Idea generation is both art and science. In investing, various quantitative methods can throw up many “names” for consideration, based on criteria such as price to earnings, enterprise value to sales, or price to tangible book value. On the surface, the companies with the lowest ratios will be the cheapest publicly traded companies at the moment. However, if investing was as simple as picking the quantitatively cheapest companies and earning a market-beating return, then investment success might not be as elusive as it is actually.

Several issues arise with the use of purely quantitative methods. First, quantitative screens suffer from a version of the “garbage in, garbage out” problem: One-time items, such as a non-recurring gain on the sale of subsidiary, can inflate reported income, making a company seems cheaper on a the basis of P/E than it would be if the one-time gain was excluded. Second, even in the absence of one-time items, a cyclical business will report the highest earnings at the top of a cycle, right before income is about to decline. Third, cheap companies are often “cheap for a reason”, with the most obvious reason being that the company in question is a terrible business with low returns on capital. If a company trades at a low P/E multiple but retains earnings and reinvests them at a low rate of return, long-term shareholders are unlikely to earn a high return. Over time, shareholder returns converge with the return on capital at companies that retain the vast majority of earnings.

Every investor faces a practical constraint: limited time. If an investor had no time constraints, idea generation strategies would be much less important, as we could analyze every available idea. Time limitations force us to prioritize. Quantitative screens are one way of prioritizing companies for further research. Conversely, David Einhorn, founder of Greenlight Capital, has talked about looking not for statistically cheap companies but scouting for situations in which non-fundamental reasons may lead to the mispricing of a security.

Over the past seven years, The Manual of Ideas has queried a number of thought-leading investment managers about their idea generation strategies. We highlight some of their insights below.

Allan Mecham, founder of Arlington Value Management:

[I generate ideas] mainly by reading a lot. I don’t have a scientific model to generate ideas. I’m weary of most screens. The one screen I’ve done in the past was by market cap, then I started alphabetically. Companies and industries that are out of favor tend to attract my interest. Over the past 13+ years, I’ve built up a base of companies that I understand well and would like to own at the right price. We tend to stay within this small circle of companies, owning the same names multiple times. It’s rare for us to buy a company we haven’t researched and followed for a number of years — we like to stick to what we know. That’s the beauty of the public markets: If you can be patient, there’s a good chance the volatility of the marketplace will give you the chance to own companies on your watch list. The average stock price fluctuates by roughly 80% annually (when comparing 52-week high to 52-week low). Certainly, the underlying value of a business doesn’t fluctuate that much on an annual basis, so the public markets are a fantastic arena to buy businesses if you can sit still without growing tired of sitting still.

 

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