Industry Study

• Is this a good business? What are the key success factors to superior performance in this industry?  (Value Added Research “VAR”)
• Define the market opportunity.  How do competitive products address this opportunity?
• What are the barriers to entry (“moats”)? (VAR!)
• What is the relative power of: (VAR)
  • Customers
  • Suppliers
  • Competitors
  • Regulators
• Who controls industry pricing?  Does the company/sector have any pricing power?
• How (and how much) can a good company differentiate itself from a bad one in this industry?
• Do you understand this business?  Test yourself and describe it to a ten year old.  DO THIS!

Business Model (VAR)

• What is the selling model:  razor/blades? services? one-off contracts?
• What are the economics of the base business unit?  How does it stack up against competitors?
• Why is the company good (or bad) at what they do?  Can they sustain it?
• Is this company growing by acquisition?  How sustainable is that?
• Be able to easily describe the entire sales process – from order to fulfillment.

Management (VAR)

• What is their background, and what do their former colleagues, investors, classmates, say about them?  Have they been successful in the past?  (Very important)
• How are they compensated?  Are their interests aligned with shareholders?
• Have they been good at allocating capital?
• Are they buying or selling stock?  How much as a percentage of their holdings, and why?

Company/Cultural Issues (VAR)

• Is this a great company?  Is it built to last?  What could change this assessment?
• Can you imagine holding stock in this company for twenty years?
• If you had access to unlimited capital, how would you feel about your chances of successfully competing against this company?
• Compare to a weak competitor in the same industry.  What is the difference and why?

Financial Measures First Step:  Check against all the accounting shenanigans in Howard Schilit’s book (Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Third Edition)

Balance Sheet

• What is the company’s capital structure, and how does it compare to its peers?
• What are the trends in inventory turns, days payable/receivable, and working capital?
• What are its coverage ratios on interest payments?

Cash Flow

• What are the company’s capital requirements and cash flow characteristics?
• How is the company choosing to invest its capital?  CapEx?  Buybacks?  Acquisitions?
• Does the company need to access the capital markets?  How soon/often?

Earnings/Profitability

• Regarding the company’s sales model, how visible are earnings quarter-to-quarter, and year-to-year?
• Is this a fixed or variable cost business?  How much cost leverage?
• Do earnings grow as a function of unit sales growth, price increases, or margin improvement?  How sustainable is this growth?

Valuation

• Looking forward, what is the company’s valuation in terms of:
  • Market Value/Earnings
  • Enterprise Value/EBITDA
  • Free Cash Flow Yield (After-Tax Free Cash Flow/Market Value)
  • Market Value/Sales
• What is the company’s growth rates in terms of earnings, EBITDA, and FCF?
• What are consensus earnings  estimates, versus your own expectations?
• What are the key leverage points in our own and the street’s earnings models?  What has to go right, and where is the most chance for surprise?
• Are their accounting policies conservative and in line with their peers?

Risks

• What are the big unknowns?  How much can the company control/influence these risks?
• What could cause this investment to be a total disaster?  How bad could it be?

Other (Timeline/timing issues) DO A TIMELINE!

• What are the catalysts (triggers) for the company’s proper valuation to be realized?
• What good news, and what bad news, will affect the company in the coming year?
• Who owns the stock?  Momentum funds?  Big mutuals? Hedge funds?
• How difficult is it to build a significant position (float, volume)?
• Draw a time line of expected events and dates.  What might go wrong and when?

Investment Framework:  Short Questions

1.  Is this a bad business?

• Who has the power – customers, suppliers, competitors?
• What are the barriers to entry?
• What kind of reinvestment of capital is needed to grow?
• How is the business changing?
• What is the historic and current rate of success in this business?
• What are the major risks to the business plan?

2.  What is the major misperception?

• Why does it exist?
• Who is responsible for it?
• What stakes do the various parties have in keeping the stock price high?
• How popular is the industry?  rising tides lift all boats – for awhile.

3.  Assess management

• Industry reputation?
• Past history of success or failure.
• Straightforward or cunning?
• Check out insider ownership and selling.

4.  Ratios:

• EBIT/EV as a percentage.
• (EBITDA-CAPEX)/EV as a percentage.
• Growth of inventories to cost of goods sold – are inventories rising faster?
• Growth of AR to sales and AP to sales.
• Any accounting changes – smaller reserve for bad debt, revenue recognition, etc.
• Cash flow/Int. expense.
• Review Howard Schilit’s red flags

5.  Sentiment:  Are more people bullish or bearish on the stock?

• Do full media search for articles.  Make list of analyst recommendations.
• Short Interest?  SIR (remember, the stock that is already short is potential buying power)  Be careful if there is universal bearishness.

6.  Timing

• What is the expected trigger on the misperception?  Do a time line.
• Who owns the stock – long term or short term, momentum investors?
• Has the souffle already risen once?
• Can the rising stock price be self-fulfilling for awhile (financing opportunities, etc)?
• Where does the company stand in terms of the fantasy, transition, reality paradigm?

