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

Challenges

·         Falling in love with companies

·         Loving underdogs and turnaround stories