Overview – Coming Up With Investment Ideas
This article marks the start of a series of three interconnected articles where we will go through a relatively simple investment analytical framework.
Now, this framework we will be going through is by no means the “perfect” or “ideal” one to follow: it is simply a sample framework that readers may wish to copy, emulate, or at least take some inspiration from.
Its purpose is to demonstrate how investors may wish to go from start to finish in their work, starting with an investment idea to a final, informed decision.
We will begin this series by looking at how to come up with investment ideas. After all, every investment in a given portfolio was once just an idea in someone’s mind; it only made its way into that portfolio because the investor decided to follow through with their idea.
For the sake of simplicity, this analytical framework will focus primarily on equities, but the major ideas we cover can most certainly be adapted to almost any other investment instrument.
So, with that being said, let’s get right into it.
High-Level Search & Suspense of Scrutiny
Say we’ve decided to put our money to work, and the way we’ve chosen to do that is by owning equities (i.e., stocks). Right away we’re presented with the challenge of figuring out which specific equities to acquire.
There are a seemingly infinite number of prospective investments to choose from, so how can investors possibly know where to start?
At this stage, it’s important not to focus on the details too much, if at all, which in the context of our discussion would mean not searching for individual companies for now.
The underlying philosophy we will be following when trying to come up with potential investment ideas is to start as broad as possible and become more granular as we proceed. So to start we begin with a broad, high-level search.
What does a high-level search look like when seeking potential equity investments? One way is to look for certain industries and/or sectors that pique an investor’s interest.
Although there are some differences between an industry and a sector, they’re similar in that they represent specific portions of a broader economy, and for the most part, can be used interchangeably. Some examples include healthcare, technology, manufacturing, and agriculture, to name a few.
When performing this high-level search there is no such thing as a “good” or “bad” idea. At this point, the emphasis is on quantity, not quality. If an industry or sector comes to mind, make note of it and keep searching for others. The industries/sectors an investor chooses can be scrutinized later.
Nothing stifles brainstorming faster than premature scrutiny, which is why at this stage we will temporarily suspend any scrutiny. There is an appropriate time and place for when scrutiny should be applied – generating a list of potential investment ideas is not one of those times or places.
As a final remark for this section, it’s important to note that this high-level searching may prove to be unnecessary as an investor gains more experience and develops a list of “favourite” industries they choose to focus on for future investments.
Of course, this doesn’t mean more experienced investors can’t benefit from this process, but they won’t benefit nearly as much as investors who do not yet have any “favourite” industries in mind.
Narrowing Down Your Industry/Sector List
Now that we have a list of potential industries/sectors to choose from, we can begin our critiquing process. We start by trimming the list of industries/sectors we wish to study further.
To create a shortlist of industries we want to seriously consider, we can begin by asking ourselves two questions:
- Which industries do we already understand, or feel we can quickly understand?
- Which industries interest us, but do not immediately understand/want to know more about?
Question 1 is essentially a question of fit: which industries best suit our current strengths and knowledge, and which industries can we learn about without much difficulty given our interests/aptitudes?
Naturally, the answer to this question will vary based on an individual investor’s educational background, personal interests, and how enthusiastic they are about learning something new, to name a few factors.
An investor who hails from a technical background but isn’t very interested in learning about things that aren’t tech-related will have a very different list of focus industries compared to someone who hails from a humanities background but loves to learn about new things.
Asking this question can also help investors identify which investment ideas they can pursue without spending too much time on analysis. Now, this doesn’t mean investors can cut corners when it comes to their analytical work, but they can potentially save time when looking at industries they already have some familiarity with.
Question 2 serves to categorize industries that may potentially be part of our portfolio someday but are not currently under serious consideration.
Just because we don’t understand an industry/sector right now does not mean it should be permanently disqualified. Potentially excellent investment opportunities may await in industries we don’t fully understand yet but may eventually understand through further study and with more investment experience.
After asking these two questions, the industries that we answered Question 1 with are the ones we will continue to focus on and will take with us to the next step.
High-Level Search of Individual Companies
After finalizing the specific industries/sectors we wish to seriously consider, we once again perform a high-level search, but this time we begin looking for individual companies. Like before, the focus for now is on quantity, not quality.
At this stage, the hope is that an investor will have narrowed their list of industries to a number they feel they can handle, but within those industries exist hundreds, if not thousands of companies. If that’s the case, how can an investor possibly hope to perform an effective high-level search without falling victim to analysis paralysis?
One method is to impose specific criteria on prospective companies. Perhaps an investor wants to focus on the major players in a given industry, maybe they want to focus on those that follow a specific business model, or maybe an investor wishes to look for lesser-known companies with the hopes of finding some hidden gems.
For example, let’s say an investor wishes to focus on the renewable energy industry. Renewable energy comes in many different forms such as wind, hydro, geothermal, and solar. Their specific area of interest is solar energy, and are particularly interested in companies involved in solar panel research and development, so this investor will look for companies that satisfy this specific criterion.
This process of focusing on a specific industry and looking for individual prospects based on specific criteria can be repeated as many times as an investor feels is necessary until they have a list of prospective companies they feel is sufficient.
Just like before, we will suspend scrutinizing this list for now so that we can come up with as many potential investment ideas as possible.
Trimming Your List of Prospective Companies
Let’s recap what we’ve done so far: performed a high-level search by looking for industries/sectors that interested us, narrowed this list of industries to a handful we felt we understood well, and compiled a list of prospective companies within these industries.
Earlier we briefly mentioned how this part of the investment analytical framework is all about starting broad and becoming more granular as we progress. We started with having no idea where to start looking for investment ideas, and now we’re on the verge of beginning our in-depth analysis of individual companies we wish to seriously pursue.
Coming up with investment ideas isn’t exactly a walk in the park, but it doesn’t have to be onerous either. The process we went through in this article is a testament to that.
At this stage of the framework, we want to reduce our list of prospective companies to the ones we will be performing in-depth analysis on. There is no hard number we will give here because the number of prospects an investor can analyze will vary between individuals. Some may be capable of analyzing 15 prospects, while others may feel comfortable working only on 8.
The prospects we decide to focus on at this stage will be the ones we will carry through to the next two parts of the analytical framework.
Wrapping Up
This entire framework we just discussed can be visualized below:
Attempting to generate investment ideas without a framework in mind is like wanting to drive from one city to another, with the plan simply being to “get to the next city” – that’s not a plan, that’s wishful thinking.
Similarly, you cannot possibly hope to generate any reasonable investment ideas by simply letting your mind wander.
Coming up with investment ideas is not an easy task, but there is no reason for an investor to make a hard task even harder by not having an appropriate framework to follow. The process we followed in this article is an example of how investors may wish to go about generating investment ideas in an effective and relatively timely manner.
