2 January , 2010
This is the third edition of our series on hedge fund interviews.
- Read as much of the material as humanly possible. No, this does not mean you have to read every single clause of a credit agreement, or every single line of a 10K. You should have enough experience at this point to know what you can skip over and what you cannot skip over. I rarely skip over the 10K footnotes because that is where you can find information that is not being readily appreciated by the market (for the positive or the negative).
- Once you have the material read, you should have some kind of understanding what the market is anticipating via a sell-side report or a Q/A session from recent conference calls. You can use the estimates from the sell-side report to get a sense of where market consensus for top-line and bottom-line figures are and you can use the Q/A session to get a feel for what qualitative concerns market participants have for the company. For example, if someone on a recent conference call asks: “So, what is the timeline for the new casino opening and how confident are you that you will be able to open on time?” … That analyst and probably a bunch of buy-siders who called to ASK that analyst are worried that delays/cost-overruns might push back a project and hence the estimated earnings and cash flow in future quarter. Write the pertinent questions / concerns down.
- You then want to identify the main drivers of both business performance. Really it should only boil down to two or three extremely relevant line items. For example, for a wireless company it could be # of subscribers and ARPU.
- With concerns and drivers in hand, you will now set out to build your model / valuation sheet. If you can build a three statement model in an hour or so, well then by all means do it, but I suggest really focusing on those two or three drivers you identified above, and zeroing in on them and determining how they affect cash flows and earnings. This model should also include things like: capital structure, liquidity, and pertinent covenants. It should also break down the businesses if the company has two or three business lines….why? Because hedge funds love sum-of-parts analysis.
- With the model in hand, you now need to go about and value the business. If I were you, while I would definitely talk about things like P/E, I would spend much more time on business specific valuation metrics, such as value/subscriber or EV/room key. If you have them, use comps in this segment, and comp these business specific segments of your case company to its competitors. Finally, and as noted above, hedge funds love sum-of-parts analysis. When you value a business using sum of parts, you always want to create a company at some level. For example, if XYZ business has three business lines, what I would do is value business A, then value business B, and then figure out where the market is creating business C (it doesn’t have to be in that exact order, but you get the idea). If the market is creating business C at an absurdly low multiple relative to peers, well maybe you have an undervalued business.
- Ok. So you have a model, and a valuation…from here I would clean everything up so it can fit on two pages. Now you fill in with qualitative information: Quick overview of what company does, management’s record on capital allocation, description of business lines, any major corporate actions in the past (spin offs or bankruptcy filings for example). You then list your thesis … i.e. a 4 or 5 sentence paragraph of why the company’s stock is cheap or overvalued. This should take into affect the market expectations and drivers you narrowed down earlier in the exercise. For example (maybe a wireless company): At $15/share, the market is anticipating declining margins and top line growth at XYZ company. While top line growth may be slowing, cost per gross user addition [driver] and fixed costs in the form of salaries employees per subscriber is declining. This will enable XYZ company to boost operating margins to levels far above where the market is anticipating. Even if margins stay flat to where they are today, sales would have to drop 15% a year for the next three years to justify current trading multiples. With increasing margins, and a more reasonable decline in sales, combined with a market multiple, the stock of XYZ should trade to $25/share. Your Excel model, combined with valuation metrics, should be able to justify this valuation with a pretty strong margin of safety.
- After the thesis is in tow, you should add some qualitative strengths and weaknesses for the company. You should know these by now, but if not, look back on the concerns / comments the sell-side had during the Q/A