One of the many benefits of a multi-part series like this is that I can drive you crazy – or at least make you keep reading – by withholding key information until the end.

In this case, though, I’m going to do something even better and give away some of it here in Part 3, before the conclusion to the series in Part 4.

This time around, we’re going to turn our attention to financial modeling and valuation in hedge fund case studies and learn what you need to know, how it’s different, and how much detail to provide with limited time and resources.

Our interviewee returns today, with even more tips to share on all of those topics – plus the all-important “how to put it all together and make a coherent presentation” point.

Let’s get modeling:

The Purpose of Models in Hedge Fund Case Studies

Q: So let’s talk about my favorite topic in the world: building financial models.

You mentioned in Part 1 and Part 2 that you’ll always need a model or valuation for use in your case study… and we know that in PE interviews, the purposes of these models is to answer the question, “If we buy this company, are we likely to hit our targeted IRR over 3-5 years?”

What’s the purpose of models for HF case studies? Valuation?

A: Most of the time, yes.

If you’re interviewing for an event-driven fund, you might analyze an M&A deal or some other type of event, but most of your modeling work in HF case studies will be valuation-focused.

More important, though, is how you use the valuation to justify your investment recommendation:

1. If you’re making a long recommendation, you have to argue that the stock is undervalued, and ideally that a) Even in the worst case scenario, you stand to at least maintain principal or not lose money; or b) That while you could lose money in the worst case scenario, it’s an asymmetric risk profile because there’s (for example) a 50% chance of losing 10% and a 50% chance of gaining 40%.
2. If you’re making a short recommendation, you argue that the stock is overvalued, and ideally that a) Even in the best case scenario, you won’t lose (much) money; or b) That while you could lose some money in this best case scenario, it’s also an asymmetric risk profile because there’s a 50% chance of the stock declining by 40% and a 50% chance of it increasing by 10%.

You could also use fairly simple financial analysis to justify your recommendation and explain why the “downside case” doesn’t present that much risk.

For example, maybe the company trades at only a 10% premium to its tangible assets (not too likely these days, but you never know).

Q: Great, so it sounds like scenarios could potentially be very important depending on how you’ve set up your model.

Before we jump into that, though, what’s the overall process that you recommend for building valuation models? And what methodologies do you use?

A: There is nothing special about the methodologies – you still use public comps, precedent transactions, and the DCF unless it’s an industry where one of those doesn’t apply (e.g. the NAV model for oil & gas companies or the dividend discount model for commercial banks and insurance firms).

You should not spend hours and hours adjusting for non-recurring charges and taking care of minutiae – your time is much better spent picking solid companies and transactions in the first place and finding data to support your predictions for the company’s own performance.

Here’s the process I recommend:

1. First, identify the 2-3 key drivers for the company in question. For many companies, these will be variants of “units sold” and “average price per unit,” and your job is to figure out what’s driving those.
2. Next, gather historical data on the company – not just their financial statements, but also how these metrics have trended over the past 5-10 years. If it’s a retailer, for example, you’d look at trends in # of Stores, Sales per Square Foot, and Square Feet per Store over that time period.
3. Build a 3-statement projection model for the company over a 3-5 year period, with these key drivers as your inputs to the model. Do not obsess over small items on the statements or items that do not change (if it doesn’t balance, simplify and tweak). Focus on the main value drivers: revenue growth, EBIT/EBITDA margins, and CapEx and (maybe) Working Capital requirements. Make sure you can make simple adjustments to these variables in your model.
4. Select public comps and precedent transactions for the company – use the “Related Companies” feature in Google Finance to find and screen comps. Precedent Transactions can be more time-consuming to find and are generally less important than public comps anyway, so you can even leave those out if it’s taking hours and hours and you’re not getting anywhere.
5. Build a DCF analysis for the company where you can vary the discount rate, the Terminal Value, and the 2-3 key drivers you identified in step #1. This analysis should be linked to your 3-statement model.
6. Summarize your findings at the end and come up with a valuation range for the company. Again, you need to be able to say something like: “In the worst case scenario, we expect a value of $XX per share, and in the best case scenario, we expect a value of $YY per share.”

