A key part of being a successful active investor is your ability to unearth investment ideas that will generate alpha: excess return you earn beyond the market index. If you’re unable to generate alpha over the long term, then you’re better off simply investing in the overall market!
But apart from the occasional stock idea you receive from financial sites or the flavour-of-the-month that’s constantly name-dropped in the news, how do you go about finding ideas that will earn you alpha? In this article, I’d like to present a structured framework you can use to find potentially high-growth investment ideas:
1. Observe macroeconomic trends
We start our approach at the highest level – studying trends of the global economy. This involves studying various macroeconomic factors such as GDP, analysing geopolitical tensions, and forming an overall picture of economic trends. This gives you an idea of which countries are more likely to succeed economically over the long term. The key to this approach is to take a broad view, thinking about how overall economic trends have a follow-on effect on industries and companies within the country. For more data about national economic trends and indicators, you can check out TradingEconomics.com.
2. Pick an industry
The next step involves analysing specific industries within a chosen country. Most times, I like to zoom in on industries which have strong growth trends and begin my analysis from there. However, learning everything about an industry from scratch can take a good amount of time and effort. After studying various industries, I would recommend choosing an industry that you’re already broadly interested in – this ensures you have a basic understanding of the industry (which saves you a lot more time). Ideally, of course, this industry should have good growth potential as well.
I have three main criteria for deciding if an industry has potential:
- Growth: Industries can be broadly viewed as sunrise or sunset industries, with most straddled in between the two. A sunrise industry presents greater growth potential compared to a sunset industry. For example, coal mining in many developed countries is increasingly being phased out as countries look to reduce their carbon emissions, thus the coal mining industry as a sunset industry is unlikely to deliver significant future growth. On the other hand, green technology is expected to grow from US$8.7 billion in 2019 to US$28.9 billion by 2024, at a CAGR of 27.1%.
- Non-cyclical: This means that the industry is well-insulated from seasonality trends or a downturn in consumer spending. For example, tourism is one of the first to be affected by a recession as consumers cut spending by travelling less, so an impending recession is likely to impact tourism companies.
- Profitability: An example of an industry I would avoid is the aviation industry due to its low profitability. However, this is by no means a hardline that all unprofitable companies should be avoided per se. In fact, many of the fastest growing tech companies started out as unprofitable – the key to investors was the expectation that these companies will generate superior profits in the future. For example, Amazon was unprofitable, or generated very low profits, for the longest time. The main reason was because the company was reinvesting for future growth by building its distribution network, warehouses, and data centres in order to dominate the growing ecommerce industry. Amazon’s profit only really started to pick up in 2016 – more than 20 years after it was found. The internet giant now rakes in over US$10 billion in profit annually.
3. Break down the industry
After deciding on a particular industry, I like to break down an industry into its smaller supply chain segments so that I can better understand how the industry works. This also provides me with deeper insights in potential businesses within each segment of the industry.
Breaking an industry into its different segments is perhaps the most important step in identifying companies with potential. This not only provides you with insights on companies who are market leaders in their own segments, it also shows companies who have significant market power and are in a niche market.
I like to start by looking at the end product that is sold in the market. From here, I then look backwards and forwards in its entire product chain. Looking backwards, I identify the different segments that provide the labour and materials that contribute to the end product:
- What other businesses does the end product manufacturer work with?
- How are the raw materials obtained?
- How do the various materials come together to form the end product?
This allows me to map out each distinct stage of the supply chain where a company adds value to the process to creating the end product.
I then look forward in the product chain:
- What marketing channels are used?
- How is the product distributed to customers?
Broadly, this helps me identify how the product is sold to the customer.
To illustrate this point, let’s look at the automotive industry. We start from the end product, which is the car. Moving backwards in its supply chain, there are numerous stages where companies come in. Besides the automaker, there are numerous companies involved in manufacturing unique parts of the car, such as the lights, windshields, wheel rims, vehicle access systems, etc.
Moving forward, there are wholesalers and retailers who distribute the cars, logistics providers for transportation of cars to end markets, and finally the consumer who purchases the car. At each step, it is important to think about how the product moves through the production process, and how the exchange of money correspondingly flows.
4. Identify growth trends and segment leaders
After you’ve broken down the different value chain segments within an industry, start to identify which segments are the fastest growing. While an industry as whole can be growing, some segments may experience higher growth than others. This would help inform your decision in choosing a company that is able to benefit from these growth trends.
