Part 3 – Lesson 9

Overview


While getting up to speed on a company, the investment thesis will either come into focus or it will become clear that the company’s stock does not provide a compelling opportunity for investment.  The investment thesis for a company is a simple summary of the reasons why an investor would choose to purchase the company’s stock.  A good investment thesis should address the bull case for a stock, the bear case for a stock, how your view stacks up vs. the bull case and bear case, valuation, and company fundamentals.

What makes a strong investment thesis?


The best investment theses are those where your view on a company is different than consensus (what other investors believe), valuation is attractive, and company fundamentals are strong.

For example, let’s assume that most investors are very bearish on Verizon’s fundamentals because they believe wireless prices are declining.  If your research on the company suggests that wireless pricing is bottoming and set to start improving, then, your view is more positive than the consensus view.  If the valuation is attractive and company fundamentals are strong (outside of just wireless pricing), there could be a compelling investment thesis for Verizon.

When an investor has a view that is different than consensus, this is referred to as a “divergent view” or “variant view.”  Generally speaking, the magnitude of divergence vs. consensus expectations is correlated with the strength of the investment thesis.  Let’s look at a few permutations:

  1. You are positive on Google, and other investors are also positive on Google. In this case, your view vs. consensus is essentially the same.  This doesn’t mean that Google stock won’t go up over time, but an investor should be aware that stock reactions may be muted in the near-term even with Google reporting good quarterly results.

  2. You are positive on Google, and other investors are exceptionally positive on Google. In this case, your view is more bearish consensus expectations.  If Google’s near-term results are more in-line with your expectations vs. the very high expectations of the Street, Google stock is likely to go down near-term.  Longer-term, the stock may work just fine, but an investor should be cautious of investing into a stock where investor expectations are significantly higher than their own.

  3. You are positive on Google, and other investors are neutral on Google. In this case, Google stock is likely to react quite positively if Google reports results that exceed consensus investor expectations.

  4. You are positive on Google, and other investors are negative on Google. In this case, Google stock is likely to react very positively to results that exceed negative consensus expectations.

Let’s put some numbers around each of these examples:

Your Expectation (2019 Revenue Growth) Consensus Expectation (2019 Revenue Growth) Actual Result (2019 Growth) Stock Reaction
20% 20% 20% Muted – little reaction
20% 40% 20% Negative
20% 10% 20% Positive
20% -5% 20% Very Positive

In the above table, we assume that the investor’s forecast of 20% growth for 2019 ends up being the correct reported growth rate for 2019.  The magnitude of the ultimate stock reaction is not based solely on the level of the 2019 growth rate (20%) but will also incorporate how this reported growth rate compared to what other investors collectively forecast for 2019.  Since stock prices are calculated as the present value of what investors collectively forecast for the future cash flows of the company, changes in the stock price come from changes in expected cash flow (or a change in the discount rate).  This is why financial performance vs. consensus expectations is so important.

How important is it to have a view that is divergent from consensus?


All else being equal, there are significant advantages to investing in companies where you have a positive divergence vs. consensus expectations.  However, it is important to not miss the forest for the trees when analyzing your view vs. consensus.  In practice, it is often very difficult to uncover information that other investors haven’t come across yet or to predict something that others are not predicting.  Instead, we should not only consider our view vs. consensus but also valuation, growth rates, and company fundamentals.

Let’s look at a few examples:

Scenario 1

Company A trades at 20x earnings and we believe they will grow EPS 10% for the next few years vs. 5% consensus estimate.

Company B trades at 10x earnings and we believe they will grow EPS 20% for the next few years.  Consensus is also forecasting 20% EPS growth.

All else equal, which stock would you rather invest in?  Although we have a more positive view vs. consensus for Company A, we would argue that Company B is a better investment because you are able to buy faster growth at a cheaper valuation.  Even though we don’t a “divergent view” on Company B, the faster expected growth rate and cheaper valuation make this a more compelling investment.

Scenario 2

Company A trades at 20x earnings and we believe they will grow EPS at 10% vs. 5% consensus estimate.

Company B trades at 10x earnings and we believe they will grow EPS at 10% vs. 5% consensus estimate.

In this case, we have a divergent view for both Company A and Company B.  However, the cheaper valuation for Company B makes it a more attractive investment (all else being equal).

