Framework for Equity Analysis

Question

Can you summarize your framework for analyzing equities?

Answer 1

Basically, whenever you are analyzing a stock or any investment, you are analyzing change. Something new happens. Some new event. The question is always: Is the new event significant? Does the new event lead to a change in the status quo for the company (or industry etc.)? Does it change the outlook for the company and thereby reverse a trend and start a new one or does it enforce the current trend?

Primary Analysis Framework

• Change Analysis: What has changed or will change? Is this change significant? How? Why?  What could happen because of this change? Usually, I tend to focus on major corporate events, like divestitures, impairments, and credit events, as there are nearly always significant. Changes in business strategy or introductions of new products, are also possibly significant, in terms of change, but there are more difficult to predict, and are not as quantifiable as the other changes mentioned above. Often, I am completely wrong about my analysis of new business strategy, and tend to overestimate the extent of the change.
• Business and Financial Analysis: For the financial analysis, you are basically looking at the income statement (gross margins, sales growth), balance sheet (debt level, when it's due, can the company survive - incidentally a large cash balance is, in theory, nice, but generally has a counterintuitive analysis, i.e. management will surely waste away the cash), and cash-flow (depreciation, cap-ex). The main kind of discrepancy you are looking for is that between income and cash-flow (i.e. on the long side, income will be understated vs cash-flow).  For the business analysis, you are really interested in qualitative factors. What is the business? Is there growth? Macro/Industrty factors (e.g. is the sector out of favor, there always should be a macro backdrop to the investment, as no investment lives in a vaccum)? Recurring aspects? Risks? Businesss analysis requires quite a bit of experience and intuitive analysis. Importantly, if there is no growth in a business, the stock is basically worthless (unless the valuation is extremely depressed), as you might as well invest in fixed income.
• Timing:  Timing is extremely important for any investment. If you are right, but very early, you will most probably lack the patience to stick it out and survice the early losses. Conversely, if you are late and right, you may have quick gains that will evaporate. Unfortunately, there is no way to time any purchase or sale exactly. If you are good investor you will always buy a bit early and always sell early (as per Baruch's famous quote). A few things can help timing, though, when buying (selling is simply the reverse): Is the stock price stock selling off? Is the Market down? Is the stock at a multi-year low? Is the news negative? Is the valuation depressed?
• Management: Is management incentivized to increase shareholder value? Where are there options priced? Salary? Generally, it's counterintuitive but hotshot managers who already have had major success are not good bets. You want to be on hungry executives with something to prove.

Secondary analysis:

• Liquidity: If you have nobody to sell to after you buy, the stock is basically worthless, as the whole point of investing in the public markets is because of the deep liquidity.
• When will you sell? What news disproves your thesis? Has there been a climax news or event? Is this is a long-trend?
• 3 to 5 year Vision
• Valuation: EV/Sales is my favorite, but this needs to be combined with gross margin and cap-ex analysis. NEVER BUY or Sell on valuation alone, it is misleading, particularly since it's impossible to really value any stock. The discrepency you are looking for in valuation is a growth story, selling at a non-growth valuation (e.g.. stock selling at 10X FCF, but growing 20% a year etc.)