List down a few companies that operate in high-growth segments within the industry. Think about whether a company is a market leader in that segment. If the company also straddles across multiple parts of a supply chain, this could potentially mean that the company has significant supply chain power and strong vertical integration. By studying the segments in detail and the companies operating within, you should also be able to outline what their underlying business models are and their strengths or weaknesses.
Another question that I like to think about is: ‘What unique problem does the company solve within this segment?’ For example, if it is a fairly new addition to the value chain that helps to improve production processes, this could be a niche market that has previously been unexplored. Many new fast-growing companies have often achieved success this way, by improving upon a certain inefficiency and opening a new market for their product.
5. Map everything out
At this point, I would like to take you through a case study I did of the U.S. healthcare industry, and how I decided on a company to analyse further. I chose the healthcare industry due to its high growth in the U.S. for the past few years. At the same time, it is an industry fairly insulated from economic recessions.
This chart doesn’t give an exhaustive overview of the complex behemoth that is the U.S. healthcare system, but it covers the key sub-industries and helps me understand how each segment works in relation to the other. This may look complex at first glance but allow me to break it down for you.
I started with the end product, which in this case would be the medical care the patient receives. This can be broadly classified into two categories – services and goods:
- Medical services comprise hospital and nursing care. For these businesses such as hospitals or nursing homes, they depend on their employees (nurses, doctors, other administrative staff) to provide direct care to the patients.
- Medical goods comprise medical drugs. Within the pharmaceutical industry, patients purchase drugs from pharmacies, who obtain the drugs from wholesalers, who in turn purchase drugs in bulk from pharmaceutical companies. Pharmacy benefit managers also play a key role in this process. In essence, they work on behalf of insurers, negotiating with pharmaceutical companies for drugs that will be placed on the formulary lists of insurers, and being in charge of reimbursing pharmacies when an insured patient purchases drugs.
I then looked at how the patient pays for medical care. There are two types of patients – one covered by medical insurance, and one without any insurance. I decided to focus on medically insured patients for this study.
When a patient decides to purchase insurance, they have the option to go through an insurance marketplace that acts as a broker to compare various insurance plans. There are three main types of insurance in the U.S.:
- Government insurance (Medicaid, Medicare Part A & B)
- Private/government insurance (Medicare Advantage plans and Medicare Part D)
- Private insurance (employer-sponsored or privately sourced insurance plans)
For each different type of insurance plans, there are different levels of premiums, and the coverage policies differ greatly.
This leads me to the final part in which I found a segment I felt had potential to deliver value. My research focused quite heavily on the role of insurers within the healthcare system, and what I found was that there was a trend towards high-deductible health plans (HDHP) – insurance plans with lower premiums but higher co-payments when a patient receives medical care.
These plans are offered by private insurers, which is a growing segment in the U.S. as more citizens adopt health insurance policies due to the growing cost of medical care. As HDHPs require higher out-of-pocket costs, it presented a new problem to patients as they need more money set aside when paying for medical care. This led to the creation of the health savings account (HSA). An HSA works in pretty much the same way as Medisave in Singapore, the only difference being that it is provided by private companies. It allows consumers to place a portion of their pre-tax income into a savings account which can be used to invest and subsequently pay for any medical expenses. Due to the shift towards HDHPs, there’s a trend of increasing uptake in HSAs, despite it being a relatively new product.
One company in the HSA industry that caught my attention was HealthEquity, for two reasons. The first of which was that it was a first mover in the HSA market and had established itself as the market leader. This was helped by its status as a pure player which gave it more focus in capturing market share. Secondly, its growth rates in administering HSA accounts had far outpaced that of the market, which is all the more impressive considering the high growth rate of the industry.
A quick glance at HealthEquity’s financials also reveal that the company has been steadily growing its revenue, cash flow, and net income since it listed in January 2014:
Of course, these numbers alone don’t mean that HealthEquity is a buy straightaway; there is a lot more research and due diligence to do. But it’s an investment idea I can start looking at in the U.S. healthcare industry.
The fifth perspective
The steps I just shared with you come from a top-down approach which is a great way to look for investment ideas based on economic and industry trends.
At the same time, investing in a company also requires you to use a bottom-up approach to analyse its business fundamentals, financial metrics, and intrinsic value. I won’t cover the bottom-up approach in this article but if you’re interested to learn more, you can read more about the Investment Quadrant and how you can use it to analyse the key fundamentals of a business.
To end off, quality investment ideas are not easy to come by all the time. But if you have a step-by-step framework, like the one above, to help you identify key economic trends and growth industries, it makes the job of finding great investment ideas for your portfolio a whole lot simpler.