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Career Resources
I'm on my second summer interning at a fund with this mandate, so I'll try to give you some color although I'm sure the professionals on the board can do a better job.
The process involves a rigorous, in depth, research process to develop both a strong understanding of the qualitative business fundamentals and quantitive framework for valuation. Because the fund is concentrated, or focused, this process allows for the fund to allocate between 5-10% of assets in high conviction investments of trading at below a conservative estimate of intrinsic value and offer a wide margin of safety. Our goal is to identify companies who will not return 50% over the next few quarters, but 15-20% annually over 3-5+ years. Additionally, risk is not viewed through individual security volatility (beta), but rather the risk analysis is centered on the individual business.
I don't think there are really any books written exclusively on focused investing, but some of my favorites as they relate to the strategy are:
Berkshire Hathaway Letters to Shareholders Competition Demystified The Most Important Thing Fooling Some of the People Margin of Safety
And you can also learn a lot by reading client letters of focused managers, their 13Fs and 10ks of their holdings.
Happy to answer any more questions the best I can, but like I said I'm sure there are some others who can do a better job than me.
Yeah, I'm at a shop like that. (Although lots of funds who claim that kind of mandate don't really follow it, at least when it comes to the "long-term" and "concentrated" parts). "Edge" at the shop I work at is mainly from sticking to sectors/subsectors where we can do meaningful primary research. Process is usually thesis-driven, a lot of time spent trying to figure out factors/trends/catalysts that others in the market might misunderstand or overlook, and also technical factors like forced selling on spinoffs, index buying, etc. Couple of examples:
1) Companies that have multiple divisions in very different sectors: we were long a boring low growth company that had a small but extremely fast growing division in a different sector. We dug deeper, realised that small division was going to end up becoming >50% of the value of the company within a couple of years. So not only were earnings expectations too low, but we expected sector coverage on the sellside would change from the low-growth sector to the high-growth sector, which meant that people would start to put a high-growth multiple on the company
2) Companies with deceptively high leverage: we were long a company that was like 6-7x net debt / EBITDA, a lot of investors were put off by that (and some simply couldn't invest in it because of risk parameters), so it traded at a big discount, but people didn't realise that this company supported nearly 10x leverage in a PE structure during the crisis and underestimated the quality of their cash flows.
Rarely screen stocks based on valuation, think a lot of people get burned trying to pick stocks doing that; prefer to go long things that are deceptively expensive / short things that are deceptively cheap.
Lots of threads on here about books. Would recommend: Margin of Safety, Value Investing (Greenwald), The Most Important Thing (Howard Marks), You Can Be a Stock Market Genius (horrible title but this is one of the best books on investing ever), Financial Shenanigans, Art of Short Selling, Quality of Earnings, The Outsiders (Thorndike), A Random Walk down Wall Street, Creative Cash Flow Reporting
Piper, thanks for your helpful posts. Do you have any opinions on which sectors are ones in which HFs can conduct meaningful primary research? I ask because not only is being able to conduct such research critical to getting good returns, I think it also enhances the learning experience of a junior person as they may be asked to conduct a lot of this type of research and report back with their findings.
Regarding such sectors, industrials comes to mind as a lot of companies in the space are cyclical and work can be done around understanding where we are in the cycle, creating buying/selling opportunities. Energy seems like one sector where no matter how much primary research is done, your thesis can still get invalidated by a sudden move in energy prices (as we have seen recently). Any thoughts on other sectors like consumer and the ability to get an edge? It seems tough in the retail apparel space where quarter-to-quarter performance can be tough to gauge ahead of time (same store sales performance, etc.). Any thoughts are appreciated, thanks.
For me it probably comes down to sectors where you have differentiated products and relatively few customers (or at least you have customers that are very representative of the overall market).
Healthcare, particularly pharma and devices is a big one, a lot of information can be gleaned from calls with doctors (who are very representative of the average doctor in the same field). I think industrials is good for research in the subsectors with more differentiated products because you can then go and do research on which products are going to have the highest adoption rates, stuff like aerospace - talk to pilots, air traffic controllers, leasing companies, airlines to try and figure out how quickly order levels will ramp up on a new model. I can never get my head around the really cyclical industrials - I don't know how you estimate the market size for pumps or valves or ball bearings.
