IDEA GENERATION: IDEA BUCKETS Continuing on the theme of idea generation, I have found that it is helpful to bucket idea types. Being very clear about the underlying characteristics of a compelling idea can aid greatly in identifying new ideas. I'll give you an example. I once
asked a member of the exec committee at [QUANT MULTI-MANAGER] if there were any common characteristics of all of his various strategies (macro, equities, quant, credit) when it came to alpha generation. He responded that the durable sources of alpha, across strategy, tended to
have "off menu to on menu" dynamics. What does that mean? Some driver of investor distaste drives a security "off menu", meaning investors don't want to hold it. Forced selling is a key screen. It could be index exclusion, a recent earnings miss, a litigation overhang, etc.
Spin-offs, where the parent holder is granted a stub equity and just wants it off the books is a long-standing example. This distaste then gets discounted in the price, and often over-discounted. The fundamental investor can analyze this situation, assess the risk/reward, and
see a catalyst path for that security going back "on menu". The skilled investor buys low (off menu, issue over-discounted), sells high (on menu, normalized valuation). CREATING YOUR IDEA BUCKETS As with most concepts I discuss, there is no one-sized-fits all. There is no
silver bullet in stock picking (if there were, quants with infinite capital would arb it quickly). Your idea buckets must fit your strategy and your style. I'll give you another example. For the bulk of my career I have been a healthcare services investor. The underlying
businesses in that space have incredibly stable cash flows, and are very hard to displace. On a pure fundamentals basis, the growth & FCF generation should point to high valuation multiples. When the inevitable regulatory or litigation overhang appears, these growing businesses
can be bought at very low multiples (off menu). As the issue dissipates, the multiple expands as investors come back around to the story, and I've been paid by the FCF generation while I waited. I can run into the proverbial burning building based on the fundamental stability of
the business (i.e. odds a McKesson goes bankrupt are very low). And I've been trained and hardwired to do that. When I took my investing approach to pharma & biotech, however, it was disastrous. There, innovation that drives revenue inflection is the name of the game. I will walk
you through 9 idea buckets that I have used in my career, but the caveat is that you must apply these buckets to your own specific strategy carefully. OFF MENU, ON MENU. Discussed above. Also called the Toll-Booth Trade (paid to wait). I like to call it the Beach Ball Trade
(some external force is pushing the beach ball below water, and all that needs to happen is that force to dissipate for the beach ball to come back). The Beach Ball trade can be applied in all sorts of situations. Ask yourself "why does the opportunity exist", and think very
carefully about the force that is creating the cheapness, and assess creatively a catalyst path for that force dissipating. COMPOUNDERS. Not to throw up the bat signal for the compounder bros on twitter. But there's a reason DHR, TMO, TDG, UNH, etc have been such great
stocks over very long periods of time. A +6% organic rev, +4% bolt-on, little bit of op leverage, +10-12% EBIT, little bit of below-the-line leverage, little bit of buyback, +15% EPS stead compounding profile is a beautiful thing when you are trying to beat the market return of
8-10%. When purchased at a reasonable P/E, all you need to do is hold the P/E and ride the +15% EPS growth. Even better, sizing up these positions when P/Es are below base case, and you are playing for EPS growth plus P/E mean reversion. I will warn you, not everything is a
compounder. In my experience, steady, predictable end markets paired with stable competitive dynamics and a long tail of bolt-on M&A have been the ingredients for a long run of compounding. MISPRICED CATALYSTS. These are more common than you think. I've found on many
catalysts, the market just doesn't want to play. Rather than run from SCOTUS rulings or elections, I've experienced some mispriced catalysts there over my career as a healthcare investor. First, assess the likely upside in a bull case, then the downside in a likely bear case.
