Mastering the investment research process

By | February 28, 2015

There is certainly not just one proper way to make an investment decision and every analyst has his own research process. The following is just a decent approach, which you can use as a base and then tailor to suit your own skills and needs. After all, an investment approach must be intuitive and adaptive rather than fixed and mechanistic. It is something that evolves with time.

The Investment Process

There are 2 important points you need to understand:

1) You need to think independently of everyone else and come to your own conclusions. Howard Marks said it best, “Unconventionality shouldn’t be a goal in itself, but rather a way of thinking.” In short, you have to be different and better.
2) You should know your target company like the palm of your own hand. This involves making use of as many SEC filings, Investor Days, Conference Call transcripts, Industry Reports, Industry and customer contacts as you can get your hands on. There is a wealth of information out there about your target and part of your job as an analyst is to go find it.

What drives revenue?

The first thing you want to know about a business is how it makes money and, to dig a little deeper, how it defines it’s revenue generating segments. If you can’t understand how the business makes money then you probably shouldn’t invest. Moreover, the specific way in which a management team divides the  business provides a great deal of insight in to what management thinks is important and how they are situating the company competitively for the present and future.

What are you doing when you make an investment in a business? You are taking an ownership stake in a company based on the understanding that the operators of the business will execute a plan to provide you returns on your investment greater than your required return. Therefore, understanding what the operators of the business think is important and how they plan to compete in the marketplace is very important and should be one of the first things you understand about a business.

Competitive Positioning

Once you understand the company’s revenue drivers and management’s competitive mindset, you need to judge the viability of each in the marketplace. Every company discloses a list of competitors, but sometimes the list isn’t that good and even if it is you don’t want to take anything at face value, so having an understanding of revenue drivers and management’s mindset allows you to hand pick a universe of competitors.

After you determine the target’s competitors you can begin to get a handle on how a business should operate in the space in respect to competitors and customers.

Essentially you should be asking three questions:

1) How does the market see this company?
2) How do competitors see this company?
3) How do customers see this company?

By now you should have an understanding of how my target is seen from most of the interested parties, namely the market, competitors and customers. While answering these questions you will develop an understanding for how the industry works as whole and start to think about how it is changing and what it may look like in the future.

So now you know how the business drives revenue as well as where it is competitively situated. You also have an idea as to where the industry is headed as well as a general understanding of how management thinks of the business going forward. And, almost by accident – but, not really – your research has given you the same general understanding of your target company’s competitors. You know how each competitor drives revenue as well as how each management team is situating its business going forward.

So your investment thesis is probably starting to form at this point, but you are going to have to keep calm and contain your excitement because there is still too much work ahead of me to get distracted. This leads us to one of the most important parts of the research process…

Management

Why is management so important?

As previously stated, when you invest in a business you are taking an ownership stake in the company with the understanding that the operators of the business will execute a plan to provide you returns on your initial investment that are greater than your cost of capital.

Therefore, in order to make an investment you not only need to be confident in management’s plan going forward, but also in the management’s ability to execute that plan in a volatile and perpetually changing environment.

Management can be divided in two areas:

1) Structure and Incentives
2) Decision-making

Structure of management refers to who makes up the Board of Directors and what each person brings to the table amongst other things as well as the operators of the business and what they bring to the table… amongst other things.

Management’s incentive is pretty straight – forward. You want to make sure that management’s compensation structure aligns closely with what you want as a shareholder as well as my time frame for the possible investment.

So by this point you are going to have an idea of how confident you are in a management team’s ability to execute on its strategy. Industry environments are constantly changing as is the overall economy and an exceptional management team can do a lot to position a company for continued success as well as limit downside risk.

Your thesis is continuing to come together and now you are going to sit down and talk with your boss and/or some senior analyst on the team about what you have so far. This update is not mandatory or necessary, but it’s good to hear other people’s opinions and be as intellectually honest as possible. As we should all know, “You gotta know what you don’t know.”

Financials

Right now you are far enough along in your thesis to really get down and dirty and dissect the financials in pretty great detail.