Retail is difficult. You can't go and stand outside every store and count traffic or sales (there are consultants who try to do it but their numbers always seem to be very wrong). Apparel especially difficult because fashion is so fickle and it is extremely difficult to call a turning point. Consumer staples a littler easier because all you need to do is talk to a bunch of retailers to figure out the trends and what is driving them.
Anything commodity-related is pretty difficult. No amount of primary research will tell you what China's steel consumption will be next year. Energy obviously hard to predict as we've seen, but oil services are a decent space to do research (actually understanding exactly what the products are, who the customers are, what products are price elastic/inelastic, what technologies are gaining the most traction with oil companies, etc).
Where you have a potential edge: 1. Concentration of resources (Time and Capital) - You end up spending more time and more capital (i.e. primary research) on fewer names and should have a better view of what drives value in the names you diligence relative to analysts that may not have the time/resources to dig beyond the basic disclosures and a GLG call. Think about the standard (consolidated) metrics/information public companies provide and think about what data/metrics/information you would actually want to know to properly value the company. The gap between the two is (typically) pretty wide but given enough time you should be able to (somewhat) bridge that gap to have a differentiated view on the company.
Industry/Operational Knowledge - Having industry/operational expertise (or having access to industry expertise) helps. This is especially true when looking at companies going through a turnaround or some other inflection point that creates a lot of ambiguity (markets hate ambiguity) and depresses the valuation. I'm seeing more and more HFs bring on operating partners similar to the way PE funds have a bench of turnaround executives/CEOs to gain an edge. Also, you start picking up patterns/trends a lot faster the longer you spend in an industry. Track any HFs 13F over time and you'll see a lot of the same themes repeat themselves.
Better Engagement with Portfolio Companies- If you have #1 and #2, you will likely be viewed as one of the smarter shareholders by the company and have a reasonably close working relationship with the management team. Why is this helpful? Having that credibility (and top 10 shareholder position) affords you the opportunity to get more interactions with management, and be more constructivist/activist than most shareholders. When you've done your homework, the conversations/debates are 1) more engaging and 2) focused on issues that keeps the CEO/Board up at night. I can go on about #3, but it's probably where rubber meets the road as far as having an advantage/edge is concerned.
Mandate - Funds that concentrated portfolios tend to have more flexible investment mandates that allow them to go into areas that other more diversified investors might avoid or can't invest in.
Hi there.
I'm a buy-side equity research analyst working in an Emerging market. I won't get into much detail, but we definitely fit the mandate that you're talking about. We are almost index-agnostic (I stress. ALMOST.), and construct portfolios based on bottom-up picks. The problem with this mandate is it's easy to say (and start), difficult to stick to. Thewaterpiper is right. Lots of shops that say that they do this type of Graham-Dodd "Superinvesting", but it's tough to stick to your guns when the index is up and your fund is down. Spell: Massive negative alpha. Then clients turn around and go "We're paying you fees to generate ALPHA, not underperform!" It's not easy, I'll tell you that; Shops that stick to it deserve massive cred, and there's no shame in trying to add more beta to your portfolios, especially in this bull market.
Thewaterpiper and Gray Fox made a few great points already, I'll just some stuff I've learned through my experience.
I highly agree that sectors where you can do a lot of primary research is a good way to go with regards to fundamentals-based or value investing. I disagree, however, that it's tough to do research on retail (Lotsa personal bias on this one haha) because it's possible if you know a lot of people who work in the industry. He's right, however, that it's important to be able to directly observe what's happening to the companies and the sectors and do "on-the-ground" research, rather than just read broker reports, sales notes, and make phone calls. It's also important for you to develop your sources of information because you can actually cross check. For example, the mall operators will have invaluable insight into how the retailers are doing. The input manufacturers can shed more light on what the demand situation of the consumer goods manufacturers. Get on the ground, pound the pavement and kick the tires. That's how you gain the conviction in your calls to stand in front of the rest of the market when you're on the wrong side. Remember, ordering boxes of See's Candy and eating it with the team was part of Warren Buffet's research process. Meet management, and not just them, but other people in the industry. Visit the shops, see the locations, etc. Channel checks are key.
