4.28.2009

Anatomy of Common Stock Due Diligence

Generally, distressed debt hedge funds as well as event-driven hedge funds do not just go long and short distressed debt bonds. In their books (portfolios), they will also own value based equities, index hedges, private equities, cheap performing bonds, etc. One thing most of them will certainly have in their portfolios is shorts on certain equity names.

One of the best books on the subject is "The Art of Short Selling" by Kathryn Staley.

I stumbled upon this book when I found a link to a Blue Ridge Capital Reading List. For those unaware, Blue Ridge Capital was the original Tiger Cub. John Griffin, its founder, was #2 at Tiger Management working under Julian Robertson in its heyday. They are long/short value investors. Some of their biggest holdings (according to the 12/31/2008 13F) include Microsoft, Covanta, Berkshire Hathaway, National Oilwell Varco, and Mastercard (I hold two of these stocks in my personal account).

In her book, Staley goes on to list some general themes/baskets that certain shorts regularly fall. They include: "Bubble Stocks", high growth stocks with sky high multiples, stocks where the SEC filings don't quite make sense, companies that burn through lots of cash and need tons of capital, heavily indebted companies, "for sale but not sold company", companies that are hiding deteriorating earnings with one off gains, companies in secularly declining industries, or all of the above.

A problem that many short sellers find themselves is a company who's stock goes higher and higher in spite of an obviously deteriorating condition (just pick one of the above). The market is irrational at times. Many hedge fund managers covered their GGP stock in early 2008 when the stock rallied to the low 40s from the low 30s. A year and a few months later, the stock trades at 60 cents. Many funds got crushed when the government banned short selling of banks. You may be right in the long run, but when you are giving your investors month to month or quarter to quarter numbers, you need to be right in the short run. Admittedly, one of the flaws of the hedge fund model which I dutifully subscribe to as an active participant.

Now, I want to start off by saying that this post is not a recommendation one way or the other to short the stock that we are going to begin to do due diligence on. I have no economic interest one way or the other in this stock. If you do your research, figure out its a good short, then I suggest you put it on. Otherwise, look at this post as more of a way as I how I approach common stock investing (on the short side).

Just like many value investors look at the 52 week low list for long value plays, some people, including myself, look at the 52 week high list for short plays. You can access this list on Bloomberg or various other financial sites on the web (do a Google search). Earlier in the week, I saw that Darden Restaurants (DRI) had ticked off a high on April 22nd.

For those that do not know, DRI owns and operates a number of restaurant chains - very well known chains such as Red Lobster, Olive Garden, Longhorn Steakhouse, etc. I was surprised to see such a stock on the 52 week high list - why? Because in recessions, I would assume people eat out significantly less. So why not investigate and see what we can find?

The first thing that I do when researching a common stock, whether it be long or short, is read the last three annual reports. Why three? That's what my boss told me my first day on the buy-side, and I just haven't experimented enough to see if one, three, five, or ten is the right number. These can be found here: Darden Annual Reports.

One caveat. I will go back quite a few years and read the shareholder letter. I want to see if the shareholder letter actually matches up with how the company performs in future years. Also I want a realistic shareholder letter. I.E. If I read a shareholder letter from 2008 where the author is all bulled up on the economy, I generally laugh and move the idea to the short pile. And in some situations, if a business is very cyclical, I will go back to the annual reports of the last down cycle to see what was happening.

What else am I looking at when reading the Annual Reports? Not only do I want to see how the business is performing, I also want to see how management is using their capital. Were they buying back stock at the highs in 2007? Were they levering up for acquisitions in the same year? How has capex trended with sales and what is the return on that capital employed. Does CFO match trends in net income. What are the accounting assumptions?

Pension assumptions are the most overlooked information in an annual report. While DRI's pension plan is fairly small relative to the size of the enterprise, from the 2008 DRI Annual Report, DRI is assuming a 9% expected return on plan assets. Definitely aggressive in the context of real world returns.

Other things I look at: I read the notes voraciously. I want to get an insight that other people may have glossed over. Remember, investing is a zero sum game. For every winner, there is a loser. I like to win. Unfortunately, I should just do a whole post about reading an annual report, cover to cover, and I will do that in the future.

