Almost every set of hedge fund interviews will include some form of a case study. The case study is used to see how you think through complicated situations, as well as to give the other analysts and PMs a chance to judge your investment acumen. The case study can vary in length, but you should assume the longer the time frame the fund gives you, the more detailed your case study should be. Typically, a fund will give you a week to complete the case study and will expect a 4-10 page write-up, depending on the complexity of the situation.
If the fund has over one billion dollars in assets you should check to see if the company files a 13F and see if they already own the position. If they do, and you recommend a short position, you better be exceptionally prepared to defend your case, because the fund likely knows the situation much better than you will know it in a week’s time. On the flip side, if you are able to present a very effective case for a short idea, it is a great way to stand out from the crowd, because generally speaking, almost everyone you are competing against will pitch a long idea.
Parts of a Case Study:
- Consensus Opinion
- Variant Perception
- How To Get Paid
- Key Catalysts
- Expected Return
- Company Overview
Each section after the first should validate the thesis you present up front. There should be little to no “filler” material. The biggest mistake hedge fund hopefuls make is thinking their case study should be long. This is not a book report—the case needs to be concise and actionable.
The thesis is the most important part of the case study. It is the first place the reader looks, and if it isn’t compelling, the reader will likely move on to the next one—and you can probably say goodbye to that job opportunity.
- Be simple and clearly defined.
- Describe the potential return and time frame.
- Describe how the situation will play out, in your estimation.
You should be able to write your entire thesis on the back of a napkin. Keep it simple and effective.
Take-Home Case Study: How to Prepare
Later in this training program you will be provided two full-blown case studies. Both case studies were completed for multi-billion dollar hedge fund interviews, and both ideas made money. Take-home case studies are typically open-ended, meaning the hedge fund will ask you to research a company, then pitch this as a long or short idea. While there is no right or wrong answer, the fund will look for how well you understand the situation, and hedge fund employees will generally already have an opinion of the company.
Timing for completion can vary, but the typical timeframe is a week. There are case study periods that are much shorter—sometimes as little as three days.
- Read the “Business Overview” section of the company’s 10-K.
- Read at least 2 sell-side initiation reports.
- Read the last 2 years worth of press releases via the company’s website.
- Read the last 6 months worth of sell-side equity research.
- Learn about the industry and company competition.
- Understand the general investor sentiment around the company (i.e., are sophisticated investors bullish or bearish on the stock?).
Some firms that hire frequently have a very structured interview process that can last anywhere from 3 to 6 months. Their case study requirements will typically be the same every time. At these firms, you will usually be given 7-10 days to complete the take-home case study, and the process is very competitive, though predictable.
Example of Take-Home Case Study Instructions
The Company is ABC Incorporated. Please answer the following questions below and tell us if you like it as a long investment idea or short investment idea.
- Please answer the following four questions (one page or less total):
- What is the consensus opinion of ABC?
- What is your variant perception—i.e., how does your view of the investment deviate from the consensus and why?
- How do we get paid (what has to happen for your view to play out)?
- How much do you expect to make if you are right?
- Please prepare and submit a financial projection model with an estimate for the remaining quarters in this fiscal year, plus the next two years. Please construct the model so that the Portfolio Manager can use the model to stress test whichever assumptions you deem to be the significant.
- Prepare a decision tree, highlighting the upside and downside cases for the investment, along with expected returns for each. Please be prepared to discuss your probability distribution.
- Prepare a description of Management’s ownership and incentives, and explain how this contributes to your thesis.
Buying Stocks Long
- Competitive advantage
- Above-average management
- Market leadership
- Attractive industry dynamics
- Good company to invest in (for any number of reasons, discussed below)
While short-term earnings and stock prices may fluctuate, the characteristics of a good company to buy stock in typically will not. Let’s walk through indicators of companies that might be a good investment.
Exhibit 16.1: Long Positions: Core vs. Opportunistic
What makes a stock price appreciate?
A stock price is simply an earnings metric multiplied by a multiple metric. The most common ways to value a stock are P/E (price/earnings), EV/EBITDA (enterprise value/EBITDA) and FCF/Market Capitalization (or Free Cash Flow yield). If a stock price is increasing, it is either being driven by higher earnings or multiple expansion. For example, if XYZ stock is trading at $10, and earns $1 per share in EPS, it is trading at 10x earnings. If you think the stock is worth $12, you are arguing that either the earnings are too low, or the multiple is too low, or possibly a combination of the two.
