Numi Advisory has advised over 400 clients by providing career coaching, mock interviews, and resume reviews for people seeking jobs in equity research and investment management (full bio at the bottom of this article).
Last time around, we learned why hedge fund case studies matter so much, what to think about before getting started with your own case studies, and why a great case study is your best friend if your pedigree isn’t quite up to the “4.0 GPA at Harvard/Wharton/Stanford and multiple internships at Goldman Sachs” level.
Oh, and there were also some jabs directed at the Occupy movement and The Hobbit, but I guess those are less relevant for interview prep.
We’ll pick up today from where we left off and cover how to research, structure, and present your stock (or other asset) pitch and support your arguments.
You might think this is the “easy part,” but that’s completely wrong – in fact, an inadequate structure and/or research often sink otherwise good investment ideas… along with those $500K+ job offers.
Let’s get back to it as I continue to extract information from our interviewee (don’t worry, I tied him up but he hasn’t been physically harmed yet):
How Many and What Types of Ideas Do You Need?
Q: I’m glad you’re not sick of talking to me yet. So far, we’ve focused on pitching a single stock or other asset and preparing for that type of case study, but is it a good idea to come prepared with multiple ideas?
A: Ideas, yes, full case studies no. I would always show up prepared to speak about at least 2 stocks – when I was recruiting, I always had at least 3 ideas that I could speak about credibly… and ideas where I felt like I would know more about them than the interviewers.
And, of course, if you’re interviewing at a fund that uses a strategy other than L/S equity, you still need at least 2-3 investment ideas that you can speak to.
A: It’s better to go with what you know the best.
Yes, the interviewer might understand a healthcare pitch better, but you actually have an advantage if you pitch a consumer retail idea because the interviewer won’t know as much about it.
Q: And what if you’re interviewing with a long-only shop but you want to pitch a short idea? Is that allowed?
A: Again, it’s better to align your pitch with the fund’s strategy, but if this is your best idea and you can explain it well, it’s fine… because the fund can just underweight that company or exclude it rather than shorting it.
True short candidates are very hard to come across, in my opinion, so sometimes this type of response can work in your favor.
You can often just get away with saying, “I understand that you guys are a long-only shop, but I have a short pitch I’d like to tell you about. I think it will give you insights into how I think about investing in general, and with respect to underweighting certain stocks in particular.”
That would make a lot of sense to either a long/short equity fund or even a long-only fund that wanted to exclude this from the index.
Q: Right. What about pitching “Hold” or “Neutral” ideas?
A: If you can pitch any stock, you probably don’t want to pitch a “hold.” But there will be situations where someone asks your opinion of a stock, especially in a case study. If your analysis reveals that potential upside is basically the same as downside – i.e. “neutral” – then that’s your view and you’ve got to stick with it.
Odds are that 9 out of 10 companies are going to be priced to perfection or near perfection because there are a lot of smart people out there analyzing them and trying to make money… but with these case studies, you’re looking for that one company that’s priced imperfectly.
How to Research Stocks… and Other Assets
Q: So, in short, pick a company you know well that others don’t, find something that’s priced imperfectly, and try to align your pick with the fund’s strategy but don’t kill yourself over it if it doesn’t quite match.
A: Yes. And please, don’t use Apple, Google, or Facebook in your pitch.
Q: Let’s jump into the actual business of researching stocks and/or other assets that you might potentially pitch in interviews.
Many candidates only have 2-3 days or less to research and decide on an idea, and they don’t know where to start.
What would you suggest?
A: First off, you may want to reevaluate your career if you want to move to the buy-side but you don’t already have stocks or companies you follow or want to invest in.
If you really don’t have anything, start by picking an industry that you know something about and reading research and commentary on it, and look for companies that might be worth analyzing further… or you could start with a “big trend” in a certain industry and find companies that are well-positioned to take advantage of it.
