People ask me one question more than any other: How do I find my investment ideas?
Different managers have different methods. Some use stock screens. Some stumble upon their ideas haphazardly. Still others dig around in the portfolios of other managers they trust.
The real trick isn't in finding an idea. The important thing (and the tougher one) is to dig in, do your homework, and think through your ideas before throwing money at them.
As Wall Street's euphoria turns to fear, the markets' recent volatility has provided us with literally hundreds of amazing investment opportunities. Chances are, you're sitting on five to 10 ideas that might be winners. Now you need to start analyzing them.
A recent favorite example of mine is FBR Capital Markets
To me, "busted IPO" reads like a flashing neon sign above a doorway to dollars. As the name describes, these companies are recent market arrivals trading at a significant discount to their IPO price. Busted IPOs can be the first sign of a potential investment opportunity.
To begin your analysis, figure out what the company does, and whether the business looks attractive enough to warrant a more thorough pass. FBR has built a niche in the fertile ground of middle-market companies, which sport market caps south of $1 billion. Goldman Sachs
FBR has three major business lines: investment banking, institutional brokerage services, and asset management. In addition to these apparently healthy segments, the company sits on a war chest of cash, marketable securities, and other investments. To sum it up:
- We have a recent IPO that is trading significantly lower.
- The company has three healthy, growing, easily understood business segments.
- It's well-capitalized, with excess cash.
Congratulations! You just made it through your first date with this potential investment idea. On to the second date.
I like a cheap date
As value investors, we're seeking good, safe companies. We'll even take a mediocre company, assuming it's staggeringly cheap. So for our next step, we'll try to roughly value the company with some back-of-the-envelope numbers, gauging whether it warrants a deeper, more detailed valuation.
FBR sits on roughly $406 million in cash and marketable securities, plus another $85 million in long-term investments. (We'll discount that latter amount by 40%, in the event of fire-sale liquidation.) These numbers give you a grand total of $457 million: $406 million in cash, plus a fully discounted $51 million in long-term investments.
When valuing non-marketable investments like the $85 million, it's best to be conservative. I'm assuming that if we were forced to sell them fast, we wouldn't have to discount them by more than 40%. A more robust analysis would try to gauge the nature of the investments before applying the discount. But remember, this is just a first pass, so I picked what I consider an extreme discount.
This quick glance shows the $457 million represents roughly $7 a share in cash and cash equivalents. At FBR's current $10.70 share price, then, you're buying three businesses for roughly $3.70 a share, or approximately $240 million.
Let's not get too excited yet. This date's resume is looking pretty good, but we're not quite ready to pop any questions.
Now that the investment idea has gotten this far, it's time to really start digging. We need to value the three businesses in which FBR participates, assessing whether they're worth significantly more than the $240 million you'd have to pay for them today.
That's where a lot of the real work comes in. But I hope you've gotten at least a rough idea of how value investors begin to approach an idea. They spend incremental amounts of time with high-level granular research, narrowing and intensifying that work ever further as they approach a potential buy decision. I'm not sure whether FBR qualifies as a buy just yet, but it certainly warrants more of my attention -- and maybe yours, too.
Fool contributor Rimmy Malhotra has a position in Citigroup. The Motley Fool has a fully valued disclosure policy.