The Little Book of Investing Like the Pros. Joshua Rosenbaum
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we demonstrate how to judge whether a company is high quality, or can become high quality. This involves examining its core strengths as well as the risks that could potentially derail your investment thesis. Much of this work is qualitative, requiring sound judgment and insight. Experience and familiarity with specific business models and sectors is particularly helpful here. Your personal interests and perspectives may also come in handy.
On the financial front, the company's core financial statements need to be thoroughly scrubbed to determine its track record, health, and prospects. A large portion of this analysis is simply making observations about key financial items and seeking defensible answers. You must be acutely aware of any key weaknesses related to growth, margins, FCF, or balance sheet. We also show you how to develop a financial projection model, which serves as the basis for your valuation work in Step IV.
If you can't gain comfort with the business and financial case, then the investment is probably not going to work for you. And that's okay. You don't want to invest in a business you don't understand or believe in. And, you don't want to invest in a company with a weak financial profile that is unlikely to dramatically improve.
Step IV: Valuation & Catalysts
In Step IV, we turn our attention to valuation, arguably the core component of the investment process. Here you need to determine what the company is worth, whether it is cheap or expensive, and whether there are any “catalysts” for revaluation. Even a stock that passes the business and financial test with flying colors may fail the valuation test. In other words, it may be too expensive at current levels to produce an attractive return. This is the trap of “good company, bad stock.”
In this chapter, we teach you how to perform the key valuation methodologies at the core of any stock analysis. These include market and intrinsic valuation techniques, such as comparable companies and discounted cash flow analysis. We also discuss M&A valuation approaches, including precedent transactions, leveraged buyout analysis, and accretion/(dilution). More nuanced techniques, such as sum-of-the-parts and net asset value, are then introduced to round out your skill set.
Some combination of these tools is used to determine your price target (PT) for a given stock, which is critical for making your ultimate investment decision. Further, we review common catalysts that can unlock the hidden value in a stock and trigger a revaluation. Catalysts may be internally-driven, as part of an evolving management strategy, or external, triggered by shareholder activism or regulatory changes. Key catalysts include earnings beats, M&A, capital return, refinancings, CEO changes, and new product launches.
Step V: Investment Decision & Portfolio Management
You have identified a compelling idea, performed due diligence, and have a view on what the company is worth. All of this informed your all-important price target. It is now time to make the ultimate investment decision. Is the stock a buy, short, track, or pass?
In the event a buy or short decision is made, the work doesn't stop there. Going forward, the position must be constantly monitored. New developments may materially change the initial investment thesis for better or worse. Effective monitoring involves constant reflection, analysis, and synthesis of events that may impact the underlying business.
Building a sound portfolio requires additional skills beyond just stock picking. Successful portfolio construction involves selecting a collection of stocks tailored to your specific investment goals, strategy, and risk tolerance. This means proper sizing and prioritization of your positions. A large position should reflect its ranking relative to other stocks in the portfolio in terms of overall quality, upside potential (including possible catalysts), and conviction level.
Disciplined investors employ risk management techniques to optimize their portfolios and protect their downside. Key tools include capping exposure levels, as well as setting guidelines for limiting losses and taking profit. Exposure levels refer to individual position sizing, sector concentration, and geographic focus, among others. We also teach you basic techniques for hedging and portfolio stress testing.
Notes
1 1 Companies exhibiting consistent above-market growth coupled with attractive valuation levels.
2 2 Effective December 2017, Delphi Automotive split into two separate enterprises via a tax-free spin of its Powertrain Segment. This segment was renamed Delphi Technologies. The Electrical/Electronic Architecture and Electronics & Safety segments were rebranded as Aptiv. More on that later …
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