With the right argument and support, you could make almost anything into a stock pitch for use in your case study – but if you don’t already have something, you need to start by spending at least a few hours reading up on the industry and looking at similar companies.
Q: Right, those are good points.
But what if it’s an unfamiliar company (i.e. they tell you the specific stock to analyze) and you don’t have much time to research it?
A: First, you need to lock down your investment process before you even begin interviewing. Over time, you should develop your own process, but that often just comes with time and experience.
However, reading some of the “classics” can help you develop your investment process or style. For me, some of the books I rely on for my own process include The Intelligent Investor by Ben Graham, Margin of Safety by Seth Klarman, and Competitive Strategy by Michael Porter.
But if you don’t already have a process, you should go through these steps to analyze an unfamiliar company:
- Review the SEC filings (or just the corporate filings if you’re pitching a company outside the US) and the company’s most recent investor presentation.
- Then, identify the 2-3 key drivers of the stock. In some sectors, this is easy: many retail companies, for example, will be driven by factors like total square feet, sales per square foot, and same-store sales growth. These can be more difficult to determine in unfamiliar industries.
- Then, read several equity research reports to figure out the “consensus thinking” (no, do not rely on these for your own thesis – these are strictly for background reading / information).
- Once you’ve done all this, start your field work – hedge funds value primary research a lot, and you can learn far more by speaking with credible industry sources than you ever could by reading analyst reports.
Q: So let me stop you right there. With this “field work,” what exactly do you recommend doing?
Should you look up key customers and suppliers in a company’s filings and then call them?
A: Absolutely. And don’t stop there – contact competitors, customers that might have switched to competitors’ products or services, company management, and so on.
Then there are industry publications, independent surveys, and interviews with management at other companies.
Also look at filings and earnings call transcripts from competitors, customers, and suppliers – yes, that’s a lot to go through, so maybe focus on the top 2-3 in each category… but always look to see if someone else is contradicting what this company’s management is saying.
If that’s the case, someone must be lying. You will definitely impress your interviewer if you can identify such situations.
Sometimes, buy-side equity research analysts know a hell of a lot more than sell-side analysts so also consider asking them for their views as well.
Q: Nice jab at your old profession of equity research there.
A: My pleasure!
Q: So let’s talk about the logistics.
How do you actually go about finding all this information? Do you just look for keywords in the company’s filings and then search for phone numbers online?
A: You could try that, though I’m not sure what your success rate would be.
I used a different strategy: I went on LinkedIn and found people working at the company I was interested in and said, “I’m doing some research on this company. I’d really appreciate 15 minutes of your time to pick your brain on a couple of things. I’m early in my career and am genuinely curious to learn more about your industry.”
People tend to be inclined to help if they see that you’re young, curious, and humble.
Now, you may have to write to 10+ people before you hear back from a couple of them.
But if one of them is a senior design engineer from a competitor and one is a former CTO somewhere else in the value chain, those are two pretty important people you could be talking to.
Another benefit is that you can keep going back to your network in the future, and effectively you’re both networking and preparing for interviews at the same time.
Q: Awesome. Networking and potentially making money at the same time, I like this.
So let me go back to one of your earlier points on reading through the SEC (or other) filings.
What should you look for in those? Are you mostly looking for items in plain sight or those that are tucked away in dusty corners?
A: First, you should never overlook the “Risk Factors” section of the filings. This section effectively contains all the legal disclaimers that could derail an investment in the company.
Some of the language may seem “boilerplate,” but pay special attention to anything that may seem unusually specific to a particular company.
I also recommend a book called Financial Shenanigans – they go through tons of examples of how companies manipulate their financial statements, hide or disguise important information, and generally try to mislead you.
There are case studies of Enron, Worldcom, and other companies that have manipulated their financial statements into bankruptcy and financial ruin.
