Value Investing Primer Version 1.00
In the theory of the competitive market, there is usually made an explicit assumption about perfect knowledge. What this means in effect is that the acquisition of knowledge of prices or exchange opportunities in a perfect market is costless, so that knowledge is, as it were, a free good. This assumption might be plausible if there were only a few buyers and sellers. However, the perfect market also assumes large numbers of buyers and sellers, and presumably large numbers of prices, and the more prices there are, the more transactions there are, clearly the less plausible becomes the assumption that knowledge is costless. We can perhaps wriggle our way out of this dilemma by supposing that the knowledge problem in perfect markets is taken care of by specialized arbitrageurs, who by devoting themselves full time to the problem of knowing what prices there are in different parts of the market and by taking advantage themselves of the price differentials thereby revealed, reduce these price differentials to so small a quantity that all the rest of the people in the market are justified in assuming that the price which they happen to observe at one point is characteristic of all transactions all over the market. We can think of the development of imperfect markets as a result of the fact that when commodities become extremely diverse and complicated, when we have to know not only their price but also their quality, arbitrage in effect breaks down, because the cost of acquiring the relevant knowledge is more than the market is willing to support. Hence we get imperfect markets facing both buyers and sellers. Kenneth Boulding The Economics of Knowledge and the Knowledge of Economic
BACKGROUND Since Upgrade Capital ran our first stock pitch competition in Fall 2012, students have been reaching out to us asking for input on their work and our hedge fund partners have been responding with essentially the same few pieces of advice time and again. The Value Investing Mentorship program was conceived as a way to make that advice available to all of our students in the form of a single, complete research process. We believe that there is no better way for you to understand this process than by applying it, and so the Mentorship program begins with each participant being assigned a name to research. Tyro Partners is a New York-based fund founded by two Upgrade Capital alumni that focuses on conducting deep dive fundamental research on macro-driven and Special Situations investments. This document was created as a living document to guide students through a precise process for evaluating a single firm. Full-time analysts often take multiple weeks to complete essentially the same process you are being challenged to apply so please don t get discouraged if you find yourself working on the same name for multiple months in a row. Completing a thorough analysis and write-up of just one name will put you years ahead of most of your peers, and we are here to answer any questions and address any concerns you may have along the way. OVERVIEW Proper fundamental analysis involves obtaining information and synthesizing research in order to develop an edge over the average market participant through superior information and/or superior comprehension. The difference between our perspective and the market s will define our Variant View, which will be the core driver of a potential investment. The process outlined in this Primer allows you to build an edge through two simple steps: First, we conduct exploratory research in order to gain familiarity with the firm and close Research Gaps. Second, we use our research to identify Information Gaps in easily accessible information. Throughout your work, maintain a research journal to document the process. Using a research management software system is highly recommended as well. CONTENTS There are four major steps to the research process outlined in this document: 1. Exploratory research 2. Defining key factors 3. Information gathering 4. Thesis construction Appendix: Sample Industry Map p. 4 p. 5 p. 6 p. 7 p. 8 Please make sure you complete each step before you move on to the next one.
EXPLORATORY RESEARCH The Exploratory Research phase exists so that you as an analyst can gain familiarity with the firm and its industry in order to identify more specific, nuanced issues Key Investment Factors (KIF s) - related to the firm, around which you will form hypotheses. You will then test those hypotheses by digging into your KIF s during the Information Gathering phase by accessing more precise and less easily available public information. Basic knowledge DO NOT read Sell-Side research or opinion pieces. Beginning research by reading other opinions will make it more difficult for you to derive an opinion from your research that is fully your own. DO read the following: Most recent year of the company s SEC filings. These can be obtained through the SEC s EDGAR website. A minimum of three years of earnings call transcripts. These can be obtained through the company s website, free investing websites such as Seeking Alpha, or through premium subscriptions such as Bloomberg, S&P Capital IQ, or Factset. Firm security prospectuses, bond offering documents, and proxy statement. Pay special attention to stated firm goals and practices, debt covenants, and management incentives. Be sure to note how or if these change over time. As you read these materials, add notes to your research journal on items of interest, things that are not well understood, key events, and keep an eye out for consistency or lack thereof in filings and statements made by the company. Evaluate management, board of directors, and firm habits. How does the firm disclose information? How does the firm issue guidance? Is the firm s strategy consistent? How are all parties compensated? Has compensation changed and have those changes correlated to firm strategy shifts? Disclosures made by the company in the documents you have read thus far are entirely deliberate, and you should not be afraid of reading too much into anything at this stage. Note impressions of the firm and management. Call Investor Relations with any basic company questions you may have. Note what they will say and what they won t say, and consider why. Building context Write out a Company History, focusing on the firm founding, key people, strategy and evolution, and how the firm got to where it is today. Done properly, this should highlight gaps in your knowledge of the firm. Go back and read more until those gaps are filled, and note when you are unable to fill them by reading easily available sources. This can produce valuable leads. If you are not sure if your Company History is robust, simply ask someone external to the project (ideally a non-finance person) to read the document and evaluate comprehensiveness. Construct an Industry Map out where the company sits in its industry, paying particular attention to how the entire value chain operates and what factors drive it (see Appendix: Sample Industry Map) try to understand the sources of capital, commodities, customers, etc. Additional reading Search out related materials on the firm and industry in question. Books, trade journals, magazines, blogs, etc. If there are books about your firm, its founder, or related parties, it may be well worth your time to read them. Stop and consider what you know and what you do not know. Does everything really make sense beyond a superficial level of plausibility? What do you need to verify? Can you understand where management is coming from? Can you think like an owner about this business? Consider why or why not. Read more and iterate the research process to answer these questions. If the holes in your research are indicative of not easily accessible information, note them and make them a focus going forward. Those are your information gaps.
