A SIMPLE STOCK SELECTION FRAMEWORK - FEV (fundamentals, expectations, valuation) In general, one of the biggest differences in hedge fund stock selection vs. mutual fund / long-only stock selection is style flexibility. By mandate, many long-only (LO) managers are
stuck in a style box. LP wants Value, and LO is a Value manager, so allocates. LO is left buying stocks that screen on traditional measures of value (P/E, P/B). The best hedge funds eschew that typical style box mandate, and are what is often called "make money" investors.
"I'm not a value investor, I'm a make-money investor" is a common, slightly arrogant, refrain you will hear from HF investors. This flexibility can be dangerous - bad HFs may end up chasing styles, buying tech/momentum too late, buying energy/value too late. The general advice
you see discussed is "stick to your approach" and wait for your style to come back in fashion. That might work in the LO world, but in the HF world where it's a "what have you done for me lately" framework, correctly anticipating where the best prospective R/Rs lie is a critical
skillset in making money in any environment. The challenge is, that leaves an entire world of potential stocks to look at. If I'm not just running a value screen and identifying my 20 favorite value longs, how do I start?
Enter the FEV 3-legged stool. An incredibly simple, yet powerful stock selection framework that was taught to me by the former CIO of Maverick. Consideration of a stock should rest on an equally balanced view of Fundamentals, Expectations and Valuation.
The power is in the intellectual view that a stock that rests simply on fundamentals alone (a great story), expectations alone (contrarianism for the sake of contrarianism) or valuation alone (just cheap) tend to be losers. This has VERY MUCH been my experience in investing.
So what do these legs mean? FUNDAMENTALS - Strong base rate of growth (strong revenue, profit & FCF growth) - Accelerating growth - Strong cash economics - Expanding incremental ROIC - Meaningful industry & competitive tailwinds - Capital-light growth - Compounder dynamics
EXPECTATIONS - That "goodness" you identified on the first leg? Yeah. No one sees that but you. (good luck!) - Negative/neutral sentiment - What's baked into the stock via the reverse-DCF key driver bar is likely to be exceeded (this is how HF's identify value...NOT low NTM P/E)
- (I will walk you through a reverse-DCF KD exercise on here at some point. An analytical tool that has been a huge benefit at extreme points in market) - Upside to street - More importantly, upside to buyside estimates
VALUATION - Typical valuation approaches. P/E, EV/EBITDA, EV/Revs, FCF yield. Absolute & relative - Creative assessment of NPV - My favorite metric on cheap stocks - distributable FCF yield (i.e. how much FCF can actually come back to equity)
- For a cheap stock without high growth or compounder dynamics, a value realization catalyst is key (or you can be waiting on a cheap stock a LONG time)
Hope this is helpful. Seems very simple, right? But this framework, over and over, has kept me from overpaying for great fundamentals (with a high bar and high valuation) or jumping into cheap, low expectations situations but with crap fundamentals.
It's not easy to find FEV ideas. But there are 6,000 stocks out there! Your job is to turn over stones and be patient. Good things happen when a stock rests on 3 FEV legs, and you fall on your ass when you rely on one or two legs.