Here are some things I look for, all of which you can search for simply by pressing Ctrl + F in the filing and then entering the keyword:
- Changes in Accounting Policy
- Changes in Revenue Recognition
- Changes in Inventory Policy
- Off-Balance Sheet Liabilities
These items don’t necessarily mean that a company is committing fraud or hiding what it’s doing, of course, but they do indicate that it’s worth a closer look.
Then there are other categories that take more work to find:
- “Creative” revenue – Enron “increased” revenue from $10B to $100B at the fastest rate ever recorded in history, if you overlook how it was all fake
- Shifting around cash flows inappropriately
- Hiding or shifting expenses or losses
- Boosting revenue with one-time gains or by recognizing it too early
- Showing misleading metrics (Groupon!)
Q: Should you use footnoted.com? They have a paid service where they go through a lot of companies’ footnotes, look in the filings, and see if there’s anything fishy.
It’s amazing what companies disclose there that they effectively just “hide” from people.
A: Potentially, yes. You definitely need to learn how to go through filings and footnotes on your own, but if you’re in a rush or need to look at a bunch of companies, a service like that could be a huge time-saver.
That’s why experience matters so much in this process – the only way to get really good at pitching stocks and making investment recommendations is to do it a lot.
Over time, you’ll also develop your own processes for analyzing stocks.
But in the meantime, if you need help, you can also sign up for the Numi Advisory stock pitch service as well – shameless plug!
Q: While this site is a benevolent dictatorship, I do allow these shameless plugs, especially when they’re for excellent services.
And in all seriousness, you’ve helped a lot of people with their stock pitches and retooling them to land equity research and hedge fund offers, so it’s fair.
A: Thanks. And yes, I’ve been doing this for a while and have yet to find a stock pitch or case study presentation that couldn’t have used some improvement.
Q: Before we move on, I wanted to go back to one point you mentioned before we started this chat, which is that you shouldn’t rely on sell-side equity research too much.
But didn’t you also say that you should go through equity research when forming your own views?
A: Yes. You should definitely look at it, but don’t rely on it because sell-side analysts tend to focus far too much on the potential upside of a stock than the downside or the major risks.
If the reports have useful market data or you just want to get the consensus view, sure, you can use it – but otherwise, be very careful about letting these reports inform your own opinion.
Structure, Structure, Structure
Q: Great, so moving on now… in Part 1 you gave a recommended structure for case study presentations.
A: Yeah, just to recap:
- Company Background
- Your Investment Thesis
- Risk Factors and How to Mitigate Them
Q: Yeah, so I think some of these points are more intuitive than others.
Everyone knows how to describe a company (I hope), so I’d rather focus on how to make your recommendation, present your thesis, and address the catalysts and risk factors (we’ll go through the valuation and putting everything together in Part 3).
Any initial thoughts before we go through those?
A: Actually, let’s play a game.
A: Let’s say that we play a coin toss game, and it costs you $10 to play every time. If it’s heads, you win $50, and if it’s tails you get nothing.
Q: This sounds great, I’m going to sign up and start playing right away.
A: OK, so now let’s say you’ve played and flipped the coin ten times and it’s tails every single time. So far you’ve paid me $100 and you’ve gotten nothing out of it.
What do you do on the 11th coin flip? Keep playing or quit?
Q: At this point, I think I would assume that the coin is not fair and stop playing.
A: Well that could be the case… but if the coin is fair, of course, probability tells you that in the long-run you have to make the bet and play again because the expected value of each coin flip is positive.
This “game” is essentially what you do as an investor all day – you have to find these types of asymmetric risk/reward profiles and then, after you’ve placed your “bet,” figure out whether or not “the coin is rigged.”
Most people lose money because they let their psychology affect them and make the wrong decisions, even if they know, logically, that they’ve made the correct decisions.
So that is what you need to think about when structuring and presenting your case study: have you found an opportunity where the expected value is substantially positive, even if “the coin seems rigged” in the very short-term?
Q: That’s a great way to put it. Did you want to add anything else to the structure before we delve into each section in more detail?
