Brett Caughran @FundamentEdge:
"IS THIS INTERESTING?" A framework for assessing single stock opportunity.
Fundamental equity investors love to talk about their "process". Good analysts will have a fancy, disciplined, structured deep dive process that can take days, weeks, or even months to execute.
Brett Caughran @FundamentEdge:
But what if we drop bait in a hole with no fish? What if we sink a drill bit into dry sand? After all, in school, we were taught that markets were efficient. $100 bills shouldn't be lying on Park Avenue, and a stock selected at random shouldn't offer superior risk-adjusted return
Brett Caughran @FundamentEdge:
The market equivalent of an empty pond is an efficiently priced stock with no prospect for superior performance. No thesis. No forcing mechanism. No "alpha load". And a LOT of research motion can be wasted fishing in empty ponds. How do I know? I came up empty a lot as a young
Brett Caughran @FundamentEdge:
analyst. My screening mechanism for "is this interesting" was weak. Trust me, it was very frustrating to spend a week on a name and conclude after that work that there was no opportunity, no thesis, no alpha load. As analysts, it's inescapable that it will happen. But minimizing
Brett Caughran @FundamentEdge:
the "empty pond" problem as an idea generator is a critical factor in driving more P&L in your seat.
WHAT MAKES A STOCK INTERESTING?
I spent some time thinking about it, and I came up with 9 characteristics that I look for on the front end to try to understand whether the idea
Brett Caughran @FundamentEdge:
merits more work. I will walk through a few of these.
GREAT COMPANY AT A REASONABLE PRICE: This is an uncontroversial view, but the market tends to structurally underprice "great businesses". What is a great business? I define a great business as: strong & steady organic growth,
Brett Caughran @FundamentEdge:
strong & steady FCF profitability, capital efficient on base and incrementally, and a long runway for durable fundamental performance. Definitions of "great" shift over time, but GOOGL was a prototypical great business over the last 20 years. Often, but not always, P/Es on
Brett Caughran @FundamentEdge:
these types of stocks get high, but not high enough to account for the "goodness" (GOOGL generally traded 15-25x and with full hindsight *should* have traded 40x+). If you have the skill to find the next "great" business, I'll bet the market will structurally underprice it along
Brett Caughran @FundamentEdge:
the way as well.
CHANGE AGENT MANAGEMENT: Management matters, and the intersection of some vectors of underperformance combined with a new manager with a mandate for improvement is a strong check for me on "this is interesting".
Brett Caughran @FundamentEdge:
ACCELERATING FUNDAMENTALS: For many reasons, the market acts like a giant extrapolation machine (mostly because there's no better way). In practice, weak fundamental performance is generally extrapolated into lower multiples and strong fundamental performance is extrapolated into
Brett Caughran @FundamentEdge:
high multiples. That pivot point from weak to strong is what you are hunting for, and if you can successfully anticipate a fundamental acceleration, you can effectively arbitrage the "extrapolation machine". DPZ is a text book example. A 10x P/E when comping 0% and a 30x P/E when
Brett Caughran @FundamentEdge:
comping 9%. Creativity and a better crystal ball on the acceleration could have identified a multi-bagger as DPZ executed a successful turnaround (stock was a 25 bagger).
VARIANCE: using the very simple P/E x EPS = Price formula, it becomes clear the "E" matters a lot!
Brett Caughran @FundamentEdge:
Stocks become interesting when there is variance/revision potential on the E, which generally happens around earnings. There are a number of checks I will run a stock through to identify potential revision/variance, which will be a big area of focus as I execute my deeper dive
Brett Caughran @FundamentEdge:
process. But on a front end screen, I want to know, is there potential for a meaningful revision here? That revision is likely to drive my performance on the stock.
10 QUESTIONS: With these buckets in mind, as I am going through my initial check on a name, there
Brett Caughran @FundamentEdge:
are 10 questions that I am asking myself.
1) is this a good company?
2) is management competent?
3) are the fundamentals getting better or worse?
4) is the stock under-valued?
5) how can this idea blow me up?
6) is there a catalyst?
7) does this set-up remind me of a past idea?
Brett Caughran @FundamentEdge:
8) am i contrarian or consensus?
9) what is the upside if i am right? Is that upside case driven by variance or valuation?
10) what is the downside if i am wrong?
IS THIS INTERESTING: VALUATION MATTERS
It's kind of insane we even need to say "valuation matters" in stock
Brett Caughran @FundamentEdge:
selection because it seems so axiomatic, but we are coming off a very odd time in markets ("valuation doesn't matter, yolo!"). Before I invest 60+ hours in a name, i will try to do a quick sketch of my best guess on where a stock can go in 3 years, and given that view, the
Brett Caughran @FundamentEdge:
current IRR on offer for the stock. 20% is a common hurdle, and one I use (lower for a safe large cap, higher for a riskier small cap). You may love the fundamental story, the management, the products, but if the stock is priced to an 8% IRR, it's likely not interesting.
Brett Caughran @FundamentEdge:
The 2 Cs. My favorite idea generation mental model is the 2'Cs: change & chaos. Markets like certainty & predictability, and the market pricing mechanism generally works pretty well in equilibrium environments, in my experience.
Brett Caughran @FundamentEdge:
The "pricing machine" breaks down in disequilibrium, however, creating more opportunities for really compelling opportunities. So I like to monitor, "what is changing here" and "is there equilibrium or chaos here". Those two questions will give me a very good initial cut on the
Brett Caughran @FundamentEdge:
likely opportunity set in markets broadly and in subsectors generally. Embrace change & chaos in markets, for they are your dearest friends as an idea generator.
IN SUMMARY
Stocks don't just magically get meaningfully undervalued. If you are not sure whether a stock is
Brett Caughran @FundamentEdge:
mispriced, it probably isn't! Assume a stock chosen at random is accurately appraised by the market. You are looking for the special cases, the exceptions. That is where the alpha lies.
WANT TO LEARN MORE?
I got some very good feedback from the Earnings webinar earlier this