How to develop conviction around valuation/catalyst/"differentiated view" portion of pitch? A lot of it seems wishy-washy.
Hey everyone,
Not recruiting for HFs, but wanted to ask this for my own learning:
As far as a public equity pitch goes, I have no issues identifying a strong, differentiated company with good business model and financial fundamentals. However, I struggle a lot with developing conviction around the portion of the pitch where I explain why a stock is currently mispriced, and what the catalyst will be to correct that.
As far as valuation, a lot of the pitches I've seen have seemed vague in this section. They'll use phrases like "the market is unfairly punishing __ for ___", but how can such a claim be made without material information that others don't have? In asserting that an equity is mispriced, should you mainly rely on your model? If so, why would your model be more correct than the market's view unless you have material, differentiated data? If you're not relying on a model, how can we even quantify to the point of suggest it's mispriced?
Additionally, I have difficulty thinking of meaningful catalysts (in the absence of having information on an event that will happen), excluding arguing that an earnings beat will be the catalyst.TL;DR: I find it pretty straight forward to identify/evaluate an attractive business, but I find it hard to develop or substantiate a "differentiated" view from the market to argue that an equity is currently mispriced and that there will be a catalyst to fix that mispricing.
Any advice is appreciated, thank you.
Bump
You’re obviously too smart for hedge funds, you should go work in tech bro
This is really the “art” of the job. The differentiation in your view vs the market should develop organically as you work on the company. While you’re never going to know exactly what is priced without talking to every actual holder and hearing their complete thesis, it is important to construct possible counter-narratives to your own view and tease out the expectations implied in the stock price.
There are a few ways to do this and start forming the mosaic of “market expectations”. You can get a feel for what investors are worried about or expecting via the sell side. Read notes over time, talk to guys if you have access, ask what kind of conversations they are having with other buysiders. Though I will caution that often sell side expectations can be quite different from the implied buyside expectations. You can also just talk to other buysiders if you have the network and contacts. Even if you don’t have formal relationships, you can chat with people at conferences and after group management meetings to see what their thoughts are. You can gain some insight by looking at the ownership of the stock as well. What types of funds are in the name? Think about how a name might move through different style boxes over time depending on how the fundamental story plays out and what that might imply for turnover. How have holdings trended, who is buying and who is selling, is there a potential long-short trade on?
Once you have an idea of what is in the price on a fundamental and sentiment basis, then you can compare that to your numbers and see if you can identify a disconnect. Based on what the differences are, if there are any to begin with, that should help you identify your catalysts.
To be frank, I tend to find the fundamentals for the next 1-2 years to be efficiently priced. I have a bit of a quality bias though, so what happens in the next 1-2 years isn’t very impactful to the valuations of my companies (longer duration). Not many will give you their numbers further out on the timeline, and the information quality of consensus numbers past +2 years declines rapidly. As a result, I tend to find that the implied expectations further out on the timeline tend to be where I can have the most differentiated view. A lot of times it will be something as simple as growth is implied to decline faster than I think is realistically possible, or the market is implying no margin expansion past x years for a business with good operating leverage and/or high incremental returns on capital. In these cases, I don’t necessarily need an explicit catalyst. The discount to fair value should amortize a little each year as expectations further out are reset, and each year that you clip that discount should drive a bit of excess returns.
Obviously if you are at a fund with a shorter time horizon, this is probably not the type of idea you can bring in (which is why these types of ideas remain durable in my view, time horizons are generally too short for them to be efficiently arbed away), but the premise is still the same – you have to figure out what is implied in the price, if your expectations differ, if you are correct, and how and when the market will come to realize that you are correct.
On that last point, if there is a wide gap between my expectations and the market and I cannot reasonably figure out why that is, the probability increases that I am the one who is missing something. That should be your base case – maybe I missed something. Generally I will table this type of idea and follow it more over time to see if I can get more comfortable that there is a genuine opportunity. I never like to bring in a pure valuation idea with a weak explanation as to why the discount persists. Those have been my worst ideas over time because more often than not the market had it right. As an analyst at a smaller shop with less access to resources, I have to acknowledge that I am likely at an informational disadvantage on just about all of the names that I cover, so if I cannot get comfortable with the “why” something is mispriced, it is probably wise to move that idea to inventory and watch from a distance for a while.
This is also why I value the DCF as my primary tool for valuations. It’s not about getting some number as an output and saying ok, this is the number. It’s about flexing different scenarios through the model and stress testing different line items to come up with varying combinations and figuring out a full risk-return distribution. It results in a range of outcomes rather than a single point estimate. You can then evaluate the market price via where it is within that range, and the upside/downside to different scenarios. Again, for myself at a smaller shop with less resources, I’m never going to have a differentiated view based off an informational advantage, so it’s more about trying to find a mispriced distribution of outcomes on a probability/expected value basis than having a deep edge with an explicit catalyst.
