Basic, lesson 1 of 3
Finding ideas
Good ideas rarely arrive from the news. Analysts find them with screens, with filings read in the right order, and by going where other investors are not looking.
9 min, 3 checks
1Screens narrow the field
A screen is a set of filters run over a universe of stocks. It does not find a buy; it finds a short list worth an afternoon each. Long-only screens usually combine a quality filter, a balance sheet filter, a valuation filter, and sometimes a neglect filter.
| Filter | Stocks left | Why it is there |
|---|---|---|
| Start: US stocks above $2 billion market cap | 1,500 | The fund's universe |
| Return on capital above 12% in each of the last five years | 300 | Proof the business earns well through a cycle |
| Net debt below 2x EBITDA | 210 | Can survive a bad year without diluting owners |
| EV / EBIT below its own five year median | 45 | Cheaper than usual, for some reason worth finding |
| Eight or fewer sell side analysts | 12 | Less crowded, more room for a different view |
Twelve names is a week of reading. Most will be cheap for a good reason: a customer leaving, a lawsuit, a product cycle ending. The job is to find the one or two where the reason is temporary or overstated.
Check 1
A screen starts with 1,200 stocks. 25% pass the quality filter, 40% of those pass the balance sheet filter, and one in six of those pass the valuation filter. How many stocks are left?
2Reading the annual report in the right order
An annual report (the 10-K in the US) runs to a hundred pages or more. Analysts read it in an order that answers the important questions first.
- Business description: what it sells, to whom, and how it describes competitors.
- Segment note: which division earns the money, often different from the one management talks about.
- Management discussion and analysis: why revenue and margins moved, in management's words.
- Risk factors, compared with last year's: new paragraphs are where the news hides.
- Revenue recognition and the notes on debt, leases, and pensions.
- The proxy statement, filed separately: how management is paid and who owns the shares.
Check 2
You want the quickest signal of a risk that is new this year. Where do you look?
3Where neglect comes from
Prices are most likely to be wrong where few people are paying attention or where the holders are forced to sell. Those situations repeat, so analysts watch for them.
| Situation | Why the price can be wrong |
|---|---|
| Spinoff | Parent shareholders receive shares they did not choose and often sell them unread |
| Index deletion | Index funds must sell on a set date regardless of value |
| Small or mid cap with little coverage | Few analysts, so slower to reflect new facts |
| Emerging from restructuring | Old holders are exhausted; new holders are distressed debt funds that want out |
| Complex structure | Holding companies and conglomerates take work to value, so many skip them |
| A boring, out of favor industry | Growth funds ignore it and value funds have been burned before |
Check 3
Halden Corp spins off its slow growing packaging unit, Corbel. Halden is in a large cap growth index; Corbel is a small cap. Why might Corbel trade below value in its first months?
Terms in this lesson: Balance sheet, Equity value, EBITDA, Enterprise value, Operating income, Factor.
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