2 January , 2010
This is the third edition of our series on hedge fund interviews.
For part 1 and part 2 of the series:
This post will discuss probably the most crucial part of the entire interview process: the final case study. This case study will either be “in-office” or prepared at home. This post we are going to focus in on the in-office case study, and for the final post of the series, we will discuss the take-home case study.
In-office case studies:
This is where the hedge fund or buy-side institution will tell you before hand that when you come to the office you will be given X number of hours and a certain amount of materials (10Ks, recent conference calls, sell-side reports), and then you will need to prepare an investment recommendation. You may be given Excel, or maybe a Bloomberg, or maybe just some paper to work your thoughts out on.
These case studies can last anywhere from 1 hour to 3 hours (I have heard of more, but never been subjected to them…thank the hedge fund gods). They are intense and stressful – especially when you consider how far you’ve come in the interview process – and that the whole outcome of the hiring may depend on where you come out on the case.
I am going to assume for the extent of the post that you have been given Excel but no Internet access – you are only given a stack of papers and a stock price. Here is how I would approach a similar situation:
- Read as much of the material as humanly possible. No, this does not mean you have to read every single clause of a credit agreement, or every single line of a 10K. You should have enough experience at this point to know what you can skip over and what you cannot skip over. I rarely skip over the 10K footnotes because that is where you can find information that is not being readily appreciated by the market (for the positive or the negative).
- Once you have the material read, you should have some kind of understanding what the market is anticipating via a sell-side report or a Q/A session from recent conference calls. You can use the estimates from the sell-side report to get a sense of where market consensus for top-line and bottom-line figures are and you can use the Q/A session to get a feel for what qualitative concerns market participants have for the company. For example, if someone on a recent conference call asks: “So, what is the timeline for the new casino opening and how confident are you that you will be able to open on time?” … That analyst and probably a bunch of buy-siders who called to ASK that analyst are worried that delays/cost-overruns might push back a project and hence the estimated earnings and cash flow in future quarter. Write the pertinent questions / concerns down.
- You then want to identify the main drivers of both business performance. Really it should only boil down to two or three extremely relevant line items. For example, for a wireless company it could be # of subscribers and ARPU.
- With concerns and drivers in hand, you will now set out to build your model / valuation sheet. If you can build a three statement model in an hour or so, well then by all means do it, but I suggest really focusing on those two or three drivers you identified above, and zeroing in on them and determining how they affect cash flows and earnings. This model should also include things like: capital structure, liquidity, and pertinent covenants. It should also break down the businesses if the company has two or three business lines….why? Because hedge funds love sum-of-parts analysis.
- With the model in hand, you now need to go about and value the business. If I were you, while I would definitely talk about things like P/E, I would spend much more time on business specific valuation metrics, such as value/subscriber or EV/room key. If you have them, use comps in this segment, and comp these business specific segments of your case company to its competitors. Finally, and as noted above, hedge funds love sum-of-parts analysis. When you value a business using sum of parts, you always want to create a company at some level. For example, if XYZ business has three business lines, what I would do is value business A, then value business B, and then figure out where the market is creating business C (it doesn’t have to be in that exact order, but you get the idea). If the market is creating business C at an absurdly low multiple relative to peers, well maybe you have an undervalued business.
- Ok. So you have a model, and a valuation…from here I would clean everything up so it can fit on two pages. Now you fill in with qualitative information: Quick overview of what company does, management’s record on capital allocation, description of business lines, any major corporate actions in the past (spin offs or bankruptcy filings for example). You then list your thesis … i.e. a 4 or 5 sentence paragraph of why the company’s stock is cheap or overvalued. This should take into affect the market expectations and drivers you narrowed down earlier in the exercise. For example (maybe a wireless company): At $15/share, the market is anticipating declining margins and top line growth at XYZ company. While top line growth may be slowing, cost per gross user addition [driver] and fixed costs in the form of salaries employees per subscriber is declining. This will enable XYZ company to boost operating margins to levels far above where the market is anticipating. Even if margins stay flat to where they are today, sales would have to drop 15% a year for the next three years to justify current trading multiples. With increasing margins, and a more reasonable decline in sales, combined with a market multiple, the stock of XYZ should trade to $25/share. Your Excel model, combined with valuation metrics, should be able to justify this valuation with a pretty strong margin of safety.
- After the thesis is in tow, you should add some qualitative strengths and weaknesses for the company. You should know these by now, but if not, look back on the concerns / comments the sell-side had during the Q/A
Ok. Case study completed. Three hours is up. Time to present your case study to your interviewers / investment committee. Now, I’ve had situation where it is just me and a few other analysts / PM or in other cases where it is the entire front-office – founder of fund all the way down to the execution traders. I think this really depends on the culture of the firm: I personally would like to see everyone there which shows me that the team is a cohesive entity without a few people call every single shot.
While you want to take your time in the presentation of the case, you do not want to go into every gory detail. You give a quick overview of the company, and its business lines. You talk about what the market is concerned about. You give a valuation. And then you give them your thesis. You back up your thesis with the Excel file that all of the interviewers should have in their hand at this point. Talk about where you are creating the company, talk about WHY you think the market is wrong in anticipating margin declines, talk about HOW the market is missing XYZ factor. Even if you only have a 10K to work with, you should bring to light things that even those that have read the same annual report may have missed.
Why? They want to see your attention to detail. To be honest, given a 10K and a few conference calls, I could reasonably argue for the bull or bear case of any situation you could throw at me. In my experience, the opinion really does not matter all that much (unless of course its the funds largest position). What matters is the process and how you think about the situation.
Something I have not mentioned above, but you should have a reasonable understanding how the fund you are interviewing looks at companies. Do research. Read Value Investor Insight, or other interviews with the principals of the hedge fund to see how they think about situations – are they a GARP shop or a deep value, hidden catalyst shop. You may want to think about at least tossing in this methodology when you do your case study. But I caution: Do not become a clone…these people want to bring on analysts that are smart, can think on their feet, and can bring diverse experience and opinions to the mix.
After you have presented your hedge fund case study, you will be barraged with questions. You will not know the answer to every single question, but you should the majority. If you do not know the answer to the question, do not make up an answer. Say: “To be honest with you, I’ll have to get back to you on that – I would like to read a few more 10Qs or conference calls to get a better sense of the issue you are asking about” When you answer, always draw examples from previous situations you have encountered in the past where you might have substantially more experience and hence are bringing the case study back on “home court.” But most importantly, be confident in your work and your self. You made it this far, now all you have to do is bring it home.
Stay tuned next time for our final series on hedge fund interviews. This will finish what I had initially set out to accomplish for the how to get a hedge fund job blog. After that post, I will be announcing a new offer to readers to help them in the hedge fund job search process. Stay tuned for that as well.