Motley Fool Money - Where Do Stock Ideas Come From?

Episode Date: March 5, 2022

Buying any stock starts with an idea, but where do you find them? Consider this a starting spot for investors. John Rotonti talks with fellow Motley Fool analysts Auri Hughes and Yasser El-Shimy in a discussion about finding stock ideas and what to look for once you've found them. They discuss: - Using 3rd-party research tools to discover new companies. - What to look for in investor letters and 10-Ks - The utility of “cloning” versus using stock screeners Stocks discussed: KKR, AMZN, KIND, SNAP, FTCH, ETSY Additional resource: How to Find Investment Ideas - https://www.fool.com/investing/how-to-invest/stocks/where-find-investment-ideas/ Hosts: John Rotonti Guests: Yasser El-Shimy, Auri Hughes Producer: Ricky Mulvey Engineer: Tim Sparks, Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

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app, which makes it so much easier to stay on track. And you can get unlimited expert help at no extra cost, even on nights and weekends during tax season. Visit turbotax.com to get matched with an expert today, only available with TurboTax full service experts. When you read a statement like that from an investor that you respect and admire so much, it almost compels you to do further research, right? And so I spent two months literally doing a deep dive on KKR because of that one sentence. I'm Chris Hill, and that was Motley Fool senior analyst John Ratante. Stock investing can be intimidating in part because it's hard to know where to even begin.

Well, this Saturday classroom is about just that, getting started, and the ideation phase of investing in great companies. John talks with fellow Motley Fool analysts Ari Hughes and Yasser al-Shimi in a discussion about how they find stock ideas and what they look for before investing in any company. Hi, fools. I'm John Rotanti. I'm here with Yasser Al-Shimi and Ari Hughes. Hi, Yasser. Hi, John. Hey, Ari. Hey, John. So, Fools, we are here to talk today about where we find stock ideas and where we start our stock research and what our stock research process looks like step for step. So maybe Yasser, starting with you first, where do you find stock ideas? Oh my gosh. How about just looking around? Since I started investing almost 15 years ago now, I usually found stock ideas in the universe around me. I just tried to pay attention whenever I'm reading a news article, whenever I'm watching even TV, or even just looking around, I try to see, you know, things that I like to use, things that I believe have a bright future ahead, and just try to imagine what that future could look like. And just to give you an example, one of my very first investment ideas that came to me was Amazon, the stock. And that was simply by just looking around and seeing all these brown boxes arriving at the doorsteps of my neighbors and starting to use the service myself and just loving it and realizing, you know what, this is the future of commerce.

This service saves us a ton of time that otherwise we'd have to spend going to individual stores to shop for every single item. and arrives conveniently, seamlessly, and is actually cost competitive too. What could possibly go wrong there? So that's kind of how I started, and I always harken back to one of my favorite old-time investors, Peter Lynch, who argued in his classic book, one up on Wall Street, that, you know, ordinary investors did not need really to understand computers to notice that Dell was onto something or have PhDs in biology to know that Amgen has. at mid-strides in the biotech field.

All you need to do is just to look around, imagine the future, and pay attention. And chances are you'll do well from there. Ari, what about you? Where do you look for stocks? Yeah, so I do a combination of three things, and I'll talk about kind of the one I like the most. But the first one is the observations of the world, kind of the Peter Lynch thinking like Yasser was talking about. The other one is screens. So using data to screen for what I.

I'd like to see the financial profile in the company. And then the third one is my favorite. I call it cloning. I took it from investors I like, where essentially you copy or discover stocks from a respected source. So that can be an analyst, a portfolio manager. But the great thing about this is a smart person has already looked at the company and vetted it. So you can read investor letters from your favorite investors. A few people I like are this gentleman named Scott Miller, Terry.

Smith and really understand their thinking can look at 13Fs or dataroma or whale wisdom to see what stocks, these big funds or money managers are holding. And then research from there, you can see what percentage of their portfolio it is or how high of conviction is. And there's a lot of great funds out there, which we can see what they're holding like Tiger Global, Fund Smith, Pulling Capital. It's a source I love because I know it's been vetted and then I can go back to understand the company myself and I know smart people have taken a look at it. So I call that cloning. All right. I love that.