I then read the last three proxy statements. These can be found here:

Darden 2008 Proxy
Darden 2007 Proxy
Darden 2006 Proxy

Why do I read the proxy statement? Well for a few reasons. I like to see the make up of the board (and how they are paid), I want to see management holdings of stock, I like to see the proposals shareholders are voting for and how management responds, and a few others. The two most important things to look at when reading a proxy is: 1) How is management compensated and 2) What related party transactions have been taking place

In regards to #1, you want a management team that is compensated for things like return on capital, not sales. Why? Because a management team can pump up sales by spending capital on low return projects. All this will be under the report from the compensation committee. While it may be counter intuitive, I like to see management being compensated with restricted and common stock, yet I generally dislike when compensation is linked to stock performance. This just gives management an incentive to cheat and lie to boost their stock price. I want a management team to think like owners. I also want to see that compensation for a certain year was in line with what the business actually did...i.e. I do not want to see lots of bonuses paid out for a terrible year.

In regards to #2, it is fairly self explanatory. The less insider / related party transactions the better. DRI has none which is a gold star in my book.

After reading the last three annual reports and proxies, I should be fairly comfortable about what the business does, its drivers, how they make money, where the capital is being spent and at what targeted return, etc. From here I will read as many conference calls and corporate presentations I can stand. You can find the conference calls on Seeking Alpha, or if you are an institutional investor on Bloomberg or Street Events. Good investor relations departments put all their historical presentations on the website, easy to find for investors. That reminds me, I will also spend quite a bit of time reviewing the corporate website, trying to get a better understand of the business. Lots of jewels to be mined there.

Why do I read the presentations and conference calls? Well first of all, I want to figure out the shared expectations of the market and the concerns of the market. Generally, an investor relations department will tailor their presentations to analysts questions and concerns. I.E. If a company is getting a lot of questions on its liquidity in private conversations with analysts and buy side professionals, the investor relations department will stick a slide in saying how great liquidity is. Always happens. On the conference call, follow the Q/A section and see what people are asking about and concerned about. You make money in the market by having different expectations about the future than the general consensus. If you think 2010 and beyond free cash flow will be substantially higher than the analyst community, you would be more apt to buy the stock.

After reading the annual report, proxies, conference calls, and presentations you should have a pretty good understanding about the business, the markets perception of the business etc. You now need to do your comp work. And I do not mean build a comp sheet.

Where do you get your comps? A lot of the good ones are in the proxy. In DRI's case, in the 2008 proxy, on page 43 of 84 of the PDF document, the company lists its peer group. I then go in and add my own (and maybe take out a few I do not find appropriate). For example, Cheesecake Factory (CAKE) is not on this list. I'd add it in. This is where you start making calls. Lots of them. While you could go back and read every one of these companies 10Ks and proxies and conference calls if you had all the time in the world, you just do not have that much time if you are new to the situation. As an aside, that is why I believe people with industry expertise in portfolio management have a substantial edge.

Back to the due diligence calls. I will call each one of these competitors that I find relevant and talk to the investor relations department and hopefully the CFO about the business in which I am studying. Darden, being a chain restaurant, there are so many questions you could ask that would give you great insight about the inner workings of the business. I might ask Bob Evans Farms how guest counts and average check size is trending in certain markets that DRI has a big presence in. I may ask Kohl's how store closures in strip malls is affecting their business and the business around them. I may ask Zales their thoughts on mall traffic. I'd ask McDonald's what they think is happening with minimum wages in Congress. I might ask each of these companies their thoughts on the chain food business for the next three of four years and how the competitive dynamic is shaping. I'd ask each of them what trade magazines are relevant and then try to read some information on the industry / trade on the web.

You get the picture. You want to get insights into the business in which you are examining and insights into the strengths / problems the market is focusing on to exploit diversions between reality and opinion. I am telling you, less than 5% of buy side professionals do this. Why? Maybe they are too busy building excel models or maybe they believe Investor Relations' job is to blow smoke up every one's ass. I don't know. If you are smart about it, you can get good information from these people.

