Reasons to buy a stock? Beyond "its cheap"...

dabullbear's picture
Rank: Monkey | 46

At a super basic level, what are the key reasons to recommend buying a stock? The most common answer is probably: "buy, the stock is cheap (relative to history, to peers, etc)"... but moving past the "cheap" answer, how about some others? I think this basically comes down to various ways an analyst can make an out of consensus call.... but would love to hear opinions. Off top of my head:

- Exposure to an attractive channel / product / customer segment / geography
- Multiple expansion: eg outlook/confidence increases in the stock even if earnings estimates are not changing, perhaps multiples just getting froth-ey across the market
- Catalyst/events/dates: eg earnings releases; Government announcement could be favorable for a stock, so can have an option on the upside potential
- Think a particular scenario will play out over a time horizon: eg M&A or acquisition target, increase in growth rate for key demand drivers, cost pressure easing on key inputs, scope for operational improvement, structural or business model change
- Management: trust them / credibility, think they will surprise to upside
- Technical argument: eg underperformed for a while for seemingly no reason, momentum
- Certain investors looking for this type of investment, inflow of potential buyers
- Not a lot of analysts cover the stock, its complicated, others haven't done the work and read through relevant documents, etc

Comments (25)

Mar 20, 2014

Generally will be arguments based on EPS and the drivers behind that. Once you have that view, you figure out why your EPS is different from consensus, and why they are wrong and you are right. You should have a catalyst/event that makes the market realize your view is right and theirs is wrong, which will then cause the correction in the stock.

Multiple arguments with no EPS argument is extremely difficult to argue. Relying on investor sentiment to change without anything fundamental to the company happening.

Technical argument also doesn't really belong in equity research.

Mar 21, 2014

@cob5 Definitely agree, probably most important to be able to describe why your EPS is different from consensus.... And those drivers or reasons is basically what I was getting at (some I listed above, demand drivers, cost, even softer stuff like management... or like you say subscriber trends, could be LFL sales, etc). Sales, traders and buyside also love the catalysts! Disagree on the two other points though... Multiple expansion happens, not the only way to make money, but it can work. The market can depress valuations from time to time, and you could wait it out and multiples can increase (essentially another form of buy low and sell high). Its one method private equity uses. It is more of a theoretical point, but in just to highlight the phenomenon... this could occur even if consensus EPS denominator does not change. (Perhaps investors don't have anywhere else to put their money, so they put it there!). Makes sense, just look at the PE of one sector in year ABC vs year XYZ, it could change, even if EPS stayed the same, right? Also disagree a bit on the second point, technical. Depends where you work, but in BB sell-side ER today, if you don't pay at least some attention to markets/technicals, you're career may be short-lived (my personal view). Time horizon is critical, and sales/traders/asset mgrs/hedgies all could have different timelines in mind. I think the "technical doesn't really belong in ER world" only applies if the only audience you have is limited to long-term value based, which isn't true for everyone. Definitely open to discussion though... just my thoughts...

Mar 22, 2014

My point was that multiple expansion should RARELY ever be the underlying reason for why someone should buy a stock. Multiples are available to all investors - it's public knowledge. There is no reason why a stock should somehow be unaware of this and not price in an accurate multiple. Now, that doesn't mean that pitches can't be somewhat based on multiples. You can maybe argue that investor sentiment will improve based on upcoming events, like new management or an analyst day.

But to really have a convincing pitch, you need to go beyond just the multiple. Look at any upgrade or downgrade research report and they will almost always make an argument on industry metrics. This is where I think most students get their pitch wrong - the discussion needs to be about the EPS/EBITDA number and the underlying assumptions that drive that, not the multiple.

On technicals, it certainly doesn't hurt to pay attention to technicals when you speak to traders. But that's about as far as I'd go in terms of how helpful it can be. In the five years I've been in ER, I can only think of one or two times where I've spoken about technicals (and they were always to traders, not clients).

Mar 21, 2014

cheap or expensive means ... how the company is perceived by the market and also why it is perceived by the market the way it is ... is it over bought, is it speculation, are the future prospects really bright and secure... so you check the intrinsic value (intrinsic stock price) which means how much the company should be worth, based on that you will see how much the stock is overvalued (expensive) or undervalued (cheap) by the market ... the other factors you mentioned lead up to the intrinsic value because these factors help you in developing the assumptions for the value drivers

and that valuation will depend upon how much value a company will create .... however, the manner in which you calculate/understand the value of a company will depend upon you (the analyst) ... but the conceptual and practical understanding of value is this:
value is created by the amount of cash (value) a company can generate, relative to the cost of capital invested to generate growth that will result in the amount of cash (value) generated ..