A lot has been said on research helping you make money. This can also help you NOT lose money. Remember that Rule #1 is Don't Lose Money. Rule #2, don't forget rule #1.
For example, there was a situation in which one retailer was the hottest "darling" stock of the market at the time; Let's call it SmallCo. Explosive growth (EPS growth of 40+% y-o-y) being driven by a rapid expansion plan, with an extremely wide addressable market that had no big "modern" retailer specifically serving it in the past. Goldilocks story in an emerging market for a retailer. It was a low-cost retailer, however, and catered to the most cost-sensitive customer base that was out there. Remember that mono-banner/chain retailers rely on location network, as the target market (ESPECIALLY in emerging markets) is extremely sensitive to travel costs, meaning that you have to get closer to your customer base in order to maintain the sales. The price of some staple foods went up by a small amount, for example, and it hit their comp sales (SSSG). Because we were doing a lot of on-the-ground research with people in the industry, with competitors, and their suppliers, we could already tell that they were running into some problems. The incumbent large-scale retailer (let's call it BigCo) was starting to fight back because SmallCo was finally starting to make a dent, and did so by initiating a price war.Remember that the larger the retailer, the more vendor dollars, supply support, and bargaining power they have for discounts. Their margins are more more flexible, and they can ask suppliers to support their price cuts with higher discounts when they need it. BigCo was almost 3x the size of SmallCo, and you guys can kind of guess what happens next. SmallCo reports a really disappointing quarter and the whole growth story is called into question. The stock pretty much goes in to free fall, and hasn't recovered since. It's tough to not get into a stock when it's returning 20% in a quarter and the sell side is pushing the heck out of it. "Going against the herd" is way easier said than done.
Like Gray Fox mentioned, this especially happens when there's no sell-side research on a name. I remember MSCI had a report recently that their research has shown that sell-side coverage is one of the biggest drivers of return in emerging markets especially, because most buy-side houses here don't really have strong in-house research teams. Even if they did, we buy-siders don't publish our research, and I'm always told "it doesn't matter if ONLY YOU buy your investment thesis!" That means that a lot of small & mid-caps get ignored because it doesn't make sense of the influential (aka Bulge Bracket equity research team) analysts to cover them due to lack of size and daily turnover. However, this is where value really lies, and the industrious buy-side analyst should embrace these less-known names. You can find surprisingly HUGE discounts to fair value in that under-researched space. For example, I've seen companies that have huge, high value pieces of land with no debt and lots of free cash flow, trading at 70-80% discount to the NAV of the land bank, because they're not the usual sexy high-street and business district developers that everyone loves. I've seen companies in somewhat wacky industries like online proxy betting and Ladrbokes PLC type models trading at not even half of their intrinsic value. This is when your industry expertise becomes key. What will make these companies a significant player in the industry? If we're gonna buy for the long term, you can't buy a company that's going to be small and insignificant to the industry forever. Best part is, you get in ahead of everyone else, and before you know it, the sell-side might start picking up on it. Starts with a few visit notes, then an initiation report will come soon enough.
Catalysts are also of the utmost importance. A sell-side analyst's job is to cover companies & sectors, and provide information flow, analysis and insight on them. A buy-side analyst's job is to help the PM's generate alpha in the sectors & companies that you cover. While investment ideas with a lot of potential are great, you also gotta figure out what will bring the price to that magic number in the summary sheet of your 999-worksheet model. An undervalued company with no catalyst will stay undervalued for a very very long time.
Books?
Maybe the Superinvestors of Graham and Doddsville. Buffett beautifully outlines the investment philosophy there. The Graham essentials Intelligent Investor and Security Analysis. Margin of Safety by Seth Klarman (the pdf is floating around on the net) is a good one, especially because investing in smaller, under-researched names involves a LOT of risk. (Lack of company access to the capital markets, liquidity risk, less visibility sometimes, etc.)
Valuation by Damodaran is a good one too, because I often see people falling into value traps, or inappropriately mislabel companies as expensive. Cheap companies can be cheap for a reason. Something might be trading at 4x trailing P/E, but if the ROE of that company is like 2-3%, it rightfully deserves to be so. Something may be trading at 20-30x P/E, but if their ROE is >20% and the sustainable growth rate is about 10%, then rightfully so. That company might not be so expensive after all.
Hope this helps.