How to: Due diligence in 48 hours

Transcription from Cove Street's portfolio manager

Ben Claremon, portfolio management of Cove Street presented to the U Ben Graham program students of UCLA a distillation of the due diligence process. I have transcribed the checklist he uses from this 1 ½ hour long talk on what he calls “The 48 hour investment process”.  

48 hour investment process

General process advice

• Take notes as you dig and read., where you also copy and paste valuable charts and graphs

• Write down questions that come up as you go.

• Think of 4 key variables that determine the success of the investment

• Have a plan that involves a checklist

• Get access to a high-quality data site. 

• Don’t go down unnecessary rabbit holes

• Recognize that you won’t know everything or understand every detail

• Always keep in mind: Book, Value and Price

Company Overview

• How does the company make money?

• What are the company’s products and services? 

• Who are its main customers and competitors? 

• Where does it have to invest in over time?

• Does it generate good margins and returns?

• What are the growth opportunities? Is the end market growing?

• Where is the room to become more profitable/efficient?

• How does the business finance itself? (Debt, equity, cash…)

• Does this company have sustainable competitive advantage that allows for either lower costs or consistent pricing power? 

• Where are the main threats and risks to the business? 

Assessing the business

• 10k /Annual Report: Almost always the best place to start

  • Company overview section

    • Products/services

    • Differentiation and strategy

    • End markets

    • Competitors

    • Customers

  • Risk Factors: mostly legalese but look for outliers

  • Management Discussion and Analysis (MD&A): how has the business performed recently

  • Financial Statements

    • Cash flow statement is king

  • Notes

    • Don't worry about things such as revenue recognition or goodwill accounting

  • Chairman or CEO Letter: Always worth reading for context (for a few years and look at the consistency and promises of the management)

• Company conference presentations: transcripts and PowerPoints

• Company Website: can have a treasure trove of information

• Sell-side initiation report available?

  • Can offer a very helpful overview

  • Beware of inherent bias and of "price targets"

• Recently quarterly conference call transcripts

• Other web-based content:

  • Industry primers

  • Write-ups from other investors (Seeking Alpha or Value Investors Club)

    • Proceed with caution

  • Industry blogs and trade magazines

Fundamentals  and quality of business

• Business quality

  • Margin and return analysis: ROIC > WACC?

    • If yes →  by how much? If no → why would it get better?

    • Margins and returns versus closest comp

  • Barriers to entry, moat, switching cost, network effects, capital intensity

    • Is it a Buffet or a Graham investment? 

  • C-PEST Analysis

    • Climate, political, economic, social, technological threats and opportunities

  • Incremental ROIC high as well?

  • Secular tailwinds or threats? Cyclical issues?

  • Can you say for sure the business is getting more valuable each day?

  • If you could not trade the stock, would you be happy to own it over the next 3 years?  5 years? 10 years?

    • Ignoring valuation is this a stock you WANT TO OWN?

Returns

• Is ROIC > WACC?

  • There are a lot of ways to calculate returns

    • ROE

      • Return on tangible capital

    • NoPAT/Capital Employed (Cove Street's preferred ROIC)

    • ROA

  • Do you include intangibles and goodwill or not?

• Simple advice

  • Use multiple metrics and do not rely on just one

  • Try to figure out what is appropriate for the industry

  • If the returns are close to WACC, err on the side of caution

    • Assume it is a Graham until proven otherwise

  • Look deeply at industry structure

    • More consolidated -> likely higher margins / returns

    • Less consolidated -> potential room for more consolidation

    • How ripe for disruption is the industry as a whole?

• Margins and returns versus closest comps (Mkt Cap, EV, EV/Revenue, EV/EBITDA, PE, Op Margin, EBITDA Margin, CAPEX % REV 3yr, Gross Margin)

  • Compare segment by segment if you can

  • Otherwise, compare margins and returns on company level

Balance Sheet

Quick Balance Sheet Review

• Few key metrics:

  • Net debt to EBITDA

  • EBITDA/Interest Expense

  • (EBITDA-CAPEX)/Interest Expense

• Does the business generate cash consistently?

• Nearest maturities

• Covenants

• Other funding requirements: dividends, buyback, M&A, legal settlements, environmental costs etc.

• Every company and industry is different

  • So the B/S risk is dependent and subjective

Ben's debt score

Leverage Questions Yes = 1 N=0

• At risk of tripping covenants?

• Would it take 5+ years of FCF to pay off the debt?

• Large Maturity (amount greater than yearly FCF) within 3 years?

• If 100% of FCF used to pay down debt, are leverage ratios still high in maturity year?

• Large amount of operating leverage in a downturn

• Is the company committed to paying down debt or are there other capital allocation priorities?