Level of Detail Required

Q: Thanks for the outline. I think most readers are familiar with the basics of valuation, so the more interesting part is probably what happens in steps #1-3.

What level of detail do you need?

A: It depends on the fund you’re interviewing with. At many long/short equity funds, they won’t necessarily value tons of detail on the revenue and expense drivers. However, they want to see that you understand the key drivers of the business and how it makes money, and your model should reflect this understanding as well.

However, I have seen more activist-oriented funds and funds with a lot of former private equity guys that do care about granular detail and do want to see that you’ve thought through those metrics.

Also be aware that some funds are betting on quarterly results, in which case more details around metrics like same-store sales and the performance in individual stores and/or geographies might help you.

So I hate to give you an “It depends” answer, but it really does.

You need to think about the fund’s strategy and what their portfolio looks like – the more diversified it is, the more of a “high-level view” they’ll take and the less they’ll care about granular details.

Q: OK, so maybe we could take a specific example here… let’s say you’re pitching a healthcare company. Should you project revenue from each major business line (e.g. primary care, specialty care, consumer healthcare, and nutrition)?

Or should you go down to the level of individual drugs or treatments? Or do something else entirely?

A: It’s almost impossible to go down to the level of individual drugs (or products, or retail stores, etc.) in the span of a few days, and you’ll probably lack the data to do so anyway – so I would avoid that.

Maybe if you’re 1000x smarter and more efficient than the average person you can try it, but otherwise avoid it.

Another risk is that the more time you spend on this exercise, the greater the chance of a stock moving away from you. So it’s a trade-off between time and production. You really want to think of the 80/20 rule here because you just won’t have unlimited time and/or data.

You do want to make it more detailed than a simple revenue growth percentage projection, but using hundreds or thousands of individual drivers is overkill.

The same applies in other industries: for oil & gas, sure, maybe run a NAV model for each of the company’s major geographies, for a commercial bank you can project the 3-5 major loan categories separately, and for Apple you can look at the iPhone vs. iPad vs. iPod vs. laptop and desktop segments separately (but please, don’t use Apple to begin with).

Q: And are there any special metrics or ratios you should pay attention to?

A: Personally, I am always cash flow-biased.

That might be because I’ve worked in PE before, where cash flow truly is king – but it’s also because other metrics and ratios can disguise how well a company is actually doing, whereas it’s harder to do that if you scrutinize cash flow generated (whether it’s Levered FCF, Unlevered FCF, or another variation).

Then you have the usual profitability margins and growth rates, all of which are useful for comparing the company to its peers.

One metric I like to look at is Return on Invested Capital (ROIC), which is Net Operating Profit After Taxes / Invested Capital.

“Invested Capital” can be defined a couple different ways, but some people use Total Assets – Cash & Cash-Equivalents – Non-Interest-Bearing Current Liabilities – (Occasionally other operationally-related long-term liabilities such as Deferred Revenue and Deferred Taxes). For some companies, it’s close to Total Debt + Preferred Stock + Equity.

NOPAT, or Net Operating Profit After Taxes, is basically just Operating Income * (1 – Tax Rate), similar to the calculation starting point in Unlevered FCF.

This one is important because any business can grow… but at what price?

All else being equal, it’s better to invest in businesses with a higher ROIC because each dollar of investment results in higher growth.

Q: But wait a minute, you’re using tax-effected Operating Income as part of that calculation, which is usually very far off from Free Cash Flow…

A: Right, that’s why it’s only one of the metrics you look at.

Cash flow is still king, but you do also care how much a company can grow its operating profits based on each dollar invested.

Where to Find the Data

Q: So I think everything you’ve described so far makes sense – but finding all this data for use in your models is another issue. What do you do when you have very limited time?

A: There are a couple tricks you can use to save time:

• Start with sell-side equity research models – don’t rely on them for projections, of course, but some of these models have tons of historical data in them, which will save you a lot of time. There are some risks, but that is one method.
• Also remember that most companies actually have historical financial statements IN Excel in the investor relations section of their websites. This may sound silly, but I’ve seen many people waste time inputting all the historical data manually.

You could also start with an existing 3-statement template or valuation template and change around the revenue and expense assumptions, but that tends to work better if the template is for a company in the same industry.

