Where Do Stock Ideas Come From?

Consider this a starting spot for investors. In this podcast, Motley Fool analyst John Rotonti talks with fellow Motley Fool analysts Auri Hughes and Yasser El-Shimy about finding stock ideas and what to do once you've found them.

They discuss:

Using third-party research tools to discover new companies.
What to look for in investor letters and 10-Ks.
The utility of copying smart people versus using stock screeners.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

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This video was recorded on March 5, 2022.

John Rotonti: 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. I spent two months literally doing a deep dive on KKR because of that one sentence.

Chris Hill: I'm Chris Hill. That was Motley Fool Senior Analyst, John Rotonti. Stock investing can be intimidating in part because it's hard to know where to even begin. 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, Auri Hughes and Yasser El-Shimy in a discussion about how they find stock ideas and what they look for before investing in any company.

John Rotonti: Hi, Fools. I am John Rotonti. I'm here with Yasser El-Shimy and Auri Hughes. Hi, Yasser.

Yasser El-Shimy: Hi, John.

John Rotonti: Hey, Auri.

Auri Hughes: Hey, John.

John Rotonti: 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?

Yasser El-Shimy: 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 try 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 things that I'd like to use, things that I believe have a bright future ahead, and just try to imagine what that future could look like. Just to give you an example, one of my very first investment ideas that came to me was Amazon, the stock. 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. The service saves us a ton of time that, otherwise, we would 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 around there? That's how I started and I always hearken back to one of my favorite all-time investors, Peter Lynch, who argued in his classic book on Wall Street that 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 had made 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 will do well from there.

John Rotonti: Auri, what about you? Where do you look for stocks?

Auri Hughes: I do a combination of three things, and I will talk about the one I like the most. But the first one is the observations of the world, the Peter Lynch thinking that Yasser is talking about. The other one is screen, so using data to screen for what I'd like to see the financial profile in the company. 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 the 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 these gentlemen named Scott Miller, Terry Smith, and really understand their thinking. I can look at 13Fs, or Dataroma, or WhaleWisdom to see what stocks these big funds or money managers are holding, and then research from there. You can see what percentage of the portfolio it is or how high of a conviction is. There's a lot of great funds out there which we can see what they're holding, like Tiger Global, Fund Smith, Holding Capital. It's a source I love because I know it has 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.

John Rotonti: Auri, 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. Scott Miller is obviously an investor that I respect and admire a lot, just like you. I respect and admire him a lot. 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. 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, but it was something almost identical to, “If I could only own one stock for the next five years, it would be KKR.” During that two-month research process, I found out that a bunch of other investors that I respect and admire deeply, all had, not just positions in KKR, but large positions in KKR. Chuck Akre and his team at Akre Capital, Bill Nygren at Oakmark, the team at ValueAct 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 BlackRock and Vanguard. Scott Miller's one sentence in his one-letter a year ago brought me into a two-month deep dive on KKR. Yasser, 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.

Yasser El-Shimy: Can I just jump in here, John, real quick?

John Rotonti: Please.

Yasser El-Shimy: Because both Auri and you bring up very important points here which is the importance of just not paying attention to what's around and what do you think has a bright future ahead, but this is just the very first step of finding an attractive idea that could potentially be an investment. However, finding attractive idea is not enough to make it investment-worthy. So we have to do our research, and as I've grown as an investor, so has the list of things that I check for when I decide whether or not any particular company is worth investing in. I try to look for product market fit, mission creditability, customer retention and expansion, sustainable competitive advantage, etc. These are very important things. Speaking of cloning, one of my all-time greats, of course, is David Gardner, and for a long time, I've seen 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.

John Rotonti: I'm really glad that you stressed 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, 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. So it's a process and maybe the perfect segue into our research process. Maybe, Auri, 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? Then take us through all of the subsequent steps for you to get comfortable enough with a company before you are ready to say it's a buy or it's a sell.

Auri Hughes: Sure. After the discovery process, the first document is the 10-K. Of course, I think that's one of the holy books for investing. It's public information. It describes the business. Then I'm going to read the 10-K. As I read the 10-K, 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? Once I understand the business, I should have an understanding of the variables that affect that business. What's going on? You're mentioning KKR. KKR is money management. So they're managing a pool of assets. They have to generate performance on those assets. 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. I want to look at the management discussion and analysis, understand the business model, and then understand some of the risks that are inherent to that business, and then next, probably, look at the last two quarters over the conference call. 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 an understanding whether I want to continue further, whether it's investable.

John Rotonti: That's incredible. Yasser, what does 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?

Yasser El-Shimy: 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. Some of the investments we make are companies, let's say, software-as-a service companies that, as just individual [inaudible 00:10:49] , we may never have the opportunity to try out the product. But, for example, recently I was looking at social media companies like Nextdoor and Snap Inc., I should say. 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 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. If I still am interested in the company at that point, I will dig deeper into the latest earnings call, the 10-K or 20-F, 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 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 and 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. So you have to understand why a company is valued the way it is, to differentiate between good value and value traps. You'd be surprised how many investors just jump in head-first into growth companies based on that promise that they might be the next FANG stock, the big stock.

But you have to 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. Once you develop that understanding, then you can hone in with developing the list of key performance indicators, or KPIs, that you want to monitor over time in that business. So in an e-commerce business like Farfetch or Etsy, you want to look at metrics like order contribution margins and take rates. In a cloud SaaS business, that might be something else, like remaining performance obligations, RPOs, or net dollar expansion rates, NDERs. 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 this management team is actually delivering on the things that matter.

Chris Hill: That was incredibly thorough and awesome answer, Yasser. Last question to you, Auri. You mentioned the 10-K as the number one place to go to start your 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 Auri, in addition to the 10-K, that's one of them, what's the next other big source that you spend a lot of time in?

Auri Hughes: 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? 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 software review websites that 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? Let's say it's a product being sold on Amazon. You can see the number of reviews. You could see how popular it is. You can read through why 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.

Chris Hill: Yeah because that helps you determine the value proposition that the company is providing. Yasser, over to you. In addition to the 10-K, what's the one or two sources you spend most of your time in?

Yasser El-Shimy: I love listening to earnings calls, not just reading them, but actually listening to them. The reason is, I think, even though numbers speak, sometimes you can pick on subtle cues in the way that management talks about the business, 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. I want to see how some of the biggest investors out there, both on the growth and value size of investing, are thinking about this particular business. What is their thesis for it? Is it similar or different from mine and if there can be any 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.

Chris Hill: Love it. There you have it, Fools, how two of The Motley Fool investing team's top analysts identify stock ideas and do their research process in a step-by-step manner. Thank you, Auri. Thank you, Yasser.

That's all for today, but coming up tomorrow, the bull 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.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Auri Hughes owns Etsy. Chris Hill owns Amazon and Etsy. John Rotonti has no position in any of the stocks mentioned. Yasser El-Shimy owns Amazon, Etsy, and KKR. The Motley Fool owns and recommends Amazon, Dell Technologies Inc., Etsy, KKR, and Nextdoor Holdings, Inc. The Motley Fool recommends Amgen. The Motley Fool has a disclosure policy.

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