How to choose which stocks to analyse

First things first- there are thousands of stocks, you can’t work on all of them, so how do you narrow the field and decide which to start work on?

Here are three easy groups which can provide excellent investment ideas:

1.  Inexorable Trends

Businesses that benefit from long-term secular trends that are difficult or ideally impossible to disrupt. Think of the sort of trend that cannot be impacted or affected by regulation, politics, market sentiment, fashions or really any external force. Some examples would be: increasing data consumption (we all use our phones more each year), growing e-commerce, aging populations, etc.

But establishing the trend itself isn’t all you need to do, you also need to work out which companies stand to benefit most from that trend. There will often be many different companies that stand to benefit, and you want the one (s) that will benefit the most.

If you get this analysis right, it gives you a substantial margin of safety in company analysis or valuation assumptions – i.e. you can be wrong in the size and scale of a trend, but so long as you get the direction right, you’re likely to still make money.

Example: increasing mobile data consumption.

This is a pretty secure long term trend. Increasing smartphone penetration, more and more video streaming, better mobile networks such as 4G etc. It’s an almost certainty that more mobile data will be used up next year than this year and the same for many years to come.

Likely companies who stand to benefit from this: mobile phone manufacturers, mobile phone component suppliers, chip makers, network providers, mobile tower owners, mobile tower manufacturers. etc. etc. Spend some time thinking through each of these, and determine which is the purest play on this long term trend.

By doing this sort of high level thinking at the start of your investment process, you might end up with just a short list of companies that warrant potential analysis. And each of those your chances of success are much higher than the market overall. You have stacked the odds in your favour.

2.  Earnings Compounders

The second group is made of businesses that have proven they can continuously compound their cash earnings by reinvesting capital at attractive rates. These businesses tend to benefit from some combination of long growth runways, wide moats, and a management culture focused on customer satisfaction, cost discipline, and generating attractive returns on invested capital.

Since these businesses do not (necessarily) benefit from secular industry tailwinds, our margin for error is smaller – i.e. poor management or new competition can quickly erode the economics here. As such, you would typically tend to hold businesses in this category for shorter durations and demand a tighter IRR range to remain holders.

These are companies that may not necessarily benefit form any specific long term trend, but they possess something about them that has enabled them to generate consistent returns historically, and you expect they’ll be able to do the same in the future as well.

3.  Inefficient Markets

The third group are high quality business that the market is simply mispricing. These businesses might belong to a currently out of favour sector, their underlying economics might be misunderstood by the market, or for structural reasons, such as liquidity or benchmark considerations, they have been ignored by investors.

In any case, these opportunities tend to only appear at times of extreme market dislocation so when we do make investments in this category, they tend to be the shortest duration holdings you’re likely to have. Hopefully after you’ve taken a position, the valuation discrepancy disappears (stock goes up) and you’re able to sell your position and move on.