A: Sure, a couple points I’ll mention first:
- Formatting is less relevant than content, so don’t obsess over colors, font sizes, etc. This is not an investment banking pitch book.
- I preferred to do write-ups of my recommendations because they can be more detailed than slides… but you could be an overachiever and do both, if you have the time.
- Always be able to back up all your numbers – ideally through primary research or other industry sources.
- Only incorporate sell-side research for market data or to get a view of the “consensus” so that you can explain how your own view is different.
- We’ll address this one in Parts 3 and 4, but you always want to think in terms of risk management: “Even if this company’s stock price tanks, what is the worst that could happen to me? And how can I hedge against that?” Sometimes you can address these points in the valuation section.
The Strength of Your Recommendations
Q: All great points… so moving into the structure now, how important is it to quantify that “asymmetric risk profile” in your recommendation in the beginning?
In other words, should you say, “There’s a 75% chance it’s going to go to $30 a share, but only a 20% chance it’s going to fall to $15 a share” – or is that too aggressive?
A: I would not recommend offering up numbers that specific, because a thoughtful interviewer will then turn around say, “How did you come up with the probabilities?”
And then what are you going to say?
It might actually work against you to be super-specific like that; there’s precision and then there’s accuracy, and a trade-off exists between the two.
Q: OK, so then what would you recommend saying in a recommendation in the beginning? Can you give us an example?
A: Sure… let’s say you’re recommending shorting a retail company. A recommendation in the beginning might go something like this:
“I recommend shorting Retailer X, which currently trades at $45.00 per share, because it’s overvalued vs. peers by approximately 20-25%, its key metrics such as sales per square foot have been stagnant despite rising valuation multiples, and the company has had increasingly poor transparency on many of these metrics over the past few years.
Catalysts to push down its stock price in the next 6 months include the expiration of key re-seller agreements with 3 of its top 10 vendors and its first earnings results post-acquisition close of a smaller retailer last year.
Investment risks include potentially better-than-expected integrated company results, as well as faster-than-expected market growth, but we could mitigate those by longing one of its competitors to reduce potential losses from unexpected market growth.”
Q: Thanks! I hope everyone is taking notes.
Now onto the next section of interest, the catalysts – you’ve mentioned a couple examples such as the renewal of key agreements, earnings results, and so on.
What else might qualify as a good catalyst?
A: Sure… a catalyst is any event that could make a meaningful impact on the stock.
It doesn’t even have to be an upcoming or planned event necessarily – it could just be a potential event in the future. Examples:
- New product releases
- New stores opening
- New competitors emerging or existing competitors changing their strategies
- A company pouring too much money into a business segment that investors don’t like – in that case, the catalyst might be the potential divestiture of that segment
- Positive clinical trial data for a biotech or healthcare company – you might have an educated guess after reading literature and speaking with doctors
- Share repurchases, debt or equity issuances, and M&A deals
In a sense, catalysts mean that all investing is “event-driven” to some extent.
Without a catalyst, the price will not move in any particular direction – so you need to think about these quantitative and qualitative factors that might move the share price.
Some stocks can stay underpriced or overpriced for years unless something forces the market to understand that it’s priced incorrectly.
Q: So what makes for a “good” catalyst vs. a “bad” catalyst?
A: Anything that’s too far into the future would not be a good catalyst. The stock market has a short-term bias, so most companies will not trade on products that might be launched 5 years from now.
You want to focus on what will happen in the near-term – a year or less, or the next few months, or something in that range.
Sometimes, candidates also pick catalysts that are too generic or that won’t make a significant impact on the company’s stock price.
Yes, the economy entering or exiting a recession could make a difference… but that’s a very generic “catalyst” since it will affect all companies.
If you want to state something like that, you need to explain how specifically it will affect the company you’re analyzing (e.g. consumer spending may fall by 3-5%, which will reduce same-store sales by X%, which will push down the company’s revenue and EPS by Y%, resulting in a potential stock price decrease of Z% if current valuation multiples stay the same).
