important purposes:

1. It helps you resist the urge to buy stocks on impulse.

2. It focuses your attention on the best opportunities you've found.

3. It lets you compare potential investments side-by-side.

4. It shows how valuations change over time.

5. It prepares you to act quickly when prices drop.

Shearn provides this example table in his book to track potential investments:

These financial metrics help you spot when a good company becomes available at an attractive price.

Services like Wisesheets (which we partner with for our Automated Stock Analysis Spreadsheet) can help update these figures automatically.

As Shearn explains, this preparation gives you a significant advantage:

By understanding where investment opportunities come from and creating systems to find and track them, you'll be better equipped to build a portfolio of exceptional investments.