From the Bottom-Up: A Millennial’s Guide to Fundamental Investing

Sometimes, it is difficult to narrow down and understand all the specifics of a niche space. Take healthcare for example. There are different developments between biotech and pharmaceutical companies. If you consider pharmaceuticals, the field of stem-cells is significantly different endocrinology. The unique identity of many companies can make the task of forming a list of comparable firms difficult for the inexperienced investor, and thereby aggravates the ability to understand what’s going on in a field.

Some individuals prefer picking a single company, whether they have done their research or not. This is common, where you’d hear someone say “OMG you need to buy this stock! It is amazing!” If you identify with this, I have some tips:

Learn about management. This, to me, is by far the most important factor when looking at a potential investment (aside from leafing through thousands of pages of 10-Ks and investor presentations). You want to make sure they are the kind of people you feel absolutely confident in executing strong leadership. See if they have relevant experience and read their biographies. Maybe hop on LinkedIn and shoot them an e-mail asking for a brief 10-15 minute call. At the heart of all great organizations is a strong management propelling them towards success. Make sure you know (or try to know) and trust these people.

Next, spend some time on their website learning about their business strategy. It is important to understand why they have adopted their strategy, as well as knowing what it is. For example, if I open a lemonade stand (Bryan’s Lemonade, LLC.), and all my competitors are beating me in terms of price. I may use honest ingredients such as organic lemons and organic cane sugar to differentiate myself. This way, I will develop a niche stance in the market and can therefore be justified by charging a premium price. This is an example of applying strategy to gain market share.

Read some investor presentations (you can usually find these in the investor relations section of most corporate websites). They are basically really colorful PowerPoints talking about the company’s financial performance, strengths, plans for growth, etc. Is it filled with jargon and abstract financial graphs you can’t understand, or is it relatively straightforward? You should consider this and understand why it’s important that they are clear. If I am a CEO of a major corporation, and I coordinate the investor relations PowerPoint structure, I will want to make it as simple, refreshing, and straightforward as possible so investors can feel comfortable and confident knowing where their money is going. Management who uses abstruse jargon is generally doing so for a reason (often not a good one).

Understand what demand for the product is, and how that ties into their revenue model. Is it a product that is sold daily for high demand, or is it more fixed for a specific audience? How are they charging compared to similar firms, and if they charge at a premium, figure out why. You get to be a detective here. Do you foresee any circumstances where the firm can’t meet all the demand, or perhaps be too overstocked due to lower demand? Some company filings have a Risks section packed with potential scenarios that may “adversely affect the [company’s] financial health”. This list is not all-inclusive, so feel free to make some guesses. Anything is possible.

Now for the financial analysis (don’t worry if you don’t know the terms I am including here, as I will post more articles teaching simplified valuation and financial analysis). Build out your three statement projection. It is important you keep an eye on debt levels, especially if you notice significant changes in leverage. You need to understand why they are changing, and whether they are coming from short-term working capital or long-term expenditures. The higher the risk, the higher your WACC, and the lower your PPS. I always recommend building out a 3-scenario DCF with highly conservative assumptions. If you don’t know how to do best and worst case, you can take a 2-sigma value of historicals and add/subtract from your base case. This part is much more art than science, and is highly speculative. What do you notice? Is there a significant deviation from the current share price? If so, is it supported by a comps analysis? You need to spend some time really leafing through the financial statements and notes to understand all your numbers. You must be able to back up your assumptions (YoY Rev growth, EBITDA margins, Terminal Values, Debt levels etc.)

Ratio analysis is super important as well. Leverage, Coverage, Activity, Profitability, Liquidity, you name it. Sensitivity analysis is key, and you can get a clearer picture by building a model with a few, but HIGHLY SIMILAR comps.

If you don’t know how to conduct financial analysis, don’t worry for now. I’ll create a simple guide for it. Maybe consult a couple of your finance friends or colleagues who are able to do it and have them explain the numbers to you. Write out all your findings and spend some time thinking. How do you see the future of the company? Does management see it differently? If so, do you think their perspective will be successful in the long-term? Do you trust this company with your money?

I’m not paying close attention to macro-factors in this article, but it’s important to note that they may influence the potential earnings of the firm in this article. Is the firm susceptible to cyclical fluctuations? Does it perform highly in January? Is it strongly correlated to the returns on some market index (e.g. S&P 500, Russell 2000, NASDAQ)? You should get a good feeling for what’s going on in the space and the macroeconomy, and ask yourself whether the surrounding circumstances may have a significant impact on the firm’s financial health. What are the potential risks to the market, and do you see them happening in the future? If so, how badly will it affect the company (assuming there’s correlation) Again, anything is possible, so it’s important to be tedious here!

Management, business strategy, supply and demand, financial analysis, your perspective on the future of the company, and the influence of the marcoeconomy are key in conducting fundamental bottoms-up research. There are a lot of other important articles (Earnings calls, 10-Qs, sell-side analyst report, 8-Ks, Announcements, etc.) you should read, but this is the bread and butter for beginners. It’s amazing how much you can learn by studying one company, and it’s no wonder people spend their careers doing so.

In sum: Read, Think, Question, Believe, and Enjoy!