How to Handle Stock Ideas

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Jul 31, 2013
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Someone emailed me asking how to do a stock analysis. What are the different parts? What is most important? It’s a good topic. And I intended to answer it today – after explaining in my last article that a good write-up is not the same thing as a good investment. But I realized I had to deal with another topic first: how to handle stock ideas.

Before you can write-up a stock for your own purposes – and that’s what we’re talking about here, not doing analysis for someone else – you need to have a stock in my mind. How do you get a stock idea?

There are probably about 10,000 stocks to choose from in the U.S. There are at least that many – probably more – available to you in the rest of the world. If you limit yourself to big stocks – say $100 million or $200 in market cap or higher – you probably cut that number in half. But even if – like many investors – you ignore microcaps entirely, you’re still talking about thousands and thousands of stocks to choose from. Even an investor who ignores all micro caps and all non-U.S. stocks will still have a few thousand stocks to choose from.

So stock ideas are plentiful. Good stock ideas may not be. I mentioned in a previous article that I ran a backtest – looking back 15 years, my idea of a truly long-term investment – and found about 700 American stocks that more than met my requirements for good returns in both relative and absolute terms. That’s a backward looking test. You can only tell in retrospect that about 700 American stocks performed well enough from 1998 through 2013 to be labeled – in hindsight – good stock ideas. It does, however, give you some idea of just how many good ideas there are. In that case, more than 1 out of 20 stocks (in fact, closer to 1 out of 10 stocks) performed adequately in both relative and absolute terms. This was a bad time period for U.S. stocks generally. That made relative comparisons easy. But it made absolute returns hard to come by.

I don’t think you can call a stock idea a good one unless you expect it to return at least 10% a year over the time you hold it – and it outperforms your benchmark. So, for many investors reading this, that means you’re looking for a stock that can return 10% a year and beat the S&P 500.

That will be tough going forward, because I doubt the S&P 500 will return 10% a year in the future. It may return that this year, next year, and the year after that. But if – as I like to do – we think in terms of something like three years forward at the shortest and 15 years forward at the longest – returns of 10% a year from here seem very unlikely. This is due to high prices. They may be justified by low interest rates. But, will interest rates be as low in three to 15 years?

Probably not.

So the absolute return odds are stacked against us. In fact, it doesn’t look like a much more opportune time to be picking stocks in the U.S. than it was back in 1998. Still, if we remember my backtest, hundreds and hundreds of stocks performed well enough over the last 15 years to be labeled “good stock ideas” in retrospect.

We’d expect at least an equal number of good ideas to be out there now. While I’m not optimistic about the future for U.S. stocks – because they’re overpriced right now – I’m no more pessimistic than I would be if presented with 1998 prices. So I’m sure there are at least as many good ideas out there now as there were in 1998. Maybe more.

In ballpark numbers, we are probably looking for the best 1 idea out of 10. How hard is that to find?

For a new investor – and a wide diversifier – it’s very hard. But there are some things you can do immediately to improve your odds of zeroing in on good stock ideas.

Read these books:

· Joel Greenblatt’s “You Can Be a Stock Market Genius”

· Peter Lynch’s “One Up On Wall Street” and “Beating the Street”

· Ben Graham’s “The Intelligent Investor”

· “There’s Always Something to Do”

· “Hidden Champions of the 21st Century”

· “The Outsiders”

The last two books will introduce you to two categories of stock ideas you might not have considered before. The other books are more personal – and more practical.

The best way to get good stock ideas is very simple – and very hard for most investors reading this to do. Basically, you have a group of other investors – a network of sorts – you know and trust. You meet with them from time to time, you chat on the phone, you trade emails, etc. This is by far the best way to get good stock ideas. It’s how many of the best ideas I’ve ever gotten came to me – someone else (someone who knew me) suggested them.

Even Phil Fisher admitted that – in retrospect – his best ideas did not come from CEOs or scientists. They came from other investors. They especially came from people who knew him.

This last part is critical. Stock ideas come in different flavors. It is no good giving a Ben Graham idea to a Phil Fisher investor. It is no good suggesting a microcap to someone who has no experience investing in them. I’ve tried talking to otherwise intelligent investors about net-nets or foreign stocks or other things they’ve never sampled – there’s no point. It’s not the idea that matters. It’s the connection between the idea and the investor.

You could try to get me to go to a great horror movie. You could do a great job pitching it. It could be a great movie. It wouldn’t matter. I’m so extraordinarily unlikely to be interested – there’s really no point in trying to pitch me something that far out of the kind of movie I enjoy.

It sounds silly, but investing works exactly the same way. We may prize ourselves on being open minded. But, generally, we’re just fooling ourselves. Until you have some experience that bumps up against the kind of interesting idea you’ve just run into – it’s not going to click with you. It may be an interesting idea. But you won’t recognize it as such.

So you can’t leap genres entirely. You can’t try to find the best net-net ideas if you’ve never explored that area of investing. What can you do?

You can stop reading general interest financial news, watching CNBC, Bloomberg, etc. This time is better spent focusing on a few specific areas.

One, start reading value investing blogs.

Two, focus on negative news and other short-term worries. I am not a contrarian investor. I like quality companies. But the best ideas are rarely those stocks that are in favor now.

Look for stocks that are being spun-off, that have hit temporary difficulties, etc. Think like a contrarian.

Don’t look for bad businesses. Sometimes bad businesses will be so cheap they will be worth buying. But that’s not what I’m suggesting when I say you should be a bit of a contrarian.