7.  Add when the story starts to unfold — regardless of stock price.

• Watch for earnings warnings, excuses, etc.  Where there’s smock, there is often fire.
• Is the company or wall street analyst group in denial of the problem?
• Watch the ratios, insider selling etc.
• Even if the stock down significantly from its high, if answering all these questions convinces you that it is still a short, do not cover and consider adding.  See below
• Does waiting for the new financials feel like waiting for Christmas?  IF “YES”  —–> ADD.

The first thing to do is to make sure that you understand the industry. Spend time reading industry reports, reading the most recent 10-k’s of the target company and major competitors, and reading the past 3-4 quarterly reports and earnings transcripts in their entirety. Once you do that, you will probably have a good idea of how the industry works and what the main metrics are. If you don’t, you can always head to a trade conference or go to more aggressive lengths to make sure you get an answer all the basic questions about the way firms do business in such space. After that’s done,  you can start building the backbone of your model. It’s better to start from scratch than to use a template, since every company needs to be modelled differently. The main thing is to figure out how the company drives revenue, and what is its pricing power. Don’t really go into details on the model; just look at what earnings have been like, what margins look like, the main aspects of the capital structure are how management has handled the company up to this point. Ideally, you would look for financial evidence of a “competitive advantage”. Don’t finish the model at this point but leave enough blank space on it so that when you find out the answer to things you are still unsure about you can easily add the new assumptions.

From here, go line item by line item analysing the trend of whatever account you are looking at on the financial statement, and if you have any questions about what’s happened with it (let’s say receivable spiked enormously in the most recent year), write that down and through this process start forming a list of questions for IR or management, depending on the size of the company. It is better to speak with management eventually but for the preliminary questions IR is fine because they know less and sometimes will either answer the question the way management wouldn’t want them to, or will be blissfully ignorant to whatever you are asking about, which is usually some sort of red flag that could help if your idea is a short. On the other hand, if it is actually a long idea and IR is able to answer all your questions sufficiently it’s probably a good sign.

At this point it’s time to talk to management, hopefully the CFO if possible. If you are looking at a company that’s been beat up or run up, you want to get an idea of how legitimate the reasoning was for the move, and there’s nobody better to talk to than the CFO about that. It’s hard to explain the nuances of learning things from management, but with experience you are able to evaluate management a lot better and this is probably a very underrated part of the investment process.

Once you have an idea you like and have done your management checks, it’s usually a good idea to spend a little bit of time looking at some technical analysis and some reasoning behind getting in at a certain price. You can build a model with a bull case, base case, and bear case for your company and develop a target price range and target time frame for the investment. You can pitch this to your boss or portfolio manager who will probably have a discussion about it. PMs then to know a lot about companies in all kind of industries and will often have additional questions for you to go out and answer. Sometimes you will have to get in touch with former employees, take a walk through the store or whatever it may be, or even buy the product. In the end, whether you convince your PM to take your stock recommendation on board will depend a lot on your actual conviction, but also on factors such as what the capital situation is, what sector the company is in or the volatility and risk behind the investment.

Once your PM decides to go for a significant investment in the company, you will have maintenance duties. Most of the time this means just keeping track of the movement on the stock, attending meetings with management periodically, sitting on earnings calls, and reading all company filings as they come out. The main goal of maintenance is to make sure that the agreed-upon investment thesis is still valid, and that nothing in the company or the market has changed that would make it lose its competitive advantage, no longer be considered a “good” company, etc. This is most hectic around earnings time, especially if management suggests that they may not perform particularly well. They don’t do this explicitly, but once you spend enough time on a company and talking with its people, you can tell when they’re having a bad quarter.

If any of the criteria outlined when you initially invested in the company is broken, exit the position. You should also exit once the pricet meets whatever target you have set out. However, with some companies that have extremely impressive advantages and continue to grow earnings and increase shareholder value, you may hold an investment indefinitely without an actual target price. Of course, when you do have a target price you may also alter it depending on how earnings have been looking and what the industry landscape has done since the beginning of the research process.

No matter whether you exit after reaching your price target or exit at a loss, this marks the end of the investment process. At the end of the day, nobody cares if you are ”working your ass off”. Your company will only care that you know how to analyse investments and can provide a reasonable thesis behind them. Oh, and you won’t last long if you’re picking losers. Work all day and night but pick losers and you’ll be fired. Only show up at the office for 5 minutes but spend that 5 minutes pitching a winner and you could be seeing 7 figures in your early 30s.

1. Develop proprietary opinions based on primary research. Regularly check with competitors, customers, and suppliers of each of your companies. Develop unique approaches to financial analysis. Perform proprietary surveys. Avoid at all costs simply repeating guidance or management opinions unless you disagree with them.

2. Be proactive. Strive to be the first to market with any new idea or piece of information–if we aren’t, our competitors will. All information becomes a commodity very quickly. Each analyst should be in front of the institutional sales force no fewer than two to three times per week.

