Saturday, June 11, 2011

Notes from an interview with a value manager

Here are my notes from a value equity management shop that shall remain anonymous:

Idea Generation
·         They like to screen for low P/S, P/B relative to the company’s own history
·         Price to Sales captures the margin structure and the P/E of a company, and it’s useful to compare current vs. historical margins
·         Price to Book is useful for asset intensive firms
·         Screen Russell 1000 for about 50 ideas
·         The company should have an IG rating
·         Typically like large market cap companies
·         Companies should be dividend payers
·         Typically generate 1 idea a month
·         Also talk to a lot of people in the industry
·         Typically takes 10 minutes to eliminate a company

Questions to ask before buying a stock
·         Identify the key “question” that will determine the success of investing the company. 80% of your success is relating to identifying the right question.
·         Think like a CEO – what would care about? For a financial services company it might be ROA; for a capital intensive company it might be ROC
·         The ability to simplify is key: Be able to explain your investment thesis in 20 words and 3 bullet points
·         Who is the rational buyer and why are they buying?
·         What is the smartest seller thinking?
·         Is this a good business? Does it need to exist?
·         What are the real cash flow dynamics of the business? What is the cash flow at the bottom of the cycle?
·         Is time on your side? Yes, if you look at the FCF at the bottom of the cycle and you have management buying back stock
·         Look at the 10 year history of sales, margins and profits over a full 10 year cycle
·         Look at the balance sheet – typically prefer low debt, but sometimes highly leveraged companies can be good investments
·         Think about ranges of earnings in your earnings models; Don’t use quarterly earnings in your earnings models (too short-term)
·         What are the big liabilities of the company (e.g. pension liabilities)?

Portfolio Construction
·         Not a big fan of conviction weighting. Found that their best ideas typically middle-of-the-pack conviction ideas that made them nervous because there was a good bear case
·         Buying strategy: they typically like to buy in batches or scoops. They initiate a position and then wait for a month since they found that buying early is a typical mistake for value investors, and this strategy maximizes their IRR. This strategy helped them to avoid increasing positions during the financial crisis.
·         Quickest full position takes at least 2 months, and the longest can take several months (and may never come)
·         They either hold positions at 4%, 3%, or 2% of the portfolio
·         They typically buy in the following “scoops”:
o   4% target positions: three scoops of 1.33% (25% IRR target for these position)
o   3% target positions: three scoops of 1%
o   2% target positions: three scoops of 0.67% (15% IRR target for these position)
·         Trading budget is a maximum of 2.5% of the portfolio per month

·         Falling in love with companies
·         Loving underdogs and turnaround stories

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