The highest quality ideas are typically driven by earnings upside rather than multiple expansion. The key is to understand why you perceive that the earnings will be increasing, and why you have a different opinion from the consensus. This differentiated view is often referred to as a “Variant Perception” or “Edge.” If you make the claim that a stock is going to have significantly higher-than-expected earnings, you will need to explain the drivers. Is it coming from higher revenue, higher margins, lower interest, lower taxes, etc.? A high-quality investment idea will show earnings growth coming from items above the Operating Income line. For example, a company that is going to have higher-than-expected revenue, or higher margins due to lower costs, is a high-quality idea. A low-quality idea might be earnings greater than expected driven by a lower tax rate or a one-time item like a cash award from the settlement of a lawsuit. An exception to this, high-quality ideas coming from below the line, can include something like earnings growth arising from well-executed share buybacks by the management team.
Often analysts argue that a stock is a great investment, but their estimates equal consensus estimates. Thus, they are arguing for pure multiple expansion. This still may be a good investment, but that is a much riskier bet because multiples are largely driven by macro factors and the overall market. If you think Company XYZ is going to make $1, just as everyone else does, but the stock market falls 20%, you are likely to lose on that bet. If you thought XYZ was going to earn $1.20 instead of the consensus of $1.00, and the stock market falls 20%, you may break even on the trade if you are right (assuming XYZ’s multiple falls in line with the market contraction). The risk to making an investment based on greater-than-expected earnings expectation is a much lower-risk bet.
The idea of finding greater-than-expected earnings is not just for short-term trading investors. This analysis also applies to 1-year and 3-year investments theses. The longer the investment horizon, the less likely there will be well-formed consensus expectations, so there is more opportunity for upside.
What is your Margin of Safety?
Unfortunately, there is no such thing as a free lunch, so there is going to be some downside risk to every investment. The key is to find an idea that has strong upside potential, but fairly limited downside risk. Most investors look for at least a 2-to-1 risk/reward ratio. This means they expect to make two times as much as they can lose if they are wrong. Ideas with limited downside potential include companies with exceptionally strong balance sheets, low multiple stocks with earnings support, and high, sustainable dividend yields.
What is your Variant View?
A variant view (or variant perception) is the new term people use instead of “edge.” Edge has developed an inferior connotation is now often associated with insider trading—because of this, you should probably avoid using the term. A variant view/perception means an out-of-consensus opinion. The best way to tell consensus expectations is to look at analyst ratings and to talk to the sell-side analysts. If there are 10 analysts covering XYZ and all 10 have an Outperform rating, it is pretty clear that the sell-side likes the stock. Sometimes it isn’t so straightforward, and a quick phone call can help determine if the analyst community really likes the name or not. To take it a step further, you need to understand why the analysts like the stock. Do they all think the company will have higher revenue growth than management expectations? Do they think margins will be higher than management expectations? A variant view is important because 1) If everyone agrees, then the market will probably have already prices in the expectation, and 2) crowds (“herds”) are very dangerous.
Is the Investment Thesis or Catalyst Priced In?
Being able to understand whether information is priced in or not is very difficult. You will know if you have a truly variant (and relevant) view when the news is announced: better earnings, etc., and the stock reacts. If the news is announced and the stock does not react, either everyone else was expecting the same thing, or the factor wasn’t as important as you thought.
Is the Investment Thesis Crowded?
Being crowded means a large number of other hedge funds entered the investment with the same thesis. Crowds are extremely dangerous because everyone is anticipating a certain result, and if the result doesn’t happen, everyone will “run for the exit” (liquidate the position) at the same time. This can cause larger-than-rational, adverse moves in the stock price, and you may be forced to run for the exit yourself—taking a major loss with it. Even if you are sure you are right, your boss won’t let you stick through the position to find out. Thinking in terms of stopping his or her losses, he or she will think, “I don’t care if you’re right, I refuse to lose any more money.”
For this reason, some hedge fund managers like to take the opposite side of consensus trades on occasion. This strategy can be very profitable because if the consensus is right, the stock usually doesn’t move much because it was already largely priced in, while if the consensus is wrong, the percentage move can be very strong for reasons explained above.
Company Earnings, Growth, and Stability
For a company to be considered a good investment, solid earnings are essential. Company earnings are usually looked at annually in year-over-year or quarter-over-quarter perspectives. Historically, a strong company should show annual earnings growth. Earnings stability should also be considered to measure how consistently those earnings have been generated—are the company’s earnings reliably strong and growing, or are they volatile? Stable earnings growth is most prevalent in industries with more predictable growth patterns and a low degree of cyclicality with respect to the business cycle (growth vs. recession).