3. Be provocative. Playing it safe turns into a loser’s game over time. It dulls our senses and results in lackluster analysis with no impact on our clients.

4. Follow and publish regularly on at least 12-15 institutional-quality stocks with market caps generally in the $300 million – $3 billion range and with an average daily volume greater than 200,000 shares. Write all research with an eye to the institutional market–it can always be encapsulated for the retail client.

5. Launch coverage on at least one new stock per quarter, pruning unproductive names from the list as required.

6. Maintain an above-average stock picking performance. According to a Nelson’s survey, the average Wall Street analyst is right about 55% of the time; our goal should be to be right 65%-70% of the time.

7. Develop a following with our top accounts. Each focus account should be contacted at least once per month. This list will be developed with the sales force and will be monitored regularly.

8. Cooperate with corporate finance. Every idea generated by corporate finance deserves our attention, but be sure to operate within the regulations that require a gatekeeper to be present for most conversations.

9. Expand our relationship with retail. Only a small amount of retail’s equity business is in our names, and it can be much higher with a modest amount of additional effort. Treat the brokers that have substantial positions in your stocks as you would an institutional client—add them to your contact list. Talk to April Langel regularly about your stocks, maintain an active Focus List, and speak to the entire retail department periodically about your group and your best ideas. Return all calls from brokers within 24 hours. There should be regular visits to the branches, with a goal of 5 – 10 visits per year. Take company management to the major branches and arrange field trips to local companies.

10. Keep trading informed about anything that you think will impact a stock’s price and any clients who have indicated an interest in your stocks. Keep tabs on our positions in your stocks. If you believe that there are events that will substantially impact the price of a stock in the very near term, be sure that the desk is either flat or on the right side of the trade, being very careful not to front run the public disclosure of material, insider information.

The answer lies in the question itself, since what you actually want to value are the 30 million ounces in resource/reserves. However, you cannot just multiply those with the market price for gold to get the market value, as the 30 million ounces of gold are still in the ground and they cannot be sold tomorrow.

In terms of absolute valuation you should focus on the net asset value (NAV) method. The more common discounted cash flows (DCF) method cannot be used to value a natural resource company because the basic assumption behind DCF valuation is that the underlying asset or firm would generate income indefinitely and there will be a terminal value associated with the same. However, this is not the case with GOLDY, as an investor/buyer would only pay the monetary equivalent of the current assets (NAV) and will not assume the firm to be a “going concern” given that the underlying asset (gold in this case) is a finite resource.

The valuation of GOLDY would grossly depend upon 4 main factors:

Stage of Production: We need to look at the stage GOLDY is in, which can be exploration, mining or production. Resource/ reserve estimates of GOLDY can be measured with higher certainty if GOLDY is in production stage than if it is in mining or in exploration stage. And, as the famous Wall Street quote goes, “the market doesn’t value uncertainty”, so GOLDY is worth more per ounce if it is in production than if it is in mining stage.

Actual time to production: The closer GOLDY is to production, the higher the company is valued per ounce by the investors. Even if two companies are in the same mining stage, the one that is closer to production will be worth more per ounce, as the market will use a lower discount rate. For example, if GOLDY is supposed to get into production in 2013 and another firm called “Lazy Gold” in 2015, one can easily say that cash flow for firm GOLDY will start one year earlier so the discount rate used would be lower.

Resource estimates: The value of a firm is not only dependent upon amount of resource and reserve estimates but also the type of estimates. There are 3 types of estimates:
a) Inferred resources
b) Measured and Indicated resources:
c) Proven & probable reserves

As a firm moves from closer to production, the amount of proven & probable reserves increases at the expense of indicated and inferred resources. The market puts a higher per ounce valuation on proven & probable reserves than on inferred and indicated resources. A mining company would have higher proportion of proven & probable estimates than an exploration firm, for example.

Price of resource (gold in this case): Although GOLDY is not currently selling gold, its value would be directly proportional to the price of gold as market expects them to sell gold at a higher price in the future –even if it is 10 years from now-. In fact, if you were to place the price chart of GOLDY and the one for gold side by side, you would find a very strong correlation.

This is why many people see big mining companies as a “macro call”. And this is why in many buy-side firms it is the senior portfolio manager who makes the calls on the Rio Tintos and BHP Billitons of this world, just as they do with banks, for example.

1. Blackstone – $3.6bn (total compensation pot in 2010), $810,717 (average staff payout)

2. Greenhill & Co – $159.9m, $551,379

3. Deutsche Bank (investment bank only) – $8.07bn, $510,474

4. Lazard - $1.7bn, $501,415

5. Goldman Sachs – $15.4bn, $431,000

6. UBS Investment Bank – $6.95bn, $418,009

7. J.P. Morgan (investment bank only) – $9.7bn, $380,000

8. Credit Suisse (investment banking) – $297,944

9. Morgan Stanley - $16.0bn, $256,000

…

?. Royal Bank of Scotland Global Banking & Markets – Average bonus payout of $76,900

Sources: Bloomberg, Reuters and The Wall Street Journal