Q: Yeah, those are good points to keep in mind. But how do you actually come up with the projected numbers in a model?

Let’s go back to the retail example – you’ve said you shouldn’t rely on equity research, so where would you get numbers for the # of New Stores Opened, changes in Sales per Square Foot, and so on in future years?

A: The easiest approach is to take a look at what estimates already exist and then modify them based on your primary research (interviews with customers, suppliers, executives, reading reports, etc.). For example:

• The company’s most recent investor presentation has extremely optimistic projections of 50 new stores being opened in the next year, and the company currently has 1,008 stores. Management is also predicting that average Sales per Square Foot will increase from $333 to $372.
• But then you speak with three of the company’s biggest vendors and find that pre-orders for this next year are lighter than expected and that there’s still a lot of unsold inventory from the past holiday season.
• You also check the earnings call transcripts of a few peer companies and find that economic conditions in the Southwest of the US have been worse than expected, resulting in lower consumer spending; 20% of the company’s sales come from there.

Projections in investor presentations are almost always incredibly optimistic, but in this case there’s evidence that sales growth will be more sluggish than the company is expecting.

So you’d run the numbers and see what slightly lower growth in the Southwest and in the product categories of those three largest vendors would correspond to, and maybe you’d reduce the estimates, say that 35-40 new stores will open, and assume that Sales per Square Foot will only increase to $355.

You would continue to do that for the rest of the projected years as well; it gets less and less accurate by the time you reach year 5, but for valuation purposes the next 2 years matter the most anyway.

Q: Great, thanks for explaining that in detail. So what are the risks of using equity research for parts of this process?

A: The main problem is that you may not be able to justify the numbers.

That can be a big issue if the PM of the fund, or any interviewer, points to a random number in the model and asks where you got it from.

It doesn’t matter as much for the historical metrics, but you need to be prepared to justify everything in your model.

The Best Case Scenario…

Q: Awesome. I hope everyone’s taking notes.

So you’ve been mentioning how important it is to consider the Downside case and what happens if a company completely tanks.

Should you include multiple scenarios in your model, e.g. with the CHOOSE or OFFSET function in Excel and different numbers for the key drivers in the future period?

A: If you have the time to come up with those different sets of numbers, yes, it’s helpful.

But make sure that your Downside case is a TRUE Downside case if you want to go that route – I’ve seen models where someone says the Upside case is a 50% increase, the Base case is a 40% increase, and the Downside case is a 30% increase.

Q: Yeah, that’s a good point to make. In our case study on Best Buy, the Downside case has the company dropping from $50 billion in revenue to only $30 billion over 5 years.

A: That sounds a little extreme, but anything is possible when the company is suffering and facing potentially major structural headwinds.

Remember that you’re focused on those asymmetric risk profiles – if your model shows that the company has a chance of going up 50% in the next year in the Upside case, going up 10% in the Base case, and falling 10% in the Downside case, that could still be compelling because the “expected value” is a 17% increase if you assume equal probabilities.

Q: Besides this argument about the probabilities of various scenarios, how else could you use the valuation in your case study?

A: You could also look at the output from the Downside case and say, “Even if the company performs poorly and the Downside scenario comes true, it would still be undervalued… according to the implied valuation range across all methodologies in that scenario” (or vice versa for a short recommendation).

And you could also use the valuation to figure out where in the cycle a cyclical company is – so if it’s something like chemicals or semiconductors and you can compare the current multiples to historical multiples and argue that it’s entering an expansionary cycle (or the opposite for s short), that’s another option.

Finally, there’s the simple argument that you see in banking all the time: that if a company is in-line with its peers in terms of revenue growth and margins but trades at a different multiple, it may be overvalued or undervalued.

Modeling On the Job

Q: Thanks for pointing out those use cases – they’re certainly useful if you don’t have much time to make your case.

Out of curiosity, how much does all of this help on the job? Is it similar to what you do in real life at a hedge fund?

A: Again, it depends on the type of fund and the background of the people there. Some will be more modeling-intensive than others, but there’s always some level of technical work required.

If you get a job at a buy-side firm, they want to see somebody who can hit the ground running as much as possible because their time is money. In fact, you’ll probably have to show that you can model even before you’re considered for an offer.