so at the Super Basic Level it is.... ROIC, Growth, Cost of Capital

hence by this conceptual understanding it can also be understood that earnings are NOT as important as cash flows generated.... because earnings can be manipulated very easily, not to say that cashflows can't be manipulated but once you reconstruct the financial statements it is clear how much cash the company has generated ... so the EPS is not really useful in understanding how much a company is worth but the ROIC along with the growth is useful

additionally

it depends upon the type of stock you are looking for
value
growth
dividend

because investments are made based upon your needs
long term return (capital gain)--- go for value
income --- go for dividend
short term return (capital gain)--- go for growth
some people look for the unique stock that for some reason has not been detected by the market but the company is large and has been generating value for a long time

so first decide your investment strategy or understand your clients investment strategy so that you can justify how the stock fits into the particular investment strategy

after that you can look at what the company is doing, what is happening in the industry, the economy (the factors you mentioned) ... then based upon your understanding about the direction the company will take you will develop your assumptions for the projections and the valuation

Mar 21, 2014

@Qureshi, Yes, also agree on the point about ROIC, Growth, Cost of Capital. Hard to argue against that. Apologize, because maybe I rattled off my initial question late at night after a long day at work...! Perhaps it wasn't very clear. I was asking more about the underlying assumptions behind that... ie the stuff that can drive good debate between the analyst and sales/trader/clients. More specifically, what are the main categories of assumptions. Less about valuation methodology and more about the types of assumptions that can drive interest/debate. Could be assumptions about the underlying business, industry environment, or the stock/markets.

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Mar 22, 2014

well the assumptions discussion will depend upon the type of a person the trader is .. there are some who are more focused on the market factors ... some on the consumer markets.... others on events ... others on the fundamentals.. few like all the details ... additionally it will also depend upon the country, the industry, the company (for both: the company being analyzed AND the traders/analysts) ... so i cannot say really ... but you have more or less covered the typical points that will be discussed

Mar 21, 2014

I think qureshi's view is the textbook answer, and while there's nothing wrong with that, I'd say that stock pitches are hardly ever framed that way in equity research -- it's usually a view on eps or ebitda (driven by some core industry metric like same store sales or subscribers).

Mar 21, 2014

yes you are right @"cob5"... you will mostly see stock pitches in terms of EPS and other multiples ... @"marketman_123" wanted to know the stock selection so i gave him the theoretical basis for it but the stock fitting the client's portfolio is a must because that is what a sell side analyst is there for giving advice regarding picking stocks that fit into portfolios ... additionally if you speak with clients they agree with the ROIC approach and its importance... i guess it is just a case of the multiples being sort of common practice ... however, if you speak in terms of ROIC no one is going to stop listening to you and knowing other multiples and speaking about valuation in those terms must also be on an analysts finger tips ... many analysts use the DCF for themselves but convey in terms of multiples... but if you find the EPS as being misleading then you just explain to the client why a particular company's EPS or other multiples are misleading

Mar 22, 2014

All of the clients that I have spoken to value a company based upon earnings and multiples. It really depends on the industry, but for most, they rely on multiples because it allows you forecast a stock price after only one or two years of financials. DCFs are not as useful because so much of the value is derived from the out years, which are the least accurate in forecasting. It's really only useful for certain industries where the cash flows are very stable.

Fair enough - ROIC is definitely something that I talk about with clients, so it's helpful to know. But it's usually within the context of whether a company is using their capex effectively and putting it towards the right projects. It's just not as applicable for whether a stock is valued correctly.

Mar 22, 2014

I think a lot has been said about the price of a business, but not enough about the value of a business. [Disclaimer: cheesy W.B. quote ahead] "Price is what you pay, value is what you get."

We spend a lot of time talking about stock prices, but not even half as much about the value of a business. I think that's because the former is quantitative which makes it easier to calculate, whereas the latter is qualitative and much more of a grey area. However, in my opinion, it is the latter which is of much greater importance.

I'd like to emphasize that, at the end of the day, you want to buy a business and not a stock. You're buying that business because, over a long period of time, it's going to give you a consistent low-to-mid-teens (if not higher) ROI.

Now how can you be sure that the business will deliver? You look for their sustainable competitive advantage. Warren B. likes to refer to this as a moat. This moat could be the result of a number of different things: technology, patents, human capital, brand image, physical resources, culture and incentive systems, etc.

These aspects allow you to determine the value, or the quality of the business. Once you've found a high quality business, the question no longer remains whether to buy, rather when to buy. And at that point you don't really need another reason than the stock being cheap.

I'm well aware that there are numerous ideas/opinions/strategies. So feel free to agree/disagree with the above. Would love to continue the discussion.

You need to understand that a good firm, a profitable firm, and an attractive stock investment can be 3 unrelated things. -Epicurean Dealmaker

Mar 22, 2014
Mar 23, 2014

Actually, Munger.

