A perfect investment thesis requires careful process of researching, developing and asking for feedback from analysts or fund managers. Investment thesis is part of a stock pitch which is used in interviews of Asset Management, Hedge Fund, Equity Sales, Equity Research. This article shows what exactly an investment thesis is and how to write a persuasive investment thesis in the interview.
1. What is Investment Thesis?
1.1 Investment Thesis is an Important Part of Stock Pitch
“Pitch me a stock” is a must-have question for all Buy-side job interviews. At least 2-3 stock pitches should be prepared before Hedge Fund interviews while at Private Equity’s investment pitches, interviewees are assigned modelling test and case studies with pre-selected companies. Stock pitch in interviews is different from real-life ones in a way that recruiters evaluate how well-reasoning evidence is in supporting an investment idea, not to assess if it is right or wrong.
Most stock pitches are open-ended in which recruiters may give their candidates weeks to choose a company and do research at home while some other firms give 4-5 hours for an assigned stock (very time-constraint). Whether it is long-time or time-constraint research, there is a common framework in pitching a stock:
Investment idea summary
Risks and how to mitigate them
*Note: These elements are flexibly arranged in a presentation depending on what “story” candidates tell recruiters/investors. Depending on the purpose of presenter as well as type of stock, there is also no fixed type of data to prove a stock gaining momentum.
1.2 There are 3 Main Elements Driving a Stock
Business quality: stable & earning growth of a company in the long run compared to other competitors. It could be growing industry, high return on capital, high margin, strong management team or good allocations of capital.
For start-ups, candidates have to demonstrate a reliable path from cash-burning stage to free cash flow.
Here is an example of Sony’s exceptional operating performance.
Catalysts: Catalysts are events affecting the price of a stock: undervalued or overvalued. “Hard” catalysts are specific and distinct events that directly affect a company such as quarterly earnings announcements, product launch, acquisition and insider transactions. In the meanwhile, “soft” catalysts are potential events that might cause a stock to move up or down such as expected M&A activity, monetary policy, global/political events or change in market share. Catalyst is necessarily used for short recommendations which mostly rely on timing.
This is a detailed analysis of catalysts in Sony & Samsung stock pitch.
Due to diverse business holdings and difficulty in forecasting so many business segments, Sony’s stock is undervalued.
When it comes to Samsung chronic undervaluation, there are four value-sapping factors causing a significant discount in its stock.
Source: Investment company, Elliott Management Corporation
Valuation: Investors can buy stocks at a discount as a company is imperfectly priced compared to others. There are basically two types of methods in valuing a company: relative valuation and intrinsic valuation approach. They are commonly used in Private Equity, Equity Research, Merger and Acquisition (M&A).
The relative valuation approach includes company comparables and precedent transactions. Discounted cash flows (DCF) is the most frequently used valuation model in the intrinsic valuation approach.
- Company comparables: This method compares a company with other public companies with similar size and the same industry. It looks at the ratio of EV/Sales, EV/EBITDA, EV/EBIT and P/E. It is important to find the right comparable companies with the same industry, size, growth rate, margin and revenue. Furthermore, the metrics will vary depending on the stage of a company: EBITDA/EPS is used for mature companies while gross profit/revenue are utilized in value early-stage companies.
Bloomberg or Capital IQ are sources of company information. Company comparables analysis is based on the assumption of similar multiples of companies in the same industry. No matter how easy it is to calculate with available data, there are still some drawbacks of company comparables. The valuation could be affected by temporary market conditions or non-fundamental factors. Besides, it is quite difficult to find comparable companies for diverse factors.
- Precedent transactions: Valuation of a company is compared to other companies that already have M&A transactions. This approach uses the same multiples as company comparables with typical metrics which are EV/Sales, EV/EBITDA, E/EPS. However, precedent transactions are based on price paid by purchasers for a business while company comparables are based on traded market value. This method is used to value a private company that does not have public trading comparables and evaluate market demand for acquiring a company. However, this approach is rarely perfectly comparable and the past transactions can not totally reflect the total market conditions.
- Discounted cash flow: This valuation method estimates the value of a company based on its future cash flow. DCF analysis helps calculate the present value of expected cash flows using a discount rate. Compared with the two methods above, investors prefer DCF since this method can project how much money the company will generate in future. If the discounted value of the future cash flows are equal or greater than the initial investments, investors will consider the opportunities. Vice versa, alternative models will be applied. And depending on the purpose of investing, investors will deliver their own decisions on whether to invest or not. You can go through Walk me through DCF to understand how it is employed to value a company.
Gilead Sciences’s Valuation (A Biotechnology company)
Source: Duke Investment Club
Applicants should focus on DCF when it comes to company valuation. There are other types of valuation such as multiples to support the stock pitch.
Besides, it is vital to show an upside/down side view. To illustrate, the current share price is $100. Upside price target: $140 for 40% return. Downside price target: $83 for 17% loss. The ratio of upside/downside: 40%/17% or $40/$17 = 2.35x which is in acceptable range in most funds (2.25 – 2.5).
1.3 Investment Thesis Examples
Gilead Sciences’s Investment Thesis (A Biotechnology company)
Starbucks investment thesis
Sony investment thesis
2. How to write an Investment Thesis?
2.1 Understand Fund’s Strategies
As mentioned before, candidates are likely to ace an interview if investors/interviewers take the investment idea into account. What makes them consider buying a stock is its suitability for their investment strategy. Generally, the first rule of thumb for applicants is to understand the fund’s AUM, style, holding period, strategy and types of holdings. For example, it is recommended to pitch a credit trade to a fixed-income fund or credit fund.
In the meanwhile, interviewees easily fail an interview if they pitch a gold-mining company to technology-focused funds or pitch a common stock that other people know better. Some common mistakes of novices are pitching a short stock to long-only funds, pitching a small cap company to large-cap funds or including technical analysis for fundamental-research funds..
There are some sources for company’s information:
Fund’s website or other blogs that follow Hedge Fund’s 13Fs closely such as InsiderMonkey, ValueWalk are useful sources for finding company’s information.
SEC filings (13-F filing) on SEC website is for any funds having more than $100 million assets at the end of the previous year. Besides, insights could be from networking with your school alumni, friend, or even LinkedIn & social media contacts.
Finally, candidates cannot miss the headlines or target funds’ latest activities on Bloomberg brief, Wall Street Journal or Financial Times.
2.2 Choose an Idea with Careful Research
When it comes to company research, there are two approaches:
|Fundamental analysis||Technical analysis|
|looks at revenue, valuation and industry trends. This approach is probably used by the majority of hedge funds with medium & long term investment.||looks at trends, support resistance, fibonacci retracements and volume analysis.|
It is recommended to choose a less covered company that portfolio managers might actually consider. This is also an opportunity to show thought-out ideas that other analysts might not think about. Portfolio Managers in Hedge Fund or other investment funds will not consider investing in a common stock that everyone knows such as Apple, Microsoft, Tesla, etc. They value outstanding interviewees who could add more values in a presentation.
There are some basic drivers to consider a company such as sales volume, sales growth, market size & growth, margins, new product lines, new product cycle, price increases, cost increases and mispriced balance sheet items. It is better to choose a mid-cap company with 3-5 key drivers. Investment thesis will be long and frustrating for the evaluator if too many drivers are proposed.
Applicants should reach out to investment analysts or bankers for investment thesis review and learn from them before developing a full stock pitch.
Developing a perfect investment thesis takes months of effort in preparation from background knowledge to networking to get insights from investment analysts. If you are confused about how to network in the most effective way, our networking guide definitely helps you with it!