You mentioned Scott Miller. One of Scott Miller's letters is how I came across KKR. In one of his letters, maybe a year ago, he mentioned that if he could only own one stock for the next five years, it would be KKR. And Scott Miller is obviously an investor that I respect and admire a lot, just like you, respect and admire him a lot. And so when you read a statement like that from an investor that you respect and admire so much, it almost compels you to do further research, right? And so I spent two months literally doing a deep dive on KKR because of that one sentence

that I read in a Scott Miller letter where he said, and I'm paraphrasing, It was something almost identical to, if I could only own one stock for the next five years, it would be KKR. And so during that two-month research process, I found out that a bunch of other investors that I respected, admire deeply, all had not just positions in KKR, but large positions in KKR. So Chuck Akre and his team at Akre Capital, Bill Nygren at Oakmark, the team at Value Act, Capital. One of my favorite investors in the world, C.T. Fitzpatrick from Vulcan Value based out of Birmingham, Alabama. For a while, they were the largest institutional holder of KKR outside

of the major funds like Black Rock and Vanguard. And so Scott Miller's one sentence in his one letter a year ago brought me into a two-month deep dive on KKR. And Yasser, and Yasser, you know, just like you said, yeah, I look all around me. I see what people are buying, what brands are relevant and in high demand in the world today. So maybe to the second part of this. Well, can I just jump in here, John, real quick, because both Ari and you bring up very important points here, which is, you know, the important of just not paying attention to what's around and what you think has a bright future ahead.

but this is just sort of the very first step of finding an attractive idea that could potentially be an investment. However, finding that attractive idea is not enough to make it investment worthy, correct? So we have to do our research. And as I've grown as an investor, so has a list of things that I check for when I decide whether or not any particular company is worth investing in. So I try to look for like product market fit, mission credibility, customer retention and expansion, sustainable competitive advantage, et cetera, et cetera. So these are very important things. And speaking of cloning, you know, one of my old-time grades, of course, is David Gardner.

And for a long time, I've seen sort of the recommendations he has made. And those have forced me to also pay attention to companies that I may not have otherwise paid attention to. Yeah. Really glad that you stress. that point, Yasser. So this is our starting point. This is how we identify ideas. This does not mean we will ultimately determine that it's a good stock buy or a good stock to recommend to our members. This is how we originally come across the idea and then we do our own thorough, rigorous, fundamental, bottoms up business analysis on the company.

And then after we've done all of that business analysis fools, which could take anywhere from weeks to months, after we've done all of that business analysis, we use that analysis to try to estimate the fair value of that business and then that stock. And so it's a process and maybe the perfect segue into our research process. So maybe Ari, starting with you this time, what does your typical research process look like? What's the first thing you read or the first source that you go to and then take us through all of the subsequent steps for you to get comfortable enough with a company before you were ready to say it's a buy or it's a sell? Sure. So after the discovery process, the first document is the 10K, of course. I think that's like, that's one of the holy books for investing. It's public information.

It describes the business. And then I'm going to read the 10K. And as I read the 10K, the first thing I look for is, do I understand this business? Can I easily explain it in conversation? Can I explain it to a child? Right. So once I understand the business, I should have an understanding of the variables that affect that business. What's going on?

Like you were mentioning KKR. KKR is money management. So they're managing a pool of assets. They have to generate performance on those assets. So a big driver of that business is probably going to be how many assets? What's their AUM? Things like that. So I think once you understand the fundamentals of the business, then you keep digging further.

So I'm going to look at the management discussion and analysis, understand the business model, and then understand some of the risk that are inherent to that business. And then next, probably look at the last two quarters over the conference. call. And then usually by that time, I have a good understanding of the business. Maybe I'll read some more articles online. And then by that time, I should have a understanding whether I want to continue further, whether it's investable. That's incredible. Yasser, what is your step-by-step process look like to get you comfortable enough with the business to decide if you think it's a good time to buy or sell

the stock? Right. So I have quite a few steps. So please bear with me. The first one I take is usually I want to lay my hands on the product or service myself if I can, right? Some of the investments we make are in companies, let's say, software as service companies, that we as just individual users, we may never have the opportunity to try out the product. But for example, recently I was looking at social media companies like Next Door and Snapchat, or Snap Inc, I should say. So I downloaded the apps myself. I tried to get my hands on them, use them, see what the experience is like, see what people are saying.

