The investment process

By | May 4, 2012

The source of an investment idea is often random in nature, so it’s probably the most complicated part to explain. A lot of ideas come from something you read, a product you use or a store you visit.  Analysts spend a lot of time looking through newspapers and keeping up on current events to see what companies are hot or hated, and if  they have some basis to start researching the company.  Has the stock been beaten up recently or has it had a huge ride up? Almost anything does in order to find potential candidates. In any case, once you have sourced your idea and done very preliminary research,  it’s time to actually do some proper analysis…

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 analyzing 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.

One thought on “The investment process

  1. Jonathan Lima

    Amazing post, looking forward for more in this topic.

    I really enjoyed reading about the investment process, hope you can post more about it

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