Stock Picking and Philosophy of the Financial Model
"How does this data point impact our EPS estimate?"
"Does this business have enough liquidity to withstand a deep recession?"
"What expectations are priced into this stock?"
"Is this stock a long or a short?"
These questions, and more, are common questions posed to the buy-side equity analyst.
Good fundamental investing consists of two dimensions: process & judgment.
The process is more scientific in nature and consists of individual steps in the research process. The process drives towards gathering information & distilling that information down into usable insights. Insights on business quality, valuation & variance, i.e. will this company beat or miss consensus estimates?
Judgment is more creative in nature and consists of ingesting those process insights into a correct pathway forward on the investment decision. Good judgment comes from experience, pattern recognition, attunement with market flow, and that ineffable "gut feeling" of activated intuition.
A typical buy-side equity investment team looks like a pyramid: one portfolio manager (PM) at the top supported by a handful of analysts, with the analyst primarily responsible for process and the PM primarily responsible for judgment. The lines of responsibility surely intersect, but one PM alone simply cannot conduct a rigorous process on enough ideas to run a scaled portfolio.
In a rigorous, process-driven investment organization the financial model is instrumental in the core elements of the investment process: business quality analysis, business growth and momentum work, valuation work, expectations & set-up work, development of a risk & reward case, and ultimately thesis development and trade execution.
A common mandate from PM to analyst is to be "the smartest person in the room" on a name, but then to distill that expertise down into the three key drivers that will move the stock, to "see the forest for the trees."
This mandate requires both an intimate understanding of the financial metrics of a company and enough context and perspective to identify what really matters.
Bridging the communication gap from process to judgment, from analyst to PM, also requires a mutually agreeable framework that can bridge the gap from information collection to idea execution. In the institutional investment process, this is the role that the model serves.
As I told my analysts when they joined my team, "The model drives everything we do."
WHAT IS THE POINT OF IT ALL?
The craft of fundamental analysis is the evaluation of the "fundamentals" of the business: revenues, profits, and cash flows. Ultimately, the valuation of a stock is determined in a similar fashion as any financial asset--the discounting of future cash flows back to the present. If our fundamental process can surface superior insights on the forward trajectory of revenues, profits, and cash flows, those insights will result in a more accurate valuation assessment.
A superior valuation assessment is a critical step in the execution of the goal of any active investor: alpha generation. If I can observe a $10 stock that "should" be priced at $20, I can invest at $10 and wait until the market sees what I see, selling at $20. As the stock appreciates my assessment of fair value, alpha is captured. The complexity in public equity markets is that stocks are a "long-duration" asset--the typical stock requires 25-35 years of free cash flows discounted back to the present to cover the current value of a stock. It would be absurd to believe the market can accurately discount 30 years of free cash flows, so the market tends to act more as an "observation mechanism" than a "discounting mechanism." As business fundamentals strengthen, the market has a tendency to re-price stocks higher. As business fundamentals weaken, the inverse tends to be true.
In this context, our role as fundamental analysts is to know the industry and business well. That knowledge, supported by the financial modeling process, can help us to better assess the prevailing expectations benchmark for a stock price.
If my superior knowledge and superior business insights can help me find situations where the market has it wrong and I have it right, that corrective market price movement is the manifestation of my alpha.
This is all a fancy way to say that we are looking for mispriced securities.
Unlike the classic value investor mindset whose value is reflected by a low current-year price-to-earnings multiple, the hedge fund mindset around value is more flexible and adaptive.
A stock trading at 25x P/E *might* be worth 40x P/E, while a stock trading at 10x P/E *might* be worth 5x P/E.
Our job is to find mispricings wherever they exist, and the financial model is a critical tool along that journey.
PROCESS DRIVEN INVESTING
The stock market is a fairly efficient place. It certainly is a highly competitive place. If it were easy to identify the stock trading at $10 that was worth $20, the crowd would descend upon that situation (and quickly drive the price above $10).
The game of alpha capture is a zero-sum game, a giant game of poker, if you will, with some of the most clever, highly resourced, competitive people in the world playing the game.
Throw a dart at random and you are not likely to identify a mispriced stock. In general, I operate under the assumption that 90% of stocks are somewhat fairly valued. That is an intentionally high bar to reflect the reality that compelling alpha opportunities are the exception, not the norm.
If that exception mindset is adopted, the key question then becomes "Why does the opportunity exist?"
Definitionally, a stock with a prospective alpha load is mispriced. The monetization of the alpha load manifests as the investor buying the underpriced stock and selling the stock when the price is fair. At the best investment institutions, the process of identifying mispricings is not ad-hoc and it is not random. There is a well-defined process to identify and validate mispriced securities.
