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Equity Research - The Process

In this post I have listed down some STEPS. TIPS to be considered while doing Equity Analysis.I have assumed that the reader is well aware of Fundamental &Technical Analysis along with Valuations -

 

1. Separate the business from the balance sheet

  1.       How is the business capitalized? Is it sustainable? Is it relatively efficient/optimal?
  2.        What are the assets worth? Liquidation value and reproduction value
  3.        Are there any “hidden” assets or liabilities?
  4.        Excess cash, real estate, LIFO, etc.
  5.        Pension, legal liability, litigation, operational malfeasance, funding/liquidity puts, etc.

2. Separate the business from the cash flows

  1.       What are the cash flows saying, regardless of the broader business stereotypes/assumptions?
  2.       How much cash can be taken out of the business every year? Owner’s earning (net income plus DA minus capex) normalized and over time
  3.        Earnings yield (EBIT/TEV) and ROIC (EBIT/(WC+fixed assets))
  4.        What are the capex requirements? With regard to inflation? Depreciation?

 

3. What is the business’s competitive situation? How good is management?

  1.        What could kill the business? What disrupts the underlying fundamentals?
  2.        Competition/moat
  3.        Cost structure
  4.        What are incremental margins? How attractive is the compounding opportunity?
  5.        Is capital being allocated properly? Investing in the business vs. returning capital to shareholders
  6.        Are the company’s end markets stable/shrinking/growing? Susceptible to rapid (technological) change?

 

4. Other considerations

  1.        Market perceptions
  2.        Quality of management and alignment of interests
  3.        Is this opportunity worth a punch on our punch card?

5. Psychological factors

·       Think in terms of the “psychology of misjudgment” and common biases

 

6. Where are we in the cycle?

  1.       Where are we in the economic cycle?
  2.        Where are we in the cycle for risk assets?
  3.        Where are we in the industry cycle applicable to this company?

 

7. Portfolio composition

  1.       Target 15-25 individual (i.e., diversified or uncorrelated) investments1
  2.        Size constraints
  3.        Portfolio liquidity
  4.        Ability to withstand pain
 

Some more TIPS for conducting research –

 

1.     Focus on original source documents, working from in to out

·       SEBI & ROC fillings in reverse chronological order

·       Press releases and earnings calls/transcripts

·       Other public information

·       Court documents, real estate records, etc.

·       Industry publications

·       Third-party analysts

 

2.     Sell-side research only as a consensus-checking exercise

3.     Research the company’s competitors with the same process

4.     Research and speak to competitors, (former) employees, and people in the supply chain

5.     Estimate valuation before looking at market valuation

6.     Valuation – What would a rational, long-term, private buyer would pay in cash today for the entire business?

·       Asset value

·       Earning power

·       if EP >NAV, then franchise value

·       Growth value

·       Requirements

7.     Large, well understood margin of safety

8.     Reinvestment opportunities for capital in the business

9.     Quality, ownership stake, and shareholder-orientation of management

10.  Ability to bear pain, both the company’s and my own

 

Munger’s “Four Filters”

1.     Understand the business

2.     Sustainable competitive advantages (aka, favorable long-term economics)

3.     Able and trustworthy management

4.     Price that affords a margin of safety (aka, a sensible purchase price)

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