Basically, you are going to tear the company to pieces line- item by line- item as deep as you can, going back usually 5 to 7 years. Anything that catches your eye, either good or bad, will go on a list of questions for management that you should have been compiling since the beginning of your research.

This isn’t a post about financial statement analysis and it’s already quite long so we will not go into much detail. There will be a specific post on what to look for in you financial statement analysis.

This analysis will give you a good grasp on the company’s accounting procedures and know that there isn’t any funny business going on in regards to the way they report things, etc. The process should also reinforce everything you have learned about their competitive positioning, capital structure, and the way they drive revenue. It’s probably better to wait a bit before actually modelling out the historical financials, but you should be intimately familiar with them by now.

Speak with Management

At this point try to sit down with management and ask them any questions you have up to this point. Obviously not everyone is in a position to get access to management, but otherwise the investors relations team tends to be a good option too.

Model

After management has answered your questions, you should feel like you’ve got a good handle on the business and what is going to happen going forward. So your next step should be to sit down and actually create your company model. It is important for you to model each company from scratch. No two companies are the same and you really do get a much deeper understanding if you start from scratch rather than just dropping stuff in a template.

You most likely will not be able to finish the model in one sitting because more questions will come up that need to be answered and sometimes you will find an answer to those on the fly as they arise. Again, modelling is rather complex a deserved a full post on its own.

Valuation

The valuation method in skeleton form:

1) Derive projections from thesis.
2) Stress–test projections
3) Derive range of values for the business

Finding the exact valuation for your target should not be a main priority. Basically, just look for a reasonable range of values for a given set of operating scenarios.

Essentially value is a product of:

1) Growth
2) Returns
3) Cost of Capital (Also called Discount Rate or Required Return)

What’s more important than a scientific and precise valuation is that you understand what is going to cause the market to realize the intrinsic value of the asset and that you get the timing of the catalyst correct. If you’re too early you can get forced out the trade before anything materializes for any number of reasons and if you’re too late you’ve lost some upside at the very least.

Much like the search for a precise valuation, the search for the “correct” cost of capital to be – in the gentlest terms – a fool’s errand. The best investments are not made because you nailed the discount rate in percentage terms and if making an investment decision comes down to whether you go with a 10% or 12% discount it most likely won’t be a good investment.

It’s often helpful to know what discount rate the market is implying looking to make an investment, but rarely – if ever – is the absolute number going to be of great concern. Approximating a required rate of return is mostly a way to keep investment risk at the forefront of my mind. Risk is anything from macro on down to the guy/girl on the other side of your trade. Often, you may start with the market – implied discount rate and then adjust it based on everything from macro factors to industry/company factors and finally to the generally psychology of the other market participants.

Finally, important to understand that at any point in time a single driver of value can dominate the others. If we look back to not too long ago, in the tech bubble growth was the main driver of valuations and returns fueled the housing bubble. Today, one can certainly make the argument that risk is the driver of the current bull market. With liquidity being pumped in to the market and treasuries at rock-bottom yields it seems as though investors have re-priced risk in the search for return.

Anyhow, by this point the thesis is pretty much complete and you have a general range of value for the business. So it’s time to prepare for the pitch.

The Pitch

Every firm and PM is going to have a different structure for how they like an idea to be pitched. Some places may have a more formal process that involves multiple investment memos, etc., while for others it will be just a face to face or phone conversation.

Basically, you pitch boils down to five basic steps:

1) Company/ Why market it wrong
2) Catalyst(s)
3) Upside %
4) Downside %
5) Be prepared to answer any possible question about your idea.

Conclusion

Much of what it is described here is not very difficult. Almost anybody can break down some financial statements or slap a value on a business. However, to do it well you need to be able to time inflection points, properly handicap the risk/reward scenarios and determine the appropriate cost of capital (required return) for the risk profile of the investment. Each of these is extremely difficult in practice and is what determines how good you are as an analyst. A lot of it comes from experience, of course.

A final, but important part of the process is to spend some time observing the way in which your target company stock price moves/reacts to market/macro/micronews. Basically, this helps you to understand the psychology of those trading it in the market, showing you what they think is important about the business/stock relative to what you think is important about the business/stock.

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