You need to understand that a good firm, a profitable firm, and an attractive stock investment can be 3 unrelated things. -Epicurean Dealmaker

Mar 28, 2014

munger, buffet, McKinsey ..they all talk about these issues in different ways to different lengths ...so their principles in terms of investing are sound .. but McKinsey differs a bit over here when they say ".... a good company and a good investment may not be the same..." the reason being that competitive advantages disappear /reappear and the company that was once competitive may not be so anymore, even if the management is very good at its job (though management can also change), the ability for company to grow fluctuates there will always be periods of slow down, stagnation or even temporary loss of value

but even the grey area can be quantified not in terms of mathematical relationships but in terms of statistical relationships (via empirical research) which obviously keep changing since the nature of business and industries changes, however the advantage of conducting empirical research for the 'grey areas' is that it gives your assumptions/understanding a temporary insight/proxy into the actual state of affairs at a certain point/range in time (though the timeliness of such research is of the essence, not to mention cost) ... Jay b. Abraham's work is a good example Quantified Business Valaution .. even the cost of capital is a good example ... btw do read Cost of Capital: Applications and Examples by Shannon Pratt

and as far the different strategies go you must separate investors and traders .. i believe one should try to see through the all the strategies for investing and trading as a type of diversification and then decide if they want to stick with one, a few or all

Mar 24, 2014

@"cob5"
@"marketman_123"

check this link

http://www.finaticsonline.com/Freebies/Stock_Selec...

it is a good discussion for different ways to filter stocks

Mar 28, 2014

I am speaking mainly from the perspective of hedge funds and equity research. Most analysts will look at stocks using this framework of fundamental metrics and multiples. Or they might look at free cash flow yield, or a DCF. I can point to hundreds of equity research reports on this (just take a look at their valuation sections). My previous post talks a little bit about why they use this method, and I'll just leave it at that. In my five years as an associate, I have yet to speak to a client about buying a stock b/c they have a high ROIC. That might be one element that we discuss about the company, but it is not the framework that we speak about stocks. So from a practical perspective, and if you are trying to get into equity research, I would suggest that you become comfortable with these valuation methods first and foremost.

While textbooks usually will talk about how P/E might not be as reliable because earnings are manipulatable, the truth is that very few companies are actually actively trying to manipulate their earnings to such a huge degree. If they are, as someone in equity research, you will usually catch on to it because you should be spending most of your time analyzing the top of the P&L anyway. And if not, then yes you can look at other valuation methods like FCF yield, but they are usually tied to fundamental metrics and a multiple still.

Mar 28, 2014

not arguing against what one would discuss with a client when talking about stocks

and neither am i talking about ROIC alone or using that as a discussion point with a client... just simply saying that if a person has to select a stock as an analyst while valuating, then ROIC with growth can show the value generated relative to the capital invested ... and that is just one aspect for selecting a stock

and i have nothing against the EPS & P/E valuation methods at all... specially if it means that is the way someone else will understand or decide to buy a stock ... i just prefer only for my understanding about a stock via the ROIC and growth and value, etc

and earnings are unreliable not because they are manipulable .. but rather not a good representation of value generated by a firm... and that has nothing to do with how an analyst should speak with a client

Mar 28, 2014

What is a good representation of value generated by the firm?

Mar 29, 2014

@"cob5" @"TheFamousTrader" @"marketman_123"

what if while making a report an analyst shows the McKinsey Way of looking at value ... ROIC, Growth, FCF, NOPLAT, invested capital, cost of capital along with whatever model for valuation is suitable ... while also showing & comparing the EPS & multiples view ...

A. how will that be perceived ... (provided no time is being wasted or diverted from an analyst's regular work/priorities)
1.will the analyst be told not to do so or
2.will the work be ignored or
3.will there be indifference or
4.will there be interest shown

B. and what will happen if the analyst also starts to compare the two different ways of looking at the company's valuation while speaking with the client
1.will the analyst be told not to do so or
2.will the work be ignored or
3.will there be indifference or
4.will there be interest shown

C. also what would be the take on analysts publishing white papers? if the initiative is the analysts idea (provided no time is being wasted or diverted from an analyst's regular work/priorities)
1.will the analyst be told not to do so or
2.will the work be ignored or
3.will there be indifference or
4.will there be interest shown

Mar 30, 2014

I assume by Analyst you mean 'Senior Analyst' (i.e. the guy running the entire sector team). If so, then:

A. The Analyst does whatever he pleases as long as it is nothing too crazy that can be vetoed by the Head of Research/Director of Research (i.e. the guy running the entire department). That's why many people like SS ER in the first place - the autonomy that you get. As long as you bring in trading volume, new clients etc. through your research - you're free to do whatever you want. But at the same time you are working for the clients, so if no one appreciates 'the other method' that you're doing - then it is clear what you need to do.

Same goes if you're an Associate on the team - you can of course provide suggestions to your Analyst in your spare time and it is actually strongly encouraged at most places, but if you repeatedly shove the same stuff to your boss after he/she said no - it's also a problem.

This is simply common sense.

What the Analyst will be told will depend on the client. Usually you just need to cover 'the basics/foundation' first, and then you move in to more in-depth stuff because without a solid foundation there's no point talking about the 0.001% change in margin.

B. Depends - is the conclusion the same? Is it conflicting? Does the client believe in your 'other method'? And so forth. A lot of the times the client guides the discussion as many come with readily prepared questions and want to know the specifics. Valuation arguably matters the least on the sell-side as buy-siders have their own practices - what they do want is sector/company specific information and expertise in general. Also, obviously access to company management.

C. I personally love white papers. Once again depends on the overall 'interest' in the topic you'd be covering and whether it is directly relevant to your sector.

Probably misunderstood a question or so.

    • 1
Mar 30, 2014
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