A typical buy-side investment process:
Initial analysis & opportunity assessment: To understand what is baked into the stock and whether there is an opportunity to generate a differential view (“the alpha load”)
Business analysis & model construction: To understand the business deeply, use a bespoke financial model to understand how the business operates financially, then use the model as a backbone to value the stock and assess business momentum and potential earnings revisions.
Key driver assessment & deep dive process: To understand the three key drivers, then execute a deep-dive research process to identify areas of differentiation on those key drivers.
Case construction & risk/reward assessment: Work to understand what is baked into the stock, then develop my own bull/base/bear cases and determine how attractive the risk/reward is on the stock
Thesis development & communication: Layer in qualitative and quantitative work into a structured thesis to pitch up to my PM (or LP)
Idea monitoring & catalyst assessment: Develop an ongoing research plan relating to catalysts and earnings, then monitor ongoing news flow to assess whether the idea is on track with my initial thesis
This process, adapted to the unique investment approach of your organization, should provide you with a structured roadmap to identify mispricings.
FROM ANALYST TO PM,
FROM PROCESS TO JUDGMENT
For a buy-side equity analyst, the targeted pathway of the fundamental research process is to go from:
Starting PM comment: "Hey go look at XYZ stock and let me know if you think it is interesting"
Ending PM comment: "Wow XYZ is a really interesting idea let's make it a top position"
How does an analyst drive an idea from conception to thesis to execution?
A rigorous, well-executed investment process is central, with the financial model playing a starring role in that investment process.
PROCESS CENTERPIECE
The thesis-construction process on an individual stock includes both quantitative and qualitative elements.
To understand the business in depth: Develop “owner’s knowledge” by understanding all the financial data disclosed. Data is the language of business, and the model is the repository for data.
To assess the health of the business: Analyze the current state economics of the business: growth, margin, capital intensity
To analyze business momentum: Is the business trending in the right or the wrong direction?
To derive an independent valuation: To assess what is currently baked into the stock price and to forecast key metrics that serve as the basis of valuation
To identify earnings revision opportunities: To find points in time where a company is likely to beat/miss consensus estimates
To have a tool to put news flow in proper context: To have a framework to analyze NPV impact
As an analyst, the model is your process tool for conducting the core analysis stack to do a deep dive on a name, distill the name into three key drivers, and then communicate that idea to your PM.
While investment styles are highly unique, there are certain common elements that a PM will want to see out of a financial model.
THE PM's TAKE ON THE MODEL
How big / liquid is the stock: Does the stock fit liquidity & size thresholds for the strategy?
Revenue growth trajectory: How fast is the revenue of the business growing? What has been the trend over the last few years/quarters and what is our expected forward outlook? What is driving that outlook--is it industry growth, market share gains, or new product introductions?
Margin trajectory: What is happening to the profitability of the business? Improving or deteriorating? What is driving that trajectory? Are we at peak/trough or median levels of profitability vs. history? How does the profitability of this business compare to its closest peers and what does that tell us about margin risks or opportunities?
Capital use/deployment: Is the business consuming or generating cash flow? How is that capital either sourced (if burning) or deployed (if generating)? What does that tell us about the risk profile of the equity?
EPS growth trajectory: Views on revenue growth, margin trajectory, and capital deployment build together to drive forecasts of EPS growth. PMs will treat a 5% 3-5 year EPS grower differently than a 20% 3-5 year EPS grower, applying a different mindset and valuation approach.
Variance: How do our estimates of fundamental metrics (revenue, EBITDA, EPS, FCF) compare to street consensus? Where and why are we different? When will that difference appear and how will it manifest, i.e. will the company have to raise or cut guidance?
Valuation: Based on both our internal estimates and street consensus estimates, what does the valuation look like in this situation? On EV/Revs, EV/EBITDA, P/E, FCF yield. How does the current valuation compare to the history of the stock? How does it compare to peers? How cheap or expensive is the stock on an absolute basis?
Risk/reward: Ultimately, what is the best guess of our base case, and how much upside do we have in that case = the reward case? What could go wrong and how much could the stock go down in that case = the risk case. What is the upside % vs. the downside %? Good PMs don't want to flip 50/50 coins, they want to flip 60/40 or 70/30 coins where they can make more if right then lose if wrong. Distilling down the entirety of the investment process to a succinct asymmetry of cases is one of the most important bridging tools from process to judgment.
When done well, the analyst takes an exhaustive due diligence process and distills the entire process into a succinct thesis, surfacing all of the key insights and due diligence items into process conclusions.
The financial model is a critical tool in executing a rigorous investment process and distilling that process into a helpful aid for investment judgment.