Not sure how involved you are on the marketing / capital raising side, but I'm curious how your fund positions itself to potential investors. What you're describing makes complete sense as an investment process, but I've found that to not resonate particularly well with allocators. Do you apply your process to some niche area (e.g. small cap, EM) and that's what sells? Or do you have a high quality client base (i.e. not allocators) that simply trusts that "good judgment, applied long term" is a valid investment process?
"What is your quantifiable edge" and "what risk systems do you have in place" are in my mind some of the toughest questions to answer convincingly for these institutional money people. "Common sense" is apparently not a good enough answer...
We have permanent capital in my group and I do think that having the right investors is very important/a competitive advantage. TBH, I think that is really our only edge, but it is material.
I know EXACTLY what you are talking about though on the allocator side. In my view, it’s the allocators that enable the industry to be shitty because they just don’t get it. We have an international group internally (my group manages our domestic strategy) that does 3P manager search and they also use 3P consultants as part of it. The consultants are just brutal, and they ask the exact questions that you have mentioned. They think all large cap is perfectly efficient because they read that in a book/paper somewhere and they only like active managers that have no active factor exposures and tight tracking errors. You know the best way to neutralize factor exposures? Closet-index. They love that.
I sit in on those meetings from time to time because I want to hear from these external managers about their strategies/philosophy/process, and sometimes I will suggest a particular manager that I follow on the international side. Obviously I am looking for managers that align with my own philosophy, and the allocators always hate my suggestions. Even if their LT track-records are good, “too much factor risk”….”not enough risk control”. TBH, if my team was external and trying to pitch to my company we wouldn’t get selected based on the allocators/consultants. It’s a complete joke. The risk systems part of every pitch is such marketing BS, but the allocators just gobble that shit up. They tell us about all these tools they have and their weekly risk meetings. WHO TF CARES. You know what risk I am worried about? Not compounding capital at a high rate over the next 10 years. I’m not worried about our beta underweight based on a trailing month of returns.
I always think that it is funny, the word risk has been completely mutilated by the allocators and our industry more broadly. Risk should be defined as the probability of a permanent impairment of capital. We have had 3P risk assessments done on our portfolio and they come out exactly as we expected – you’re overweight to profitability, growth, and good balance sheets, underweight to “value” and beta. We always say ok, that is what we expected, those tilts are intentional. Then they will say the bets are too large, too much risk. This is when I give the most push back. I say “ok, we are overweight to better quality companies and you’re saying we should lower our risk by buying higher risk companies? Does that make logical sense to you?” There is never a good answer to that, but that is the actual alternative – go out and buy some garbage to lower your “risk”. It’s the equivalent of a really healthy individual saying “you know what, I’m too healthy, I’m way healthier than the average person. I’m gonna go rip some heroin to lower my tracking error.” I don’t think that is the right way to think about risk, whether in investments or really any other arena you can think of.
Look at holders list if big smart holders own I buy. It’s a nice way of outsourcing diligence to those with more resources and best in class investment process- this for multi year investments not quarterly trades since 13fs lag
Channel checks bish
Historical information about a company is widely available, making conviction around “how attractive a business is” very low quality.
Any stock or asset you cover will have 2-5+ critical factors that will materially drive revisions and result in a significant (5%+) beat/miss.
These factors can be boiled down to (from less edge to more edge):
- industry dynamics, such as a dramatic change in end markets, macro, or inputs, that will result in a “permanently higher” asp or cogs
- competitive positioning or leapfrogging; such as a company’s low ebit margin relative to peers explained by heavy investment in nex-gen product
- company specific terms such as hedging contracts
Each factor has a catalyst, or an event that leads to information — for a new product it’s a release date/analyst day, for industry dynamics it’s macro indicators across the value chain, and so on.
Here’s a basic example:
- xyz is a company that sells widgets in the USA
- the company has underperformed against peers with very low margins and recently raised capital to help with a new product release
- the company’s new product is part of a new strategy by management to capture the emerging trend in abc
- management is also investing in its supply chain, which hints at the possibility of an international launch
- the stock is trading at a discount to peers given its perceived weakness in operations and lack of international exposure
- the company is hosting a conference to announce the new product in two weeks
- management has not run an international campaign before and channel checks do not show any sign of international presence building (no job postings in other countries, no strategy roles etc)
- this hints that management may not have a clear strategy for int’l exposure, and may take a “wait and see” approach after the release
- the inventory build up adds a layer of risk, as it will require the company to raise additional capital if it does decide to expand internationally
So now we have the building blocks.
