Stock Idea Generation

of Hedge Fund Training

How can you generate ideas that will produce robust annualized returns? This chapter will address what characteristics and types of trades to look for.

An attractive long position typically has two characteristics: it is both undervalued by the market and under-earning. Under-earning means that the company is not realizing its full earnings potential. One example is a company that is not maximizing the price for its product when there is either very strong demand or limited competition. This company has the opportunity to charge its customers more, with limited risk of customer attrition. Another example is a company that has unusually depressed margins due to the switching of suppliers, or adverse raw material price shocks that can soon change in the company’s favor.

In contrast, an attractive short position will ideally be both overvalued by the market and over-earning. Before choosing a short position, one must be aware that it is more difficult to be successful shorting a stock then being long. One classic shorting mistake that a majority of investors are vulnerable to is shorting a stock simply because it is expensive when compared to its competition and the market. For whatever reason, certain stocks can consistently trade at very high multiples. Although a stock may seem relatively or even wildly expensive, that evidence alone is not enough to make it a good short position. Instead, it is safer to search for stocks that are both overvalued and over-earning. When talking to a management team or sell-side analyst, the pitch of a security that is over-earning usually contains the phrase or concept “this time it’s different.” Identify companies that have experienced sudden and drastic changes in their business after a long history of consistent and steady margins or revenue growth. Unless something has structurally changed to the company’s business model or industry, the company is likely experiencing a period of over-earning.

One prime example of over-earning occurred when Tempur-Pedic introduced its new Cloud bed. This new bed was an instant hit and caused a big increase in the company’s stock price. However, Tempur-Pedic had been selling high-end beds for a long period of time; the introduction of the new Cloud bed did not justify the company being worth 3-4x as much as it had been over the course of a few years. What the market didn’t correctly grasp at the time was that beds were ultimately a commodity business and sooner or later competition would introduce a similar product.. Once competition in the new Cloud bed market stiffened, Tempur-Pedic’s revenue growth slowed dramatically and the stock price quickly imploded.

Here is a list of common things to look for in long and short position ideas:

long and short position ideas

Resources to Generate Investment Ideas

Sometimes finding a great investment idea can be as simple as watching TV or reading the newspaper. Having a good sense what’s going on in the financial markets and what’s going on in popular culture can help investors find attractive investing opportunities. One example is when Weight Watchers launched a large advertising campaign starring Oscar winner Jennifer Hudson. At the time, Jennifer Hudson had reached new heights in her career and the ad campaign had the potential to revive a struggling company. This insight could have been a valid reason to start researching a potentially great turnaround story.

Below are additional resources / tips to use when searching for new ideas:

  • Read the Wall Street Journal, Barrons, The New York Times, Financial Times.
  • Set up Google Alerts to track certain industries.
  • Track industry blogs.
  • Use Scribd to search for investment presentations.
  • Follow 13F Sites such as
  • Read Value Investment Club and SumZero.
  • Track Insider transactions to gain a sense of how management perceives a company’s stock’s prospects.
    • E-Z Insider
    • Insider Score
    • Barron’s

Traditional Screens for Idea Generation

Most investors use screens to find companies that “stick out” and fit specific criteria. Some screens include searches for (on the long side):

  • Low Price/Book value
  • Low Price/Earnings
  • High Free Cash Flow (FCF)
  • Spin-offs
  • Recent Insider buying
You can screen for these items using the following resources:

  • Bloomberg
  • Factset
  • Capital IQ
  • Barron’s
  • 13F filings

Getting an Edge

One of the primary roles of a hedge fund analyst is to figure out something that other investors and the general public does not know. This doesn’t mean doing anything illegal, it just means searching, collecting, and analyzing information in a way that helps form a unique opinion. The three most common types of edges are:

  • Informational Edge: Having a key piece of information before the market does. This does not mean having inside information. This type of edge typically comes from unique data collection and analysis.
    • For example, a person in tune with the housing market in Connecticut may realize that home prices in the surrounding neighborhoods and states are all falling. This person can have a very different view than the market, which may be expecting earnings of a Connecticut-based homebuilder to increase significantly based on the prediction of a healthy housing market and rising home prices.
  • Analytical Edge: Having analyzed information in a way that is superior to the rest of the market. Investors often interchange the terms Informational Edge and Analytical Edge.
    • For example, someone who was a former manager of an auto manufacturer, and then became an auto analyst, might know how to take information released and process it better than the rest of the market. This could mean, for example, interpreting new data as simply a seasonal headwind, while the broad market believes instead that it is the start of a new trend.
  • Behavioral Edge: Acting differently than the crowd—in other words, being able to truly act and invest as a contrarian. This is the edge most investors claim to have, but a characteristic only a select few actually possess. Everyone talks about being a contrarian, but if you analyze the 13F filings of hedge funds, you will see a tremendous amount of overlap among hedge fund investors. and therefore many crowded positions.
    • Some examples of contrarian styles include investing with a long-term view (greater than 2 years), buying crowded shorts, or having very concentrated portfolios (less than 10 investments).