that to me is kind of part and parcel of making this a very personal experience of investing and just actually judging for myself the quality of the service or the product. Now, I go to the company's website. I want to see how they present their product, what their mission is, how qualified the management team is as well. And from there, I usually go to documents, so latest investor presentation. Keeping in mind, of course, that's going to be like the company's PR page almost, but it can still be very constructive. Then I kind of dig deeper if I still am

interested in the company at that point. I will dig deeper into the latest earnings call, the 10K or 20F if it's a foreign company, and any available third-party research I can lay my hand on. Now, once I've established that background and I'm still interested, I will dig deeper into valuation multiples, especially compared to peers. So, you know, back in the day when I first started investing, I would only usually look at revenue growth and price-to-sales ratios. But as I grew as an investor, I have been paying attention to many other metrics, including operating on financial margins, especially EBIT, gross margin, SG&A, and free cash flow margins.

I also look at return on invested capital and how that has grown over time. earnings growth. And in my view, a great company that promises to be a good investment or a great investment will show improvement over time on these metrics. And so you have to understand why a company is valued the way it is to differentiate between, you know, good value and valued traps. You know, you'd be surprised how many investors just jump in headfirst into growth companies based on kind of like that promise that they might be the next fang stock, you know, the big Tannock stock.

But you have to kind of differentiate and be discerning on terms of the resiliency and fragility of these companies. You have to understand what makes for a sustainable competitive advantage or for attractive unit economics for any particular business. And once you develop that understanding, then you can sort of, you know, hone in with, developing the list of key performance indicators or KPI that you want to monitor over time in that business. So, you know, in an e-commerce business like Farfetch or Etsy, you want to look at, you know, metrics like order contribution margins and take rates. In a cloud SaaS business, that might be something else like remaining performance obligations, RPO's, or a NID dollar expansion rate and DERs. So, you know, only by keeping tabs on these things, can you actually see how the company is delivering on its key performance indicators over time and therefore whether, you know, this management team is actually delivering on the things that matter? That was an incredibly thorough and awesome answer, Yasser.

Last question for each of you. Ari, you mentioned the 10K as sort of like, you know, the number one place to go to start your research. research. For each of you, if you can only use two or three sources, what two or three sources do you think you spend the most of your time in? So, Ari, in addition to the 10K, that's one of them, what's the next other big source that you spend a lot of time in? Good question. I think probably just press those quarterly press releases, understanding the financial direction of the company. Is that something I'm comfortable with? Is it attractive? does it look like value is being created at a rate I'm happy with? And then probably, I'd say

third, depending on the company third party research, if I can find some strong reviews online, a consensus, there's multiple of these like software review websites that just you have an aggregate of reviews from people and their commentary. So I think that's great because you can get a consensus based on the customers that are actually using some of these software products or products online, which are great, because I love to get as close to the customer as possible and understand why they like this product. Am I seeing evidence of that? You've got, like, let's say it's a product being sold on Amazon. You've got, you can see the number of reviews.

You can see how popular it is. You can read through what people like it. So I would say quarterly press releases, and then if I can get customer data or some type of insight of how people feel about this product. Yeah, because that helps you determine the value proposition that the company is providing. Yasser, over to you. In addition to the 10K, what's the one or two sources you spend most of your time in? Sure.

I love listening to earnings calls, not just reading them, but actually listening to them. And the reason is, I think, even though numbers speak, you know, sometimes you can pick on subtle cues in the way that management talks about the business, in the way that, you know, especially in the Q&A session where it's not scripted anymore and they're getting questions from analysts and they have to respond to them in real time, that can often be very illuminating on the state of the business and where management believes things are likely to go from there. Another source that I often go to as well is investor letters. So, you know, I want to see how some of the, you know, biggest investors out there, both on the, you know,

growth and value sides of investing are thinking about this particular business. You know, what is their kind of thesis for it? Is it similar or different from mine? And sort of if there can be any, any, you know, aspects of thinking about that business that I had not personally paid attention to before. So I find these two sources to be pretty helpful to my process. Love it. There you have it, fools. How two of the Motley Fool investing teams top analyst, identify stock ideas, and do their research process in a step-by-step manner. Thank you, Ari. Thank you, Yasser. That's all for today, but coming up tomorrow, the bold case for Bitcoin.

As always, people on the program may have interest in the stocks they talk about, and the Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.