Return on Equity (ROE)
ROE measures the ability of a company’s management to turn a profit on invested equity. The ROE calculation is simply:
ROE = Net Income ÷ Shareholder’s Equity
ROE is the purest form of absolute and relative valuation. It is also important to examine a company’s historical ROE, to evaluate its stability and consistency.
Shorting stocks is sometimes called a “young man’s game,” simply because older and more experienced portfolio managers have likely gotten burned badly at some point by playing it. The reason is straightforward: when you buy a stock, the most you can lose is 100% of your investment, by the stock price falling to zero. The odds of a stock price going to zero are very low, unless there is some type of fraud involved (or a disaster occurs, quickly sending the company into financial distress and bankruptcy).
When you short a stock, however, your downside is unlimited because stocks can keep going up, up, and up, and you can lose greater than 100%. In fact, you could in theory lose an infinite amount of money on a short position, even without employing any leverage!
Still, shorting equities is an important component of successful hedge fund investing, and there are a variety of reasons why a stock might be a good candidate to short.
Types of Shorts
- Structural: Mature business model that is in decline, or a major change in the industry making the company obsolete or significantly less competitive.
- Cyclical: As the cycle turns, many industries suffer a slowdown in growth. Shorting housing stocks in 2005 would be a prime example of this.
- Competitive: Fundamentals are deteriorating due to competition.
- Competitive & Structural: Often the best shorts: the company is losing ground within the industry, AND the industry is becoming much less profitable.
- Short-Term Catalyst: You know something that is not reflected in the stock price. Make sure to really think about this, because the market is smart. More importantly, make sure the market will care.
- Distressed Balanced Sheets: A company has too much debt, not enough cash flow, etc. You need to catch these short ideas early, though, because by the time everyone figures out the math and there is a liquidity event, the short will no longer work. Not understanding the industry can hurt you— leveraged businesses can easily go up 2x to 3x against you if you are wrong.
- The Falling Giant: Once great growth and industry leaders, but showing deterioration in operating metrics as a result of heightened competition and limited growth.
- Valuation Shorts: There are a variety of reasons why this short idea can fail; unless there are other dynamics at play to support your short thesis, valuation alone is arguably the worst reason to support a short idea, and to quote an industry insider, it is “the quickest way to lose all your money.”
- Revenue Recognition Shorts: Companies with blatant fraud. The key is to time the investment, because fraud can perpetuate for quite a while.
Exhibit 17.1: Short Positions: Deteriorating Fundamentals & Business Stress
Structural Shorts vs. Underperformers
A structural short will lose value over the long term because the core business is materially changing for the worse and will continue to decline in almost every scenario. The newspaper industry is a good example of an industry in structural decline: free daily updates on the Internet have made expensive print news obsolete. Although an underperforming stock isn’t suffering from the same game-changing circumstances as structural shorts, the stock’s performance will still lag behind their peers in a bull market and significantly underperform in a bear market. Most underperforming shorts suffer from a short-term problem at the company level or industry level, resulting in missed earnings, missed expectations, or lowered guidance. A structural short investment thesis is usually longer in duration than underperforming short theses because companies don’t just lie down and die. It takes a while for them to wither away, so even though newspapers are struggling today, they will likely still exist in ten years. Structural shorts are much more exciting to invest in, but they often become crowded quickly, because it is difficult to hide rapid deceleration at company or sector levels. Underperformers may or may not have a negative catalyst, but it is clear that they won’t have a positive catalyst, so they will likely underperform. Therefore, underperformers tend to be a much safer bet whether the stock market goes up or down.
This is probably the hardest part of a short idea to wrap your head around. You need to know the bull (optimistic) story, the consensus expectations, who owns the stock, and why they own it. Deep value holders could not care less about a small earnings miss and if you are short for that reason, it is a good way to lose your money. Do the current holders care about the reason why you are short? Are investors aware that these factors have been priced accordingly?
It may be helpful to look at bond and CDS pricing for indications of distress at the company level. Ask yourself if the current valuation tells you something about expectations for the company. If the company is trading at a discount to its peers, the market may already understand the factors leading to your short thesis. The fact that a stock is cheap does not necessarily mean it is priced incorrectly. It could be cheap for other reasons, but a quick sanity check into other related assets can help you avoid trouble.
Very importantly: short positions make money when things change, i.e. a bad situation becomes worse. Therefore, shorting stocks because they have slow growth trends, low return on equity, and the worst margins in the group are not good enough reasons. To make money on short ideas, your short needs a catalyst.