Risk Factors and How to Mitigate Them
Q: Awesome, thanks for those tips. I’m going to skip the Valuation section for now and treat that separately in Part 3. Let’s move into the “Risk Factors” section next.
How do you think about risk factors, and what are the main categories?
A: The main categories are:
- The economy as a whole
- The overall market / industry this company is in
- Company-specific factors
You should almost always start with company-specific factors first because an argument based on the overall economy is usually too generic – if you want to bring up those types of factors, you have to explain how they’ll impact company-specific metrics, which will in turn impact its valuation.
A bad argument would be: “We think taxes are going up, so consumers will spend less and the company’s sales might fall.”
A better argument might be: “We think taxes are going up, so customers especially in segment X may spend Y-Z% less and as a result, supplier A will not be able to fill as many orders, resulting in potentially higher COGS for the company and reduced margins, even though its own direct customers might still be spending at their current levels.”
Q: Great. And what about company-specific risk factors?
A: Those could be almost anything because they depend on the company and its key drivers. A few ideas:
- Market Size – Is the total addressable market bigger / smaller than expected?
- Pricing – Is the company under pricing pressure? Or can it raise prices regardless of competitors or industry trends?
- Key Drivers – What do the company’s key operating metrics look like? Have they been trending up, down, or not changing?
- Acquisitions – How have they performed? What will the company do in the future?
- Partnerships – Are any suppliers, customers, or partners on shaky grounds with the company?
- Financials – Are the company’s key ratios changing as you’d expect? For example, CapEx growth or expense growth that’s out-of-line with revenue growth is usually a red flag.
- Legal / IP Issues – Are there ongoing lawsuits? Patent problems? Disputes?
Your job is to pick the most important risk factors and explain why, although they could result in your prediction being wrong, you don’t think that will happen – or, how you could hedge yourself via protective options or investments elsewhere.
Keep in mind that the risk factors also depend on your investment recommendation – positive factors would be a risk for a “short” view, while negative factors would be a risk for a “long” position.
Q: Thanks for explaining that. I think options and other investments are commonly cited as ways to mitigate risks, but are there other ways to do it?
A: Sure. You could also mitigate risk by pointing to the company’s financials and especially anything on its Balance Sheet that could be sold in the future.
For example, let’s say that a company is trading at around $10.00 per share and it has cash plus other tangible assets that are worth the equivalent of $5.00 per share.
In that case, sure, the stock price could still fall by 50% if the worst happens, but you’re unlikely to lose all your money because of the company’s Balance Sheet (unless the company’s management team is seriously value-destructive or otherwise insane).
The point is to show that you’ve thought through these risk factors – not that you know exactly how to hedge against all of them 100%.
Q: Great. So now let’s jump back into the valuation and modeling part and how to put all this together …
A: Next time, Brian, next time.
Q: Good point. Until then…
Complete Hedge Fund Case Study Series:
- Part 1 – Hedge Fund Case Study Overview
- Part 2 – How to Generate Investment Ideas and Research and Structure Your Case Study
- Part 3 – How to Model and Value Companies and Deals for Use in Your Case Studies
- Part 4 – Walkthrough of an Actual Hedge Fund Stock Pitch / Case Study
Numi Advisory has advised over 400 clients by providing career coaching, mock interviews, and resume reviews for people seeking jobs in equity research and investment management. With extensive investment experience in equity research and private equity and now working as an analyst at a long/short equity hedge fund, Numi has unparalleled insights into the recruiting process and advancing on the job.
Numi customizes solutions to each client’s unique background and career aspirations, and teaches clients the most efficient and impactful methods to achieve successful results on their career search. He has helped place over 50 candidates in leading buy-side and sell-side jobs. For more information on career services and client testimonials, please contact firstname.lastname@example.org, or visit Numi’s LinkedIn page.