Impute the implied probability of success (PSUC), shown in graphic above. Then layer on your expected PSUC. Where there is a large gap, there is large expected value (not that you will be right every time, but if you flip 60/40 coins consistently are likely to generate good
outcomes over time). EXTRAPOLATION MEET INFLECTION. I think we all agree that markets can be far from efficient. Which makes sense on first principles...the market is attempting to ascribe value based on a view on 30 years of cash flows, when the CFO of a company rarely has
good visibility beyond 12-18 months (often less). So what happens in practice is the market tends to extrapolate recent data points, often trading stocks peak on peak and trough on trough. The idea bucket of looking for ideas where the market is extrapolating recent fundamental
performance, but your research process identifies a likely inflection, is likely to be a fruitful source of outperformance. At some point I will walk through my "what's in the stock" analysis with reverse 30-year DCF and multiples analysis to help you identify these mis-placed
extrapolations. COMPLEXITY TO SIMPLICITY. The market doesn't like complexity. The market likes simplicity. Basic, but true. Messy situations, either operationally or financially, can be fruitful opportunities to dig in. As the situation is cleaned up, either an
underperforming division sold, a debt stack simplified, a litigation resolved, the story becomes much simpler and more "ownable". A version of the off menu to on menu trade. CHANGE AGENT. Generally either an activist pushing for margin improvement, better capital
deployment, or management change. Or a new management coming in with fresh eyes. Turnaround stories aren't a one-way street, "failed turnarounds" can be great shorts when too much hope creeps into the stock. But a new CEO with a sharp pencil can really be an investible thesis.
GROWTH ACCELERATION. This is an idea bucket that exploits the extrapolative bias of the stock market. My worst shorts have been fast growing businesses that accelerate. When a business goes from +10% revenue growth to +15% revenue growth, most often the multiple will expand
on top of that. The "valuation doesn't matter" era in 2020-2021 captured this reality. When fundamentals are accelerating, WATCH OUT. The P/E can often overshoot any sense of reality. Use this reality to your advantage. CONT'D
CAP DEPLOY / CASH ABUNDANCE. There are certain times, in certain stocks, where there is just too much damn cash for a stock to go down much, and those situations can provide very asymmetric returns. I was long HMOs in 2012, despite the uncertainty of the Affordable Care Act,
on a belief that the ACA wouldn't be draconian, but mostly on a view that at 15% FCF yields (w/ growing FCF streams) the HMOs could cover over half of their market cap in 3 years. Even in an extremely unlikely scenario where AET/UNH/HUM were put out of business, they could have
generated ~70% of their market cap by the time they went BK. That moderate risk case was truly where I was able to source my conviction. Where there is a large cash balance, cash flow generation, high FCF yields, and a owner-oriented management team, good things tend to happen.
INNOVATION. The first image that comes to mind is Peter Lynch bringing home 8 different kinds of panty hose for his wife to try. There certainly are VC elements of public market investing, where all that matters is figuring out the best product and best business model.
Seeing clearly 5+ years out will be an enduring source of alpha. The Phillipe Laffont's & Chase Coleman's of the world have just had a better crystal ball on tech innovation than the rest of us. There is a dark side to chasing innovation, however. For every TSLA there is a
Rivian, Lucid, and Nikola. I don't know how many "next Amazon" pitches I've heard. Innovation investing is not for the faint of heart, and many retail traders in particular get very excited about some bullshit EV charging thesis without having the requisite industry expertise
to bet on the real winners (I've seen many of these pitches in my class and delight at ripping them apart, kindly). I'm sorry to break it to you, but BROS isn't the next SBUX. SECTOR SPECIFIC BUCKETS Figure out your own buckets based on your experience (or if you are a PM,
communicate these to your analyst). I'll give you two examples. Back when I was a restaurant analyst, I saw an analysis (John Glass, MS) showing that restaurant P/Es broke right around hitting 50% penetration. Hunt for those stories. In medtech, the market tends to pay high
multiples for organic growth. 3-5% might be one bucket, 5-7% another bucket of P/Es, and if you can get to +10%+ your P/E will skyrocket. For a period of time, when TFX bought Urolift, the market got really excited about a faster growing acquisition eventually layering into a
faster aggregate comp profile, and bit the P/E up to new heights. So if a medtech investor, layer in bolt-on's carefully to investigate where M&A programs may lead to faster aggregate organic growth. THAT'S ALL FOR NOW. HOPE THAT IS HELPFUL