So modeling is definitely important, and anything you can do to learn valuation and how to build a clean model in advance will give you a big leg-up.

That’s why I’ve recommended your financial modeling courses to clients, and will continue to do so – they’re the most effective way to learn these skills and prove that you can do all of that and more.

Q: Wow, I didn’t want you to shamelessly plug my products and services. Yours are acceptable to promote, though.

A: We’ll get to that at the end…

Putting It All Together

Q: OK, so let’s take a step back and put everything together… in Part 2 we went through an outline of what a stock pitch might look like, but maybe we could extend that here and include more on the valuation side.

A: Sure… here’s how the pitch began (the Recommendation part):

“I recommend shorting Retailer X, which currently trades at $45.00 per share, because it’s overvalued vs. peers by approximately 20-25%, its key metrics such as sales per square foot have been stagnant despite rising valuation multiples, and the company has had increasingly poor transparency on many of these key metrics over the past few years.

Catalysts to push down its stock price in the next 6 months include the expiration of key reseller agreements with 3 of its top 10 vendors and the first earnings results post-acquisition close of a smaller retailer last year. Investment risks include potentially better-than-expected integrated company results, as well as faster-than-expected market growth, but we could mitigate those by longing one of its competitors to reduce potential losses from unexpected market growth.”

And here’s how you might fill in each of my recommended points in more detail:

• Company Background: Summarize the company’s business, key geographies and customers, and what its current market cap, valuation multiples, and growth and profitability are.
• Investment Thesis: The company is overvalued by at least 20-25% vs. peers, but consensus hasn’t “noticed” because the company has done a good job of obfuscating key metrics and not disclosing its reliance on its top 5-10 vendors. Its recent acquisition has also under-performed relative to expectations and the premium paid.
• Catalysts: The upcoming renewal of key vendor contracts and the first earnings call post-transaction-close could push down the company’s stock price as the market finally notes its weaknesses.
• Valuation: Even in an “Upside” scenario, with Sales per Square Foot and Total # Stores increasing at a 5% premium to management’s expectations, the company is still overvalued by approximately 5-10% vs. peers; and in the Base case and Downside scenarios, which have been reduced from consensus estimates based on conversations with vendors and suppliers, the company is overvalued by 15-25%. These results hold for both public comps and the DCF analysis (you would paste in the output for both here).
• Risk Factors and How to Mitigate Them: One of the company’s key geographies could produce faster-than-expected growth, or the post-merger integrated results could be better than expected. To hedge against that risk, we could long a competitor in that geography, or long another company that has made a similar acquisition recently.

Q: Great, thanks for expanding on that. I think a lot of people struggle with the risk factors and how to mitigate them. Any tips if you’re presenting a Long recommendation?

A: You could take a similar approach and recommend shorting a peer or buying a protective option, but you could also raise other points:

• Sustainable Competitive Advantage: Does the company have a key patent, legal ruling, or regulation in its favor? Does it have a “network effect” in its business (e.g. Facebook) that protects it from competitors?
• Cash on Balance Sheet: A high cash balance and/or tangible assets can also be a hedge against an extreme downside scenario.
• Low Valuation Multiple: And finally, of course, if the company is trading at a low multiple already, that is arguably a hedge as well because its valuation couldn’t fall as much as a healthier company’s valuation could. Just be wary of value traps.

Q: Great. Any other good sources for example stock pitches and case studies?

A: Sure:

• Seeking Alpha – Some good material but there’s no filter or quality control, so “browser beware.”
• Value Investing Congress – Even more.

Finally, check out any of David Einhorn’s presentations – the one on Green Mountain Coffee is fantastic and (temporarily) resulted in a massive drop in the company’s stock price.

The Top Case Study Mistakes to Avoid

Q: Yeah, if you Google “Value Investing Congress note” each year, you can get stock picks and examples of the rationale used by some of the top fund managers out there.

Before we move on, any thoughts on the top mistakes to avoid in case studies?

