How to identify and monitor the main drivers of a stock

By | September 5, 2013

The most distinguishing element of great analysts is that they spend a disproportionate amount of time on the few drivers that are likely to move their stocks. This approach turns the traditional company analysis on its head because they’re not attempting to know everything about their companies. The problem many analysts have is that they approach company analysis similarly to college students, highlighting all 300 pages of their textbooks to ensure that everything is understood for the final exam. Great analysts focus their time on only those questions that have been asked in prior exams or, due to a change in the environment, are likely to be asked on the next exam. Focusing on the critical drivers that are likely to move the company’s stock price allows the analyst to better allocate time and be a better stock picker.

1. For a driver to be critical it will likely meet these criteria:
   a. Occur during the investor’s typical investment time horizon.
   b. Have an associated catalyst that, when triggered, will cause the driver to become a greater opportunity or risk in the view of market participants. In most instances, this driver causes one or more of the following:

  1. Material changes in earnings or cash flow growth.
  2. Material changes in returns.
  3. Material changes in the volatility profile of the stock.
  4. Material changes in the probability of:
  • The company makes an acquisition.
  • The company is purchased by another entity.
  • There is a change in senior management.

2. Dedicate a place in your notes to compile the critical drivers (and their catalysts for each company and sector. It’s important to have this Information in one easy-to-reference place.

3. Identify and understand the historical (10 years or more) cause of anomalies or fluctuations to each company’s:
   a. Financial metrics in absolute terms and relative to its peers.
   b. Valuation levels relative to its peers and the market.

4. Record the events that caused these historical anomalies as drivers (on a company or sector level) as well as the catalyst that triggered the event (e.g., stronger customer pricing is the driver, while the catalyst is an upside surprise at the company’s upcoming quarterly earnings release).

5. Review current valuations to identify what’s in the stock, in terms of current expectations. Record the drivers that drive key assumptions necessary for each company to achieve consensus expectations.

6. For analysts who have the time and resources, meet with company management to understand if it’s aware of the analyst’s critical drivers and determine if there’s a plan to exploit or mitigate them. Ask appropriate questions during the meeting and prepare in advance. Use the meeting as an opportunity to prioritize critical drivers.

7. Of all the drivers recorded, rank them in terms of impact on earnings and cashflow over a reasonable investment time horizon (e.g., 6 to 12 months). Those that are most likely to move consensus EPS or CFPS by 5 percent or more are generally among the better candidates for critical drivers.

8. Identify potential catalysts for the more significant critical drivers. Those with catalysts that can be identified and forecast through detailed research are usually the best critical drivers for the purpose of stock picking (e.g., it’s much more difficult to forecast the next recession than assess a company’s likely success or failure with a new product launch).

9. Aggressively monitor your network of information sources to forecast the catalysts for two to four critical drivers (for each company better than the broader market).

10. Over time, add new critical drivers to the list and remove old ones, based on their probability to move EPS or CFPS by your threshold. To remain on-task and efficient with time, an analyst should follow the following process to determine if a new critical driver has emerged:
   a. Determine if new information is more likely to be an opportunity or risk.
   b. Briefly surmise the potential impact on the stock from this driver:

  • Likely to occur within investment time horizon?
  • Material (e.g., move financials more than 5 percent)?
  • Will be triggered by a catalyst that can be forecast?

c. If the driver meets the criteria above, determine if it’s not yet in the stock in terms of consensus expectations or the valuation multiple.

11. If it meets all of the criteria above, it likely warrants further research to determine if it’s a critical driver.

Some final remarks in terms of seeking out drivers:
o You ‘re not looking for data points but rather changes in trends.
o Don’t “go underground” when conducting research; get out there and learn by having conversations. Inexperienced analysts hide in their spreadsheets, which fails to get them out into the debate.
o You can’t do this on your own, especially when you’re new. You ‘ll need to ask for help from:
– Colleagues in your firm
– Investor relations
– Sell-side (if on the buy-side)
– Industry contacts
o The market often over-simplifies the investment thesis, which offers us an opportunity.

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