• Large % of debt is floating debt? FCF meaningfully down if interest rates rise?

• Lots of debt or material cash flow denominated in another currency?

• Low predictability of cash flows and/or cyclical/commodity industry?

• Large expenditures required prior to nearest large maturity?

• Off B/S liabilities or other listed potential liabilities that are meaningful?

  Subtotal
  

Potential OffsetsYes = 1 No =0

• Even with the high debt, does the company's cash flow easily cover interest expenses?

• Is the company expecting a cash or earnings windfall?

• Does the company have monetizable assets?

• Does the debt sit at the sub and not the corporate level?

• Is there a reason to believe that material OPEX/CAPEX spend is stopping?
  Subtotal
  
  
  Total Leverage Score
  

Value

• As an investor all you can control is

  • Your DD process

  • The price you pay

• Academic research says valuations really matters when it comes to future returns

• Core skill of being an equity analyst

• Allows you to employ creativity

• Building consistency is key to a good process.

Key Valuation Techniques

• DCF

• Historical Multiples Analysis

• SOTP

• Private Market Value

• Triangulate!!

  • You want multiple metrics that suggest the stock is trading below intrinsic value

    • But no bell goes off when you hit a stock's intrinsic value

DCF

• The value of ANY company is equal to the present value of future cash flows

  • The difficulty is properly understanding what the future will look like

  • This is why you have to perform DD on the business:

    • Competitive Advantage

    • Total addressable market

    • Incremental returns on capital

    • Margin /return enhancement opportunities

    • Capital allocation avenues

  • Garbage in =  garbage out

    • Any stock can be cheap or expensive based on assumptions

  • Multiples are simply short hands for a DCF

• Cove Street's conservative DCF

  • Risk free rate = 5%

    • Far higher than current 30 Year UST

    • Think of WACC as a minimum level of return you would accept as an equity investor

      • Long term market returns of 6-7% WACC > market returns

  • Terminal growth rate = 0%

  • Modest growth expectations year 5 to 10

Quick and Dirty Model NoPat

• Income Statement

  • Revenue

    • Ideally driven by a metric such as subscribers

      • Forecast out subs and revenue/sub

  • Gross margins

    • Tells you a lot about the quality of the business

  • Operating Income and Operating Margin

  • EBITDA (necessary for PMV and STOP values) and EBITDA %

  • Tax rate

  • EPS

• Cash Flow Statement

  • D&A

  • Changes in working capital

  • CAPEX and Maintenance CAPEX

  • Option expense

Historical Multiples

• Capital IQ to determine the standard deviation adjusted average multiples for every company

  • 5,10,15 year average if available

• Apply the chosen multiple to 3 year out EV/EBITDA, P/E, EV/Sales multiple

  • Include cash generated over that period (for EV-based calcs) to determine the value in 3 years

• WU Multiples

Sum of the parts (SOTP)

• If the company has multiple segments:

  • Find public comps for each of the segments

    • Apply those multiples to the various segments

    • Can use precedential transactions as well

    • Add discount or premium based on business quality vs peers.

    • Be very careful if there are no/few perfect comps; beware inflated multiples

    • Sum up the various parts, substract debt -> equity value

Private Market Value

• What would this company be worth if it were sold today?

• Look for presidential transactions

  • Either apply those multiples to segments or the whole company

  • Add discount or premium based on business quality vs peer

  • Understand where you are in the cycle and when the deals were completed

  • Again be very careful if there are no/few perfect comps; beware of inflated multiples

  • Understand differences that stem from:

    • Margins

    • Returns

    • Growth profile

    • Geographic exposures

    • Where the stock is traded (US Chemical companies historically traded at higher multiples than European)

    • Size and scale

    • Strategic vs private equity acquirerer

Combining Valuation Techniques

• Triangulate value

  • Again what you want is multiple metrics that suggest undervaluation

  • If one doesn't scream cheap --> not necessarily a deal breaker

  • Make sure you are consistent in your assumptions across techniques

• Use the DCF to test your assumptions:

  • What is the current stock price implying abut growth/margins?

    • Is that reasonable or unreasonable?

• Too conservative --> you miss opportunities

  • Too bullish -> you LOSE money

  • First rule is don't lose money

• Demand a sufficient margin of safety for the risk you are taking

• Make sure you have a contrarian thesis on why the market is wrong at the current valuation.

Understanding the people

Major things to consider

•     Have to assess prior capital allocation

  • M&A, buybacks, dividends, divestitures, R&D spend, CAPEX

• Read the proxy to understand incentives

  • ST and LT compensation: what metrics do they use?