A typical concept taught in many investment classes is the art of searching for “motivated sellers.” This typically means finding someone on the other side of the trade that is more incentivized to get in or out of a position quickly than to receive a favorable price. This is fine in theory but in real life is rarely actionable. Ultimately, the market is extremely efficient and there are a lot of funds set up specifically to identify these types of situations. This generally leads to these opportunities disappearing fairly quickly. Classic situations like this include corporate spin-offs, or index de-listings, where a supply/demand imbalance is synthetically created. The problem with this strategy is that most investors have access to the same information, and these situations often are “arbitraged out” (expected profits disappear) before anything can be done about it.

Channel Checks

Channel checks are a common way of conducting primary research. A channel check is when an analyst performs due diligence on competitors, customers, or substitute products to understand business trends better. Channel checks can serve as a confirmation to other research theses, or can lead to an entirely new investment thesis. Channel checks are typically performed after initial financial analysis has been completed.

How to Conduct a Channel Check

  • Identify your mission and develop a clear hypothesis: Ask yourself what the primary goal of the channel check is. It is very easy to start reaching out to companies and asking questions and finish a conversation with little new information due to a lack of planning and research.
  • Identify your value drivers: Ask yourself, “What do I need to know in order to prove my thesis, or to contradict it?”
  • Understand the industry: People can very easily discover when you are unprepared or unqualified to speak about a certain field or industry. People are looking to exchange ideas and information, and you will squander the opportunity if you are unprepared, because the other party will be less likely to give you information if he feels you cannot help him as well.
  • Ask for a follow up: Be direct and ask for a follow up. It is always beneficial to build relationships with professionals in preferred industries as it might help you identify new trends quickly.
  • Be thankful: Be extremely gracious and considerate when speaking to industry contacts, and tell each person how helpful the conversation was. Compliment them on their knowledge on the specific area of focus. This will help you maintain and develop relationships and improve your response rate.

What to Expect

  • Expect to get called out: It’s ok and inevitable. People will eventually realize that you are not really an industry participant but an analyst, and they may call you out on this. Do not overreact and hang up–simply try to level with them. Honesty is the best way to go.
  • Expect only 15-20% of the people you contact to talk to you: The friendlier you are, the better the call will go. However, most people you might want to contact will be busy, or may know that you are an analyst, and may not speak to you as a result.
  • In-person contacts are the most effective: In-person meetings are more intimate than phone conversations and are very helpful in developing relationships
  • Try to identify a consistent theme: If you hear the same trend mentioned 3 or times, you may have uncovered something—especially if it is not broadly known.

What to Do

  • Write down all your questions first, and then edit your list. If you have too many questions it will be very difficult to accomplish anything. Test your list out on friends or colleagues to make sure your questions are logical and flow nicely.
  • Identify the questions that uncover issues that will directly impact the financial statements.
  • Make sure you are spending time talking with the right people. The information is only as good as the source.
  • Always write up a summary of your notes. This will help you re-process all the information and provide you a helpful record of all the discussions that you’ve had.

Questions to Ask

  • People are most comfortable when talking about themselves or when providing their own thoughts. Let the speaker open up by asking for their opinions instead of directly asking for the facts. The more comfortable someone is, the more they will be willing to share.
  • Ask comparative questions. This will help you identify trends and establish helpful reference points.
  • Ask open-ended questions that do not favor a specific view or overly guide a conversation.
  • Wherever applicable, try to identify specific ranges. A sample question may be, “Are your sales up 10-15%?” rather than a vague question like “Are your sales up?”
  • You can try asking unreasonable questions to incite a reaction in order to gauge the reasonableness of a view. Once you get the reaction, ask for a more reasonable number or a better estimate. For example, you might ask, “Are your sales up 100% over last year?” The response likely will be along the lines of “no way!” From there, you can ask for a better estimate.
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