How Do You Find Investment Ideas?
My idea generation process is more creative to start which later informs a quantitative analysis
To find unrecognized value, I think it’s helpful to collect a broad set of information and ask a lot of questions
09/13/2021
“For certain, you have to be lost to find a place as can’t be found. Elseways, everyone would know where it was.”
Hector Barbossa, Pirates of the Caribbean
People often ask me, “How do you get your investment ideas?”. The preferred answer in the industry is to rattle off a prescribed and organized process of filtering investments through screens (database tool for filtering stocks) looking for stocks with ideal characteristics. It sounds organized, professional, and repeatable. I have experimented with various screens over the years with little luck. Screen for value and most of the output is dilapidated business models. Screen for growth and profitability and you’ll mostly find successful businesses with nosebleed valuations. I look for businesses with sustainable economic moats and aligned management teams trading at attractive prices. By definition, unrecognized value isn’t easily found through methodical approaches. In Mr. Barbossa’s words, this is “a place that can’t be found.” If it could be, quantitative experts with smart algorithms would spot them “everyone would know where it was” and arbitrage away any perceived opportunity. The solution requires an open, curious mind and a little creativity.
So how do I find investment ideas? The simple answer is “you have to be lost” in a creative process. Yes, numbers are involved but the opportunity I seek is found in obtaining unique qualitative knowledge behind the hard data.
Read widely and voraciously (my favorite publication is The Economist)
Engage with people knowledgeable on the chosen subject and learn as much from them as possible
Be Curious. Ask a lot of questions “How does something work” “Why do consumers make X decision?”
Example: (Disclaimer: Some of our clients own this stock as of the date of publication. The start of this example predates my history with Aurora Financial Strategies.)
Read widely and voraciously: In 2014, Michael Brown Jr. was killed by a police officer in Ferguson, Missouri. I’m not an expert on the case and don’t have any special knowledge about what happened, but what was clear to me was that there was a lack of trust between law enforcement and the public. I had read about body cameras and the potential benefits of creating visual evidence that could encourage better behavior by both police and the public. It struck me that this moment could be a catalyst for change. I started reading about the potential technological solutions and the body camera industry in general.
Engage with people knowledgeable on the subject: I spoke with members of law enforcement. Many of them were against change, but they acknowledged that body cameras would likely be a requirement in the future. This did not seem to be widely understood by the investment community.
Be Curious. Ask a lot of questions “How does something work” “Why do consumers make X decision?”: What would convince law enforcement to adopt body cameras? Police in many areas are unionized and if many were against it then it could be difficult to impose. After further investigation I concluded that body cameras resulted in reduced public complaints and litigation costs for police agencies. Both parties’ actions are being documented which encourages better behavior. Once officers realize this, they warm up to the product.
Fast forward to 2017, a company called Taser changed its name to Axon Enterprises to signify the business shift to focus on more holistic problem solving for police agencies. I watched an investor presentation and was fascinated by their plan to build a sustainable economic moat around the video data collected by the body cameras to sell software. They envisioned an entire ecosystem where video data could be collected from body cameras and be fed into software that allowed it to be easily shared with prosecutors and help officers with report writing, saving them countless hours. And Axon’s existing moat in Taser’s would reinforce this ecosystem. Axon introduced sensors that would alert the body camera to record anytime a Taser was drawn.
The business didn’t show up in many traditional investment screens. The legacy Taser business had strong economics but they were reinvesting everything into this new ecosystem. They were growing quickly but profits were declining as body cameras and software grew. I tore the business apart in my spreadsheets and concluded that the stock was attractively priced even if I only considered the legacy Taser business. It seemed to me that the market was ascribing negative value to the body camera and software business. There were substantial fixed costs they would need to scale into, but the gross margins on the new segment were high enough to justify the risk. I figured if the venture didn’t work, they would likely shut down the new division and I would still be ok with the result.
In the end, I felt I had found a business that helped solve a real problem that society was deeply motivated to fix. Granted, body cameras are not a panacea but I was correct in that governments would look to them as part of the solution. It took a little bit of creativity to envision how the business would look in the future and how the financial statements would evolve over time. I couldn’t find many investors that agreed with me on this, which gave me a sense that if I was correct then I had found “what can’t be found”. Being a contrarian investor can be lonely and it takes a lot of conviction to follow through on an unpopular conclusion. But if everyone agrees with your investment idea then you haven’t discovered anything.
Today, AXON is trading significantly higher and you could probably find it with a screen looking for quickly growing companies with strong profit margins. I provide this example not to toot my own horn. Most investors can easily recite their successful investments. But I think it helps illustrate the creative process to finding unrecognized value.
In Summary
In order to find unrecognized value, I find it helpful to “get lost” in the creative process reading widely, asking questions, and letting my natural curiosity guide my research to finding answers “that can’t be found.” It’s a long and tedious journey filled with dead ends, but I believe it is the best way to find companies with sustainable economic moats and aligned management teams trading at an attractive price.
This blog represents our thinking at the time of publication. If you are a DIY investor, use this only as a starting point for your research and be sure to do your own due diligence. For questions regarding our individual stock strategies, please reach out to us!
Invest Curiously,
Austin Crites, CFA
Austin Crites is the Chief Investment Officer of Aurora Financial Strategies, a financial advisory firm based out of Kokomo, IN. He can be reached via email at austin@auroramgt.com. Investment Advisory Services are offered through BCGM Wealth Management, LLC, a SEC registered investment adviser. This blog does not constitute advice. This is not an offer to buy or sell securities. Advisor is not licensed in all states. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. BCGM Wealth Management, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results. Clients may own positions in the securities discussed.
Source: https://www.aurorafinancialstrategies.com/blog/how-do-you-find-investment-ideas
