How we go about selecting individual stocks for our long and short baskets
The process of uncovering good ideas begins by utilizing various stock screeners to identify stocks which may be interesting. In general, we like to focus on stocks in the $500 million to $5 billion market cap range, because they are less followed than large cap stocks. We may use a combination of fundamental and technical criteria to identify prospective opportunities.
Once we identify a company that looks interesting, we then begin by reviewing the company's 10K, other SEC filings, company presentations, and earnings call transcripts to learn more about the business. Once we have a better understanding of the operation and business model, we then build a financial model of their cash flows. If at this point we feel that there is a meaningful opportunity for gain, we begin a more detailed discovery process into the key drivers and assumptions of the financial model. This may include industry research, external databases, analyst research, traditional news media, competitor presentations, SEC filings, and earnings call transcripts, and store visits if applicable. Our core motivation from all of this is to arrive at a valuation that we feel comfortable with, however, valuation can present itself in many different forms (earnings yield, price to book, liquidation value, value to another entity, breakup value, replacement cost and many others), and we spend a considerable amount of time thinking about this.
This is the general process we follow for selecting both long and short candidates, and below we highlight some specifics to each category. We recommend that you explore the various individual equity research pieces we have published to get a sense of how we approach our analysis.
The Long Basket
These are all companies that we are keen on owning for the long term. We try to assess whether the company's cash flows are sustainable in light of their business model, and the competition. We pay a lot of attention to the VC and startup universe to stay aware of new innovations or business models that may be disruptive to the industry. We like to purchase in-place value at a discount, as opposed to making a bet that the company will be able to create additional value in the future.
Our expected holding period is long-term but will depend on how the stock price evolves.
Risk management: The maximum position size for any individual equity is 15% at the time of initial purchase.
In this case, we identified a REIT, Istar Financial (STAR) which was being perceived as primarily a mortgage lender, still suffering from the 2008 real estate fallout, whereas in fact their profile had significantly shifted to being more like that of a landowner, in a good position to benefit from new home construction among other factors. We published our thoughts in September of 2012 and the stock experienced a 100% gain over the next 15 months.
The Short Basket
These are all companies that we would generally not own at any price. There is a generally a flaw in their business model, a problem with their disclosures or accounting methods, or in many cases it is simply a case of proving that management's own projections for the future are not achievable. While identifying overvalued stocks can sometimes be easy, getting the timing right can be difficult, particularly for story type stocks in new industries, or when market optimism becomes euphoric (see case study below). We generally avoid stocks that already have a very high short interest, even though the thesis may be solid, because the thesis is already widely disseminated, and the risk of a short squeeze is materially higher.
Risk management: The maximum position size for any individual equity is 10% at the time of initial purchase.
In this case, we identified a 3D printing company 3D Systems Corporation (DDD) which was caught up in the euphoria over the potential for 3D printing, and this company, on its own, was being valued by the market at more than the future total projected value for the entire 3D printing industry. We published our thoughts in June of 2013 and the stock experienced a 100% gain over the next 7 months, followed by a 90% loss over the next two years. This is an example of the challenge when shorting stocks of getting the thesis right, but getting the timing wrong, which can result in large drawdowns before retreating.