IDEA GENERATION MACHINE The most flawlessly executed fundamental research process means NOTHING if not tilted towards the right investment opportunity. An analyst can spend 2 weeks checking off every box on a Deep Dive Research Roadmap,
but what if that stock is fairly valued, with no immediate prospects for being mis-valued? And all that research goes to waste? I'VE BEEN THERE! MANY, MANY TIMES! IT SUCKS! Early in my career my roles were a bit vague. I was junior analyst support to two senior analysts,
updating and building models, taking meetings, doing one-off tasks. About 3 months in, I had some free time and wanted to prove myself, so I updated the Kroger model, did a little research, and confidently walked into my Sector Head's office and pitched it as a long.
After letting me ramble for 5 minutes about how Kroger was a great operator, much better than Safeway, and trading at a cheap 10x P/E ratio, he stopped me. "Brett, but what's the thesis? Why does the opportunity exist?". It was his kind way of telling me I was an idiot, and to
promptly get the f*ck out of his office. But it was a powerful lesson for me. No thesis, no capital. PATTERN RECOGNITION "At a senior level, this job is just about pattern recognition". Ever heard that? I have. About 684 times. It's a trope about how the PM's job is just
to wait in his/her office for analysts to pitch ideas, then assess which ones have promise by referencing those ideas to the mental library of past ideas that have (or haven't) worked. I'll give you an example. My team pounded the table to get me to buy TEVA in 2017. They saw
a good asset with a new CEO as change agent. I saw a pile of crap asset with a promotional CEO, and I was still nursing my wounds from the carnage ENDP inflicted on my P&L 18 months prior. Even if they were right, nothing in the world could have gotten me to hit the buy button on
that one. TEVA felt too much like ENDP to me, and I was determined not to make that mistake twice (the first time, it basically got me canned). Senior investment professionals inevitably build up these wounds, scar tissue from failed stocks, and positive associations from the
winners. "This feels like XYZ stock" is a powerful framework, and a key tool used by the pros to hit fewer dry wells on new ideas. SYNTHESIZING PATTERN RECOGNITION The stock market is an incredibly difficult game. Markets tend towards efficiency over time, and
in my opinion, alpha pools are secularly shrinking. 50c dollars don't grow on trees. At any given time, I believe the majority of stocks in the market are pretty close to fairly valued. The odds that you are going to throw a dart and find a great thesis are slim.
But we are training analysts here! Are we just supposed to say, oh well, let the new analyst have 10 years of experience to finally identify new ideas via lived pattern recognition? No, that's not how Fundamental Edge rolls. I believe there are a few ways to synthesize pattern
recognition and short-circuit that required time to become a pattern recognizing idea generation machine. STEP 1: RETROSPECTIVES. A good way to synthesize pattern recognition of past events is to simply study the past.
Want to find the best software long over the next 3 years? Go study the last 20 years of software stock performance. Each year, identify the top decile of software stocks, then go study them ex-ante. Before the big move up, what were the pre-conditions that existed in that stock?
Read some sell-side research, earnings transcripts. look at the financial model. If you hire a new analyst, have them do this exercise! And write a one-pager on each of the top 3 software stocks over the last 20 years. What were the prevailing conditions when move started, what
happened, and what were the prevailing conditions (sell-side commentary, etc) when the move peaked? Then look at these 60 stocks (3 each year over 20 years) and attempt to discern common patterns, and have analyst write a 5 page report on what has worked in software investing.
There you go, synthesized pattern recognition! When looking for that next winner, analyst has 60 prior successful situations to pull from mentally. STEP 2: DEFINE ALPHA BUCKETS I feel strongly that each PM should have a 15-20 page new-hire manual for new analysts to read.
Things as simple as standard model formatting conventions. Probably the most important element of that manual is to codify and define alpha buckets. Have you made most of your money in a certain type of trade? Say when software companies accelerate from +10% to +15% rev and also
multiple expansion? Spell this out, and have your analyst on the hunt for these types of situations. Give your analyst a little kickstart on understanding what types of ideas you want to own (I could have saved my team a LOT of time on TEVA).
THE 2 C'S: CHAOS & CHANGE Over my career, I have developed a mental model called "equilibrium, disequilibrium". In equilibrium, things are steady. Fundamentals are consistent and predictable. Sentiment is consistent. In equilibrium, stocks are fairly easy to value. Generally,
in equilibrium it is more difficult to find great ideas. Big picture, I've found that the best opportunities come from disequilibrium, either at a company level, an industry level, or a
broader markets level. When the shit hits the fan, the fun begins. Change is a key form of disequilibrium. On Invest Like the Best, Steve Mandel described his career as mostly investing behind change. Markets have a blind
spot for structural change, and the good analyst can see the effects of that change before the broader market. SAAS-conversions sparked by ADBE are a key "change" bucket. But there are many secular changes that have been enduring alpha sources for stock pickers (e-commerce, cloud
computing, etc). Chaos and Change = your friends in idea generation. WHY DOES THE OPPORTUNITY EXIST? If you cannot define why an opportunity exists in the market, the odds are there might not be an opportunity. In a hedge fund context, generally the first ~4% of alpha
generation just covers the 2 & 20. There is no "market perform" in a hedge fund, every idea must contain a prospective alpha load. A good idea is mispriced relative to its prospects, and a good analyst must define why. I personally like to address this when I'm pitching a
stock. Why is the stock cheap? What, specifically is causing this asset to be mispriced or overlooked? Convincingly explaining why the stock is mispriced is a key element of effective pitching. Next, I will walk through 8 COMMON ALPHA BUCKETS.