Scenario 3

Company A trades at 20x earnings and we believe they will grow EPS at 30% vs. 10% consensus estimate.

Company B trades at 15x earnings and we believe they will grow EPS at 30% vs. 20% consensus estimate.

In this case, the magnitude of our divergent view is larger for Company A than it is for Company B.  However, Company B trades at a lower valuation (15x) vs. Company A (20x).  Since we believe both companies will grow at 30%, we’d argue that Company B is the more attractive investment even though our view is more divergent for Company A.

Scenario 4

Company A trades at 20x earnings and we believe they will grow EPS at 30% vs. 10% consensus estimate.  Company A has diversified revenue streams.

Company B trades at 20x earnings and we believe they will grow EPS at 30% vs. 10% consensus estimate.  Company B only has one customer.

In this case, we have a divergent view for both Company A and Company B.  However, Company A’s fundamentals are stronger due to the lower risk associated with having diversified revenue streams.  Company B with only one customer is certainly a riskier proposition.  For this reason, we’d argue that Company A is the more attractive investment.

From these examples, you can see that it is important to not just look at your view vs. consensus but to also incorporate valuation, growth rates, and company fundamentals into your decision-making process.

How do you write an investment thesis?


While there is no accepted formula for writing an investment thesis, there are a few basic elements a properly written investment thesis should address, including: brief summary of relevant facts, the bull case, the bear case, your view vs. consensus, company fundamentals, and valuation.  Not every investment thesis will address all these points, and some investors will stress some of these elements more than others depending on the situation.

The investment thesis should be concise and easy to follow.  Let’s look at an example of a brief investment thesis for Charter Communications (CHTR).

Charter (CHTR), Long
August 2018

Investment Thesis

CHTR stock has struggled in the first half of 2018 due to a few worse than expected quarterly earnings reports, where pay TV and broadband subscriber additions missed expectations.  With investors already nervous about consumers cancelling their cable TV subscriptions to stream video content online, already poor investor sentiment worsened as investor fears appeared to be confirmed by recent results.

We believe the bear case around consumers going over the top has been fully priced into the stock, providing investors an opportunity to buy CHTR stock at an attractive valuation.  The CHTR long thesis is built around these key elements:

  1. Broadband adds should improve – The recent weakness in broadband adds was not due to a worsening in the fundamentals of CHTR. Instead, it was because CHTR’s IT system had mistakenly approved low credit quality consumers, which ultimately resulted in elevated churn as these consumers rolled off.  Although management explained this issue on the 1Q earnings call, investors are in a ‘sell now, ask questions later’ mindset.  Additionally, when CHTR has made a cable acquisition historically, the improvement in broadband results has not been linear.  The integration of Time Warner cable will ultimately lead to sustainably better net adds, but management has always communicated that some quarters will be bumpy as the company moves legacy Time Warner subscribers onto CHTR’s new pricing and packaging.

  2. Video margins are low – Investors are very concerned about declining video subscribers. However, margins on the video product are very low due to increased distributions costs in recent years.  CHTR’s cash flows and growth are predominantly driven by broadband, not video.

  3. CHTR’s broadband is a must-have product and the best in the market – Broadband has become a must-have product for consumers. Even if consumers are cancelling their pay TV subscription to watch video online, consumers must still have a robust broadband connection.  Broadband connectivity has become a non-discretionary purchase for most consumers.  Additionally, CHTR’s broadband product is the fastest in the market, giving CHTR tremendous pricing power for their broadband.

  4. Capex is declining – As CHTR’s network goes all digital and as more subscribers take broadband only, the capex associated with cable boxes is declining. The lower capex will boost free cash flow over time.

  5. Valuation is attractive – CHTR stock is trading at roughly 14x FCF/share for FCF that will grow 15-20% per year for the next few years.

  6. CHTR management is the best in the industry – Tom Rutledge and the Liberty Media management team are widely regarded as being some of the best in the telecom and media sector.

As you can see in the above investment thesis, we highlight the strong fundamentals of the CHTR business, the attractive valuation, the strong management team, and the poor investor sentiment as the foundation of the thesis.  Why is poor investor sentiment a good thing for this investment thesis?  Because having a positive view on a company when others are negative is creating an opportunity for investors to purchase CHTR stock at an attractive valuation.