Look for stocks where the business, industry, and stock has perhaps performed poorly for the last one year, three years or five years. Not 10 or 15 years. There’s a difference.

Spin-offs are a good example of this. They – since they’re kind of the opposite of IPOs – often have performed worse, grown less and gotten less interest from analysts and investors in the last three years or so. Not always much beyond that.

Remember the quote from Horace that Ben Graham used. Companies aren’t in favor or out of favor forever. They are seen as good for one decade, then bad the next. Sometimes the underlying business has changed a lot. More often, perspective has changed even more.

Doing all this – reading those books, trading all your general financial news reading for value blog reading, and taking a contrary mindset – will probably only get you to the point where you can pick maybe the best idea out of three. You can probably see which of three stocks is – at a glance – likely to be most interesting.

I have a very fast – and very, very effective – shortcut for you. Put much of your effort into historically profitable companies – a good test is 10 straight years of profits – trading at reasonable multiples. Anything above 8 times EBITDA is not reasonable. It might be justified. But it can only be justified by quality.

In tough times for stock, you’ll be able to find plenty of stocks – often unglamorous, but still consistently profitable – hovering at closer to 5 times EBITDA than 8. At times like now – expensive times for stocks – it’s hard enough finding consistently profitable companies trading around 8 times EBITDA.

Why 8 times EBITDA?

Here’s a very quick rule of thumb. Take a stock’s EV/EBITDA. Double it. The normalized P/E ratio will be less than that. It’s not a perfect rule. But it’s a very good tool to use. If you see a stock trading at 7 times EBITDA, that’s probably a stock trading at no more than 14 times its normal earnings – adjusted for leverage.

Because financial stocks, utilities, railroads, etc. use leverage – this rule won’t help you with them. It will help you with industrial stocks. It’ll help you with most simple businesses – that you don’t want to reward for added leverage – around the world.

You can also use a similar tool to approximate return on capital. I use a simple rule of thumb for calculating net tangible assets and a company’s unleveraged ROE. Remember, I care about owner earnings – not reported earnings under GAAP – that’s why I’m using EBITDA and NTA.

I take a stock’s inventory and receivables and PP&E. Then I subtract that stock’s accounts payable and accrued expenses. The resulting difference – usually, but not always positive – is a pretty good idea of the net tangible assets the business uses.

Take EBITDA. Divide by NTA. Then divide that number by 2. It’s a pretty good bet the normalized return on equity – after-tax – of the business will be greater than that number.

For example, a stock with EBITDA of $2 a share and NTA (inventory plus receivables plus PP&E minus accounts payable and accrued expenses) of $5 a share will have a normal return on equity of at least 20%. Basically, the unleveraged return on equity will often be 20% or higher.

What about cash, debt, etc? You can cover that later in your analysis. At this point, you want to know what the business earns – not what the corporation earns. They are too different questions. The more permanent issue is the economics of the business. The way the corporation is financed matters too – but it’s not the first thing you need to check.

Why mention these two rules?

I use them all the time. They cut to two of the most important questions you want to answer with any stock.

How cheap is it? And how much does it return on the equity it uses?

What other questions matter?

Generally, growth and capital allocation. But their relationship is usually too hard to resolve when you first spot a stock idea. A stock can be a good investment purely on its dividend yield. It can be a good investment purely on its stock buyback. And it can be a good investment purely on its growth. If growth is high enough – you don’t need the other two (though you do need return on capital).

Is return on equity always important?

Almost always. It’s not important if the company redirects the capital. This is extraordinarily rare in the wild. Read “The Outsiders” for examples – like Berkshire Hathaway (BRK.B, Financial) and Teledyne – where this happened. It’s important to recognize these situations when you see them. But they are so rare that if you buy a low ROE stock and hold it for the long term, your results will tend to deteriorate – on an annualized basis – over time because the company will reinvest too much in the business.

Companies almost always choose to grow more than what would actually serve shareholders best. Your best defense against this is a high ROE. Another good defense is excellent capital allocation.

At this point – after we’ve checked the EV/EBITDA and gotten some idea of the company’s ROE – we have really transitioned into the start of our analysis.

Everyone has their own analytical checklist. Mine tends to focus on seven worries:

1. Understanding

2. Durability

3. Moat

4. Quality

5. Capital Allocation

6. Value

7. Growth

Should you use the same process?

It depends on how similar you are to me as an investor and how similar the stocks you analyze are to the ones I analyze.

A lot of people put value and growth near the top of their checklist. For me, they are at the bottom. I’ve basically ranked my analytical concerns from quickest way to kill and idea (No. 1 I don’t understand it) to least likely to kill an investment idea (No. 8 it’s not going to grow at all).

I’m not going to buy something I don’t understand. Given the right circumstances, I’m totally fine buying a company that doesn’t grow.

I’ll explain why when I run through the seven points of my analytical checklist in the next article.

As far as handling the stock idea – and deciding whether or not to move on to analysis – there are four questions you should always ask (and a zero question I find very helpful):

0. Who referred the idea to you?

1. Did the idea “click” with you?

2. Has the company been consistently profitable?

3. Is the EV/EBITDA reasonable?

4. Is the ROE (EBITDA/NTA) adequate?

If you like the answers to those questions, move on to analyzing the stock. If the stock already falls flat in this first stage – it’ll be very hard to come up with convincing reasons to buy it anyway. At least as a long-term investment.

Personally, I would scrap a stock idea that fails on these four points.

Talk to Geoff about How to Handle a Stock Idea