Critical factors —> catalyst
new product release —> investor presentation
international expansion —> potentially investor presentation or on earnings call
capital raise for int’l expansion —> probably by next fq or nfq+1
Product and potential for int’l exposure is probably priced in. When you compare the price of the stock and it’s valuation trend from last quarter to d0, is the stock rising/falling relative to revisions? When you talk to your broker (sales trader) and ask about interest in the stock what are they saying? If the stock price = hypothetical market view on valuation, what are the outcomes the price is capturing? Do you agree or disagree with that?
For example if the stock has begun to rally, you may take that as a sign of pricing in higher revenue and eps scenarios which could potentially come from int’l exposure. If you think that move is too early, this may be a reason to for a hunch to short. Ideally you’d want the move up to be meaningful and you would expect the stock to get punished if expectations around int’l expansion are disappointed during the investor presentation. If you have an idea of what will happen then you would want to put a position on sooner. If you need to wait until after, then you’d put the position on immediately once the info was released.
This is an approximation of the way you should be thinking about building conviction and forming a view on price in a discretionary L/S style.
This is incredibly helpful, really appreciate it mate.
The example sounds like a great short target if the market prices in too aggressively management expansion plans, as you mentioned.
Growth treadmill company that just chases the next cool market.
Legacy, declining biz expanding to "new cool things."
Short-term technical signals for the breakout, headline news drives overzealous retail crowd. Happens all the time.
Being early here on the short is also common. Depending on the implied "new market size" and other fundamental factors, being early could be deadly.
If the conservative Implied new market attributes another 2-3x of current valuation, with no easy logical fallacies to disprove the long case and OK fundamentals, Channel checks validations with management that consistently delivers, then will consider joining the party. Though, ideally, we would have known 1-2 q's before and are in before the pricing action and technical breakout.
Vice versa for a short.
One comment about shorts: it is worth waiting until you are very close to your catalyst. You can get your face ripped off before you are eventually proved right.
Great write up.
Following up, what would you say is the expected diligence timeline (once you decide its worth looking at how long should this process take) for a new and/or existing name you cover? Is there a frequency expectation on new ideas (one a month, etc.)?
That depends on what's driving your idea generation process. If you are covering the stock already (pre-built model, already well informed) then it can be as quick as 2-8 hours to complete due diligence, which will primarily center around scenario tests, broker calls, and channel checks. If you have not covered the stock, give yourself a week. Ideally, you are looking for opportunities that will give you 40%+ returns on an annualized basis. A 10% move is not going to cut it, given you will lose 3-5% going in and out from transaction costs and such. Teaching yourself to be patient enough to go through various companies in order to find potential heavy-hitters is key. Do not see it as a numbers game (it is but if you accept that you will never improve!).
You should read Best Practices for Equity Research Analysts by James Valentine. As a matter of fact I may do a post on the book and why it is possibly the best book for L/S equity analysts to read.
James outlines the that you need to have a proprietary view on either the financial forecast, valuation method or market sentiment. Granted that having a differentiated view on Valuation and Sentiment is difficult difficult the easiest way is to have a variant perception on the EPS/Revenue over whatever is your preferred time frame.
So, how do you develop a variant perception on the operating performance of a stock? You need to develop some form of proprietary insight. Take Peloton for example. The street was modelling this thing to grow at 30% yoy after covid which pulled forward significant demand from 2022 and beyond. If you checked FB market place and eBay you would've seen that people were selling their bikes in droves. Now that piece of anecdotal evidence in isolation is not enough but if you read through the earnings transcripts over the prior three qtrs your would've noticed how incongruent management was in their comments around future demand. Try to think of yourself as a detective trying to find pieces of information that aren't fully appreciated by consensus.
I cannot emphasize enough as to how much value I gained from reading James Valentine's book. I'll do that write up sometime next week.
I look forward to it.
That covid one-off short is all over the place....
It is also inversely correlated with vaccination and general resumption of gyms/normal life.
Though the 2nd hand marketplace is a nice check. Looking at the number of listings and the change over time etc. but the vaccination rate/resumption is more leading in comparison.
Agreed - shorting tech, story stocks or anything that has an implied vol over 60 is going to be all over the place. And yes the idea that as more people got vaxed and started going back to the gym it would lead to decreased demand was definitely the core of my thesis. However that is definitely not what the street was seeing. Hence the primary research I did confirmed that indeed it was going to miss and most likely guide down for the year. It is also worth noting that there are many ancillary pieces of evidence that supported my view. CFO selling all her stock, discontinuing key guidance, financial shenanigans etc.
helpful. know of any hfs that shorted pton in size?
Once you stop believing that markets are perfectly efficients it becomes pretty easy to answer your question.
The only way you can be confident the assumptions in your model are better than the market's assumptions is by doing thorough research based on objective facts.
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