Sometimes companies are experiencing these factors because of competition or structural disadvantages that could cause things to get worse if things change. But if the company is simply mismanaged, a situation may be shaping up for a good long, not a short. Because the market typically grinds higher, subpar growth trends, margins, and return on equity are not always good enough reasons to short a company. It is possible that the company is in structural decline; however, sometimes the company could also be ripe for a change and is therefore positioning itself well for a good turnaround story. If you step in front of that company with a short sale, you could be in for a catastrophic loss.
When shorting a stock you need to be early to the party. Who else is shorting the stock alongside you? Why are they short the stock? What is their conviction, time horizon, catalyst? You should be looking at short-interest ratio to determine who else is shorting the stock and if anyone is aware of the same disadvantages you are seeing. Oftentimes, a stock that already has a high short interest ratio is a poor candidate for shorting, simply because it means that you’re late to the party, and if the short idea goes sour, a short squeeze can occur, meaning that short investors may be forced to cover their position at a much higher price than expected. This could situation very volatile and it could make you a big money loser in the process.
Initiating a Short Position
- M&A risk: As an example: what is your downside if the company elects to sell itself? Oftentimes strategic M&A can lead to very high valuations due to merger synergies and consolidation. This could be a major problem if you short this stock—you must assess how likely it is that a dwindling company could be saved by a strategic or financial buyer and thereby turn your short position into a disaster.
- Restructuring risk: How would you fix the problems if you ran the company? Is that solution possible? What would the stock do if they announced the “fix” tomorrow? Talking with management is important to gauge their expectations of the problem and their ability to fix this.
- Hedging: What specific aspects are you shorting and can you isolate them by hedging out the rest? Watch out for hedges that can just cancel out the investment.
- Timing: The market will tend to uncover shorts very quickly. If other people who are short are investing in the same problem, there may be limited upside to shorting the stock in the near term.
- Catalyst: Make sure to have a clear understanding of the catalysts—this cannot be stressed enough. You can have the best short idea in the world but if there is no catalyst to make the investment fundamentals change, then you are very likely to lose money. Having clear, definable catalysts are very important on the short side. What is going to make the business change? How long will it take for this to be recognized by the equity markets?
Monitoring a Short
It is ideal to establish a time frame for shorting a stock up front. Make sure to develop signs to determine whether your thesis is materializing, or perhaps that there are other factors at play that are causing the stock to drop. Keep revisiting your original thesis—is it still relevant? Frequently monitor earnings revisions (EEG on Bloomberg) and short interest (SI on Bloomberg). If the stock is going down with no news, find out why. Are they any new reasons to short the stock? Why are there new investors shorting the stock (or long investors abandoning it)? If investors are shorting the stock into the quarter because research reports warn of a possible miss, this is a good reason to take the position off. Deep value investors typically do not trade off of quarterly earnings.
Taking the Position Off
“Good shorts are hard to find. So stick with it.” On successful shorts, getting out of your position at a predetermined price will often mean leaving money on the table. When the structural/competitive short thesis plays out, it always seems to wind up oversold and the stock will generally hit the low end of the valuation range. After that happens, ask yourself: can the company recover from this? Can the business turn around? If so, maybe it is worth taking a look at a potential long position now.
The Danger of Shorting
The best shorts are on bad companies, which is usually hard to hide. Bad companies have management that games earnings, misleads investors, and generally hides the truth. Companies who are under tremendous pressure will not go down without a fight, so even when things are going poorly, a bad company may try to distract the street with things like one-time charges that are not really one-time, spin-offs to create an entity to stuff with debt or costs (a process known as fraudulent conveyance), or delayed expectations (e.g., “We missed this quarter but next quarter is going to be huge.”) Once the street catches on to a company being a good short, it becomes crowded quickly. A company with high short interest is very susceptible to a short squeeze, which means short-sellers try to buy the shares to cover their position, but this causes the stock to go higher, triggering other short-sellers to cover, which can lead to a quick spike in the stock price. The best example of a short squeeze is what happened to Volkswagen in 2008, when the stock more than doubled within a week as short sellers had to cover their positions. In fact, Volkswagen AG became the world’s biggest company by market value during this period: Porsche announced plans to raise its stake in the company, and short sellers were forced buy back shares causing one of the largest short squeezes in history.
The other significant danger of short selling is that the stock market can stay irrational for a very long time. There have been many famous hedge fund managers who have taken serious losses, or even gone out of business, by staying short in stocks that continued to trade higher for a significantly longer-than-expected timeframe. The most famous example of this is Julian Robertson’s short positions in tech stocks in 2000.←Hedge Fund ResumeStock Idea Generation→