So now you know a fair deal about the business, the industry, what is going on in the real world. From here it depends on the company being analyzed. You want some real on the ground, scuttlebutt research. For DRI, I may call 10-15 different restaurants and chat up the hostess or manager and get some information about what is going on in the stores. How has business been? What's new to the menu? What are customers liking? Etc. For other businesses, I may call direct competitors or maybe even suppliers to get the same sort of information.

At this point, you should have a pretty solid opinion of what is going on in the business. At this point, I will throw together a few excel spreadsheets. The first will be a model (with some historical included) that will have three or four drivers. At this point, with all your due diligence, you should know the drivers. If not, go back and call the competitors and figure it out. You want to compare your thoughts on the drivers with the market assumptions. If you do not know the markets assumptions call up sell side analysts and ask. For DRI, here is the Darden analyst coverage. You do not want to call up analysts and ask their opinion. You are smart enough to form your own opinions. You talk to them to get factual information that you may have trouble getting and for figuring out where the market expectations are. So you have your model, with your drivers, and then you compare it to the markets assumptions and drivers. For example, the consensus EBITDA for FY2010 for DRI is $959M. If your model comes in materially lower than that you would be biased on the short side.

Unfortunately, that is not the only step. How much of this is already priced in? Maybe everyone know the analysts are wrong and that is priced in with low multiples. So now we do our multiple work. I want to compare the multiple to those direct competitors on a current basis, but also on a historical basis. What is the lowest a restaurant similar to Darden has ever traded for? What is the highest multiple ever traded? What is DRI's highest EV/EBIT multiple ever (on a normalized basis)? What is the lowest cash flow multiple it has ever traded for? Etc. If you find a stock where your expectations are significant lower than the market, and the stock is trading at a relatively high multiple to its competitors and its historical range, well that is just a beautiful thing.

You will want to establish a target. We will talk about how we do that on the long / short side in a future post. Also, you want to see if the common stock is the best way to go...maybe you buy the CDS (trading at ~150bps) to get short the company. Or maybe you want to hedge yourself and go long bonds, short common. Again, a great subject for a future post.

This is the general undertaking I do with most common stock investments. Certain situations call for different due diligence practices. I may go further down the rabbit hole for some stocks and less for others. Nonetheless, I love the process. Each time I do it, I try to get better. And each time I learn about a company, I have more information for future investing opportunities.

8 comments:

Lawrence D. Loeb 4/28/2009  

When you are calculating enterprise value, are you using face or are you utilizing trading prices to calculate the value of the debt?

widemoatinvesting 4/28/2009  

I'm all for hard work and research, but your approach seems particularly aimed at gaming the market for short term gains--for example, figuring out analysts' consensus so as to anticipate the price move. Is that fair?

Hunter 4/28/2009  

Lawrence - For the more junior securities, I will use par for the senior securities to figure out my residual claim.

WideMoatInvesting - I am not anticipating price moves. That is speculating. I am determining consensus expectations not just next quarter, but for 1-3 years out. If my due diligence combined with my valuation works leads me to believe that the consensus/market is incorrect than I will more than likely put on a position. I have read your EBAY piece. It is a very good one. I am doing exactly what you did there. You determined that the market's assessment of EBAY's prospects were incorrect. And you had a large margin of safety.

Rower32 4/28/2009  

Hunter, how much time do you spend for this valuation process? secondly how do you estimate the variables for DCF model? Great blog again, thanks!

Lawrence D. Loeb 4/28/2009  

Hunter - "Margin of safety?"

You're starting to sound like a certain gentleman from Omaha. :-)

I don't know how sophisticated all of the readers of this blog are. You might want to mention some of the perils of short selling (like having the shares called back and having to re-borrow).

market folly 5/04/2009  

hey quick (semi unrelated) question. On the Blue Ridge reading list you referenced above, wondered if you had any other resources like that relating to the Tiger Cubs?

I track the Tiger Cubs in depth on my blog and had somehow never seen this reading list. I feel like I've searched the internet high and low for all things Tiger Cub and then this pops up haha. Thanks for pointing it out! Always on the lookout for stuff like that.

Anonymous,  5/13/2009  

great blog!

Anonymous,  12/21/2009  

Hi Hunter,

I just came across and enjoyed this post. How about another post on the DD process soon?

Email

hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.