DEFINE KEY FACTORS There are typically 10-15 specific topics that ultimately drive the success or failure of the firm and merit deeper analysis. Develop a list of these Key Investment Factors (KIF s). Your KIF s may be: Managerial e.g. are management s interests aligned with those of the shareholders? Technical e.g. what chemically makes drug maker X s compound better than drug maker Y s? Economic e.g. how will the price of oil change over the next three years? Regulatory e.g. how likely is the government to succeed in its crackdown on payday lenders? Behavioral e.g. why do customers choose a Big Mac over a Whopper? just to name a few. You should have hypotheses for each of your KIF s, and should think about what information you need to prove or disprove them and about ways to obtain that information. These are you Information Gaps. At this stage you should also model out in Excel all of the accounting information you got from firm filings. Build in drivers related to your KIF s if possible, so that you can test scenarios based on your exploration of those factors. As you do this, consider the implications of the level of complexity required depending on the firm. Overly elaborate accounting can be a source of risk in your analysis. Also pay attention to the consistency of reporting and whether key practices change over time.
INFORMATION GATHERING Once you have completed building a list of Information Gaps, compose a plan of action for filling those gaps. Interviews The best way to fill your Information Gaps is through interviews with key stakeholders and experts, such as: Suppliers s Business partners Competitors Academics in related fields You will find that it is generally easiest to set up interviews through your personal network, school network, and professional network but do not be afraid to also cold call / cold email. In our experience, hit-rate (number of good interviews divided by number of people contacted) is typically around 50% for first- and second-degree contacts and 10-20% for cold contacts, A few things to keep in mind when doing interviews: Prepare a list of questions ahead of each call. Stay cognisant of your Information Gaps when putting this list together. Stay aware of everyone s respective motivations and biases when analyzing the information they give you. If possible, try to get both information and referrals. Throughout this stage of your research process, try to get as much insight as possible into and context for past and current actions by the firm s Management and the Board of Directors. Analyse investor base Look into who owns significant portions of the company s shares. Evaluate why they own the shares and consider the implications of ownership. Data mining Explore for additional data feeds that provide more up to date information on any relevant factors to your business. Especially when something doesn t add up around a firm, pay special attention to job postings and reviews of the firm. Iterate After you have gone through the above steps once, you will likely find that your KIF s have changed and that you have identified new Information Gaps to fill. Iterate any necessary steps of the process as much as necessary. Once you are satisfied with your thorough understanding of the relevant KIF s, you are ready to begin constructing a thesis.
THESIS CONSTRUCTION Implicit assumption check Now that you have a comprehensive understanding of the firm, try to figure out how you could still be wrong and what blind spots you may have left in your analysis. One tactic we would recommend is to write a hypothetical obituary for your company; ask yourself how could it die? Write out as many scenarios as you can. If you are bearish on a firm at this point, write the firm s hypothetical success story. The intention here is to understand very specifically where you are drawing the line between a plausible future scenario and an implausible one. The implicit assumptions you make in your analysis are as important as the explicit assumptions, so pay special attention here. Are you making reasonable assumptions (ex: a meteor will probably not come down and destroy company HQ) or less reasonable ones (ex: VHS tapes will never become obsolete)? If you are identifying plausible scenarios that could ruin your firm/hypothesis, go back and make sure your KIF s cover them. Variant view Evaluate others opinions on the stock. Look for material factual misstatements, over-hyping of certain factors, and figure out precisely why people agree or disagree with your analysis on the name. It is not necessary to always be contrarian as a fundamental analyst. Do not try to force a disagreement when there isn t one. Model construction If you have compelling variant views then you have the makings of a strong thesis. Go ahead and conduct valuation using multiple methods. We recommend looking at Discounted Cash Flow, Comparables & Multiples (EV/EBIT, EV/[EBITDA Capex], P/E), Liquidation Value, Replacement Value, Book Value. Try to understand why different valuation methods produce difference results. The model s primary purpose is to quantify how your variant views will impact stock price, but be aware that this impact can often be dominated by exogenous factors, so be sure to also conduct sensitivity analysis on key variables e.g. crude oil price for a drilling company. Write-up See the write-up template for a summary of how a fund manager would expect you to present your thesis. Final note Try to unmoor yourself from your stock s current price: instead of deciding whether you would buy or sell right now, try to determine what the stock s price should be for it to be a compelling long / short. The best pitches are those where even if all exogenous factors go against you, the investment still generates a strong return this is the price that fundamental analysts should attempt to discover.
APPENDIX: SAMPLE INDUSTRY MAP The following is a simple example of what an industry map might look like: Capital Supply Raw Goods Supply Tech Supply Firm A Competitors Firm 1 Firm 2 Firm 3 Distributor Distributor Distributor Building an industry map forces analysts to think about entire value chain, the relationships that define it, and how those relationships might impact the company. It is also helpful to think about how the industry map for the company you are analyzing compares to the industry maps of its competitors.