Tuesday, 15 May 2012

Investing in Shares: Generating an Investment Idea

A question I often get asked by my friends who want to start investing in stocks is "what shares are good value?" or "what shares should I invest in?".  I think this is fundamentally the wrong question to be asking - especially if you are just starting to invest.  The right question should be "how do I generate an investment thesis which will lead me to shares to invest in".

The above question is the right one to ask because then you will start generating ideas that you understand.  The problem with taking another persons suggestion (whether it be a friend, broker report, accountant or any other advisor) is that, without even realising it, you are buying into their view of the world (and especially of the investment landscape which you may not believe in).  I have outlined a few steps below which hopefully will help you generate your own investment thesis and should help generate lists of stocks for you to investigate further

Note that this is not the end of the process!  This will only generate a list of ideas.  You then have to do the appropriate amount of research on your stocks.  I have posted on this before so please don't generate an idea and then just go out and invest in it - it may be a perfect thesis but everyone else may have already recognised it and the stock will probably be too expensive.

1. Only invest in those industries you understand
This is not a new idea.  It is one that Warren Buffet stresses all the time.  For a really detailed look at how you can spot ideas yourself I highly recommend the book "You can be a stock market genius" by Joel Greenblatt.  I have linked to this book on the left (if you want to check out fishpond / book depository for pricing there are links on the right of my blog).

 All of us have certain industries we understand better than others.  For most people the simple ones are things like retail banks, retailers (both staples as well as things such as clothing / electronics),  many Internet companies, clothing manufacturers.  We have a detailed understanding of these industries because we (like most people) use them every day.

However there are some industries that you may understand better than others.  For example if you like to gamble at the casino you will understand that industry a whole lot better than I will because I don't go very often.  Doctors / nurses will have a much better understanding of the health care industry (as well as the biotech industry).  Financial professionals will understand the investment banks / fund manager space and the things that drive that.  If you're a builder there are building materials companies as well as home builders and property construction firms.

2. Be on the look out for investment ideas where you can get in before the financial professionals

After you have made a list of things you understand be on the look out for investment ideas.  Often you will see trends before the financial professionals become aware of them. 
  • For example if you are into fashion and you see a new trend start to emerge and you see the company who is at the forefront of that trend.  Chances are that the people that work in the financial world have no idea of this emerging trend and will only start to find out once they start making real money. 
  • If you're a builder and you see demand really start to pick up chances are you are going to see this before the data is released to the financial professionals.  It is all about using your individual knowledge.
  • Doctors are often able to decipher the hype around drugs especially which are actually one of a kind and which can be replaced effectively by others.  The financial community has a hard time separating the good drugs from the hype and so may not pay as much for that great product (and the biotech firm developing it) 
There are so many situations like the two above that it is hard to mention them all.  The key is to constantly keep a look out.

3.  Ideas can come from anywhere - but you need to follow your own train of thought

In the first two points I have really stressed areas where you deal in it personally and are able to see the trends before others.  However you can also make money by looking at a situation differently from others.  You may read something in a newspaper or a magazine article which has nothing to do with stocks but it may cause you to think of an idea or to research something further and go against the grain.  I have said it before but going against the market is the hardest thing one can do.
  • For example: During the GFC all financial institutions and highly leveraged companies were being battered because debt was not available at any price.  There were news articles on a daily basis about the external funding markets drying up and banks with exposure to the US and Europe being in real trouble and going bust.  You could look at this idea and decide to stay from all banks.  Or you could look at these articles and look for those banks which primarily funded their book domestically and lent money domestically. In Australia you would have come up with Commonwealth Bank of Australia which is the largest listed local bank and invested in them as the price had gone down substantially for no reason related to the stock itself.
Ideas don't even have to be that complicated.  One I invested in was much simpler.  I read an article in 2008 talking about diamonds and how they were so cheap because Indian suppliers were flooding the market but no new diamond mines had been discovered in the last 10 years so the price should recover at some point.  I looked around and all diamond miners share prices were suffering even though it only appeared to be a short term problem.  All I had to do was find one with a good resource that didn't have too much debt and wait for the market to recover which it did within a year.

4. After you generate an idea - research the idea properly THEN research the stock properly
If you are going to invest successfully then you need to do the work.  Research your idea or thesis thoroughly and make sure that it stacks up.  After this research your stock and make sure that the value proposition stacks up. 

Following the above advice should have you generating a list of ideas in no time.  Not all your ideas will be good ones and that is why the necessary research is required.  I try for one idea per month.  This may not sound like a lot but if you think about how much money you have to invest - you do not need a whole lot of ideas to start investing.

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