  • Payout in a change in control scenario

  • Board and management red flags

  • Does compensation feel excessive?

• Does management hit the goals and targets it sets out ?

• How long they have been there and previous experience

• How have financial results and stock price performance been over time

• Be skeptical but make a call on management: friend, foe or neutral.

ESG

There is no good E & S without goog G

• Everything starts with good corporate governance

• Good management teams anticipate changes and invest for the long run

• Focus on E&S comes from the top but hast to be part of the culture

Will be hard to know a lot about ESG in a short period of time

• Have to follow a company and an industry for a while

• Focus on governance if you are time contraind

• Look on Indeed and Glassdoor to get a sense for culture (S Part)

• Do they publish an annual CSR or ESG report?

  • If so, read through it

• Ascertaining the E can be tough as well

  • So many different reporting standards

  • Do you reward companies that have low scores but are importing?

  • Tech companies score high on environmental but how about social?

Cheap allocation might not be enough to protect you from issues. Maybe the company is not positioned for a more difficult world.

ESG is a hot space so Beware of greenwashing by companies, a lot of yes is not a good sign

Sustainability Questions Yes= 1, No= 0

• Company Impacted by warming temperatures (either products or facilities)?

• Company Impacted by rising seas (either products or facilities)?

• Questions about product relevance in a more sustainable future

• Production not feasible or economic without subsidies or if the company paid the true environmental costs

• Business only exists in its current form due to lack of regulation

• Long supply chain that requires quick and cheap shipping from around the world

• Generally a polluting/dirty company or industry

• Company has never run a carbon footprint analysis or an environmental impact assessment.

• No ability or willingness to make products more sustainable or circular

• Inevitable social change that moves people away from the company's products/services
  Total Score
  

Risk Factors

• Pay special attention to what can cause you to lose money

  • FIrst and second rule of investing

• Be your own short

  • Create 4-5 short points for why this will not be a good investment

• There are lots of ways to lose money

• Markets are relatively efficient -> you better have a good reason to be a contrarian

  • There are a lot of stocks that are cheap for a reason

    • What is going to be different going forward?

  • Would you rather buy Tootsie Roll (TR)?

• Approach every investment with skepticism and humility

  • Look for reasons NOT to recommend/own the stock

  • Other people appreciate you highlighting the risks

• But also try to be optimistic about the future /because stocks do go up over time

  • Tough balance

Good ways to lose money

Permanent Capital Impairment Risk Factors

• Leverage is too high)

• Management with a history of poor capital allocation; Under investment in CAPEX/R&D

• Cyclical or commodity-based industry

• Secularly declining business makes up a material % of cash flows

• Customer concentration or other binary issues such as a single product company

• Material questions about sustainability of business or product

• Cash flows that have historically been hard to predict

• Valuation multiples higher than historical multiples and/or hard to make valuation work without aggressive assumptions (especially DCF)

• Management incentives not aligned shareholders; staggered board and/or questionable governance issues or related party transactions

• New public company or limited financial history; PE IPO

• Major technological risk associated with main products

• Company could be significantly impacted by regulatory changes

• A/B Share structure or founder/family run and /or controlled company

• Politically unstable country makes up a material % of revenues; Significant currency risk

• Material off or on-balance sheet liabilities

• Investing in a bad business: ROIC > WACC and/or Incremental ROIC < Past ROIC

• Valuation based on an SOTP or NAV analysis

• Highly acquisitive company /a roll up

• Company is in the middle of a turnaround/restructuring

• New management story.

Developing a contrarian thesis

• Be careful not to parrot the management or sell-side pitch

  • Have to be different from "consensus"

• Write down your narrative for what needs to happen for the stock price to be a lot higher in 3 years

  • Make sure you have identified the 4 key variables

    • What is your view on how each will play out over time

  • If 10 things have to go right to make money -> red flag

    • Think in terms of base rates

• What are you thinking that other aren't

• What aspects of the company might be under-appreciated?

• Is it possible to develop an informational edge? (Not possible with something like Apple, but maybe with a microcap company or others)

• Potential catalysts to value creation

Making a recommendation?

First find a way to highlight the work you had done

• Marrying the qualitative and quantitative approach

• Discuss the depth of the process

• Remember the expectations associated with the analysis

  • Hard/impossible to get conviction in 48 hours

  • Don't make your investment decision but opine:

    • Is this a company you would like to own at any price yes, or no?

    • Does it appear to be trading at a large discount or not?

      • At what price would it be more interesting?

    • Is this a business you would be willing to pay up for?

    • What do you think of the people: friend, foe or neutra?

    • What further work do you like to do to learn more?

• Put yourself in the shoes of a portfolio manager, not just a stock analyst.