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How To Generate Good Investing Ideas    Bookmark and Share

We live in the information age. You can find information about anything you can imagine. There are countless news websites, blogs, and online forums discussing just about any topic under the sun. The good news for investors is that learning how to effectively utilize this information properly can lead to a seemingly limitless stream of investing ideas. The challenging part is figuring out exactly how to use all of this information to your advantage. Let's briefly examine some of the predominant methods investors use to generate investing ideas.

The Top-Down Approach

What methods typically come to mind when you think about generating investing ideas? If you're like most people, you might consider reading the business section of the newspaper, or reading a finance-oriented publication, or visiting a finance website. There is no doubt that these types of sources can provide good information, but there are some also some potential pitfalls to exclusively using these types of sources to generate ideas.

For example, an article in the business section of your favorite website might report that GE's profits were up in the second quarter of the year compared to the first quarter. But what does this really tell you as an investor, and is it enough to make you think that GE might be a good long-term investment? On one hand, this news could mean that the company's products or services have improved, and this led to the increase in profits. On the other hand, the increased profits could simply be a result of a one-time event and might not be indicative of the direction of future earnings. It's hard to say exactly what the increased profits mean without doing more research.

People who use the top-down method typically prefer a much broader approach when it comes to generating investing ideas. In addition to reading finance and business-related news stories, they like to explore a variety of other sources of information, and even look for ideas in everyday life. They look for investing ideas while watching the news, reading articles online, watching television, or even listening to a conversation between colleagues or friends.

Let's take a look at a simple hypothetical example of how you can generate an investing idea using the top-down approach. Let's assume that you come across an article that says that there is increasing scientific evidence that drinking green tea regularly can lead to weight loss. Since you know that there has been an increased incidence of obesity in America, you think that drinking green tea is something that people will probably start to do in order to try to lose weight. You decide that you are going to find the best company that manufactures green tea products and invest in it to capitalize on this recent scientific breakthrough.

So what you have done here is taken a big picture idea (in this case, the assumption that drinking green tea causes weight loss), then considered the possible implications (that people would drink more green tea to try to lose weight), and based on the implications were able to generate an investing idea and narrow your focus to a specific company that might benefit from this trend.

This is just one example of how to come up with an idea using the top-down approach. Another popular way to use the top-down approach is to use the economic or business cycle as a guide. This is called cyclical investing. This involves pinpointing where you are in the economic or business cycle. Once you determine where you are in the economic cycle, you can then more easily locate industries that are undervalued, and thus possibly worthy of investment. You can then narrow your focus to more specific sub-industries and then to companies within the sub-industry.

In a nutshell, the top-down investment style involves looking at the big picture, thinking about what types of products and services are likely to be in demand based on your observations, and then investing in quality companies that offer these types of products and services. Using the top-down method, you'll be surprised about how many good investing ideas you can come up with, especially if you make a habit of thinking about the implications of what you observe in everyday life.

The Bottom-up Approach

Another popular approach to investing is the bottom-up approach. This is an entirely different approach that can also be successful if properly executed. As opposed to the top-down approach looking at the big picture and then eventually narrowing their focus to an individual stock, bottom-up investors like to focus almost entirely on individual companies. This type of investor typically thinks that good companies can make money regardless of economic or other external conditions. Analysis of both the competition and industry conditions is de-emphasized and a more thorough analysis of the company's operations and financial condition is emphasized.

For example, a bottom-up investor might start by running a stock screener to figure out which stocks meet his or her basic objective investment criteria, and then do some thorough research on each of these companies to determine which of these companies might make good investment candidates. Other methods that a bottom-up investor might use to come up with possible investment candidate companies include reading articles about individual stocks, listening to company conference calls, or reading annual reports.

Let's look at a quick example of how I might come up with an investment idea if I used the bottom-up strategy. Let's say I come across an article about a specific company and how well it has performed over the past several years. The article outlines some basic financial ratios and how the company's profitability has increased over the past several years. Now interested in the company, I decide to research the company in more detail. I read the annual report, study the balance sheet, income and cash flow statements, listen to the most recent conference call, analyze the company's management, and review some financial ratios. As a result of all of this research, I make a determination about whether this company is a suitable investment candidate.

To summarize, in contrast with the top-down approach which stresses starting with the big picture and narrowing your focus to an individual company, the bottom-up approach emphasizes analyzing individual companies on their own merits and determining their chances of success completely independent of external factors.

A Blended Approach

Maybe you decide that don't want to exclusively use either the top-down or bottom-up approach. Maybe you like to use a stock screener to come up with a few companies that meet your basic criteria. You then do some basic research on the resulting companies. You briefly review some financial ratios, but also think briefly about how the companies compare to other companies in their respective industries, and think about whether it is the right time in the economic cycle to invest in each company. Using the aforementioned steps you narrow the original list to two or three legitimate investment candidates.

Since you are reviewing both external conditions and information about the quality of the individual companies, you are using what I like to call the blended approach to generating investing ideas. I tend to think that most investors take this approach to one degree or another, and that it can also be a very successful approach if properly used.

In Conclusion

We have reviewed several different approaches that investors use to generate investing ideas. Regardless of which approach you choose, make sure the approach you decide to use makes sense to you and that you are persistent in your efforts. The best investors, even Warren Buffett, are constantly looking for new investing ideas. If you are diligent and consistent in your approach, you will be sure to find some quality investment opportunities. After all, developing the ability to pinpoint quality investment opportunities is the first step to becoming a successful investor.

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