A: Besides the “not giving a clear recommendation” one, a couple I’ve seen before:

• Weak Risk Factors and Mitigants: This is very common if you’re moving in from banking or sell-side research, because you rarely think about these factors there.
• Being Unable to Explain Part of Your Model: They could point to any number included anywhere in your presentation or model and ask you to explain it. If you don’t have a set of notes in front of you that explains where the key numbers came from, you’re shooting yourself in the foot. And yes, bring these notes to the interview.
• Lack of Energy / Conviction: If you had $10 million and were not 100% ready to put your own money behind this idea, you’re doing something wrong. Much of the job is selling the PM on your ideas, so you need to express this enthusiasm from the start.

Q: All good points. So with mistake #2, what happens if you really don’t know where some random number came from? Are you screwed if you can’t explain it right away?

A: I would offer to get back to him and explain it. Say something like, “I don’t know that exact number. No one else has asked me before. But I understand why it’s important. I can get back to you later with that number. But just at a high level, my intuition leads me to think X, Y, and Z. And I’m happy to follow up in an email afterward.”

But if you say something like this, you really do need to follow-up afterward or you look even worse (yes, they will remember it).

Q: Very similar to tips for sales & trading interviews when problems come up there as well…

So, now, moving onto our real example of a case study that could use improvement and how we can give it a “makeover”…

A: Next time, next time…

Coming Up Next

Yes, we’re almost done – admit it, you’re a little sad, aren’t you?

Not to worry, though, because our grand finale is coming up in Part 4:

• Part 1 – Hedge Fund Case Study Overview
• Part 2 – How to Generate Investment Ideas and Research and Structure Your Case Study
• Part 3 – How to Model and Value Companies and Deals for Use in Your Case Studies
• Part 4 – Walkthrough of an Actual Hedge Fund Case Study / Pitch That is Lacking and How to Give it a Winning Makeover

You don’t want to miss this one.

Numi Advisory has advised over 250 clients by providing career coaching, mock interviews, and resume reviews for people seeking jobs in equity research and investment management. With extensive investment experience in equity research and private equity and now working as an analyst at a long/short equity hedge fund, Numi has unparalleled insights into the recruiting process and advancing on the job.

Numi customizes solutions to each client’s unique background and career aspirations, and teaches clients the most efficient and impactful methods to achieve successful results on their career search. He has helped place over 50 candidates in leading buy-side and sell-side jobs. For more information on career services and client testimonials, please contact numi.advisory@gmail.com, or visit Numi’s LinkedIn page.

The post Hedge Fund Case Studies 101, Part 3: How to Build the Financial Models You Need to Land Offers – and Put Together Your Stock Pitch appeared first on Mergers & Inquisitions.

You naturally want that stamp of approval when you’re up for that next job or promotion.

Well, at least if it’s a stamp of approval from Harvard / Wharton / Stanford as opposed to Unknown University.

If you’re already in the finance industry, you’re probably already considering your options, assigning risk-weights to various plans and figuring out the trade-offs between going to business school now vs. several years from now as your “Plan B” backup option.

But what if you’re not sure about business school? It is, after all, 2 years of unpaid salary and over $160K in costs to cover tuition, books, trips, dinners, and more.

You don’t exactly want to pay for the entire expense upfront if you’re not sure whether or not you really want to go… but the good news is that you don’t have to.

Instead, you could simply take the GMAT exam and consider it a “call option” on your career.

Say What?

If you’re reading this site and don’t know what a call option is, well, I don’t know what to say, but let’s recap the basics just in case:

With a call option on a stock, you pay an upfront fee and then get the right, but not the obligation, to buy the stock at a certain price.

For example, if a company’s stock price is currently $100.00, you might pay $1.16 for a call option to buy the company’s stock when it reaches $105.00 (the exercise price).

You’d have to weigh that cost to buy the option against the probability that the stock will rise above $106.16 ($105.00 + $1.16), meaning that you make a profit, as well as the days until expiration and other factors such as the stock’s volatility, interest rates, and so on.

Call options are interesting because they have potentially asymmetric payoff profiles: you pay a small fixed amount upfront, and the stock price could theoretically appreciate indefinitely, which mean that your profits also keep increasing indefinitely.

Here’s how the analogy applies to the GMAT:

• Underlying Entity: Your career rather than the stock
• Option Premium: Cost of the exam and the time required to study for the exam
• Potential Upside: Infinite, or at least an order of magnitude higher than the cost of the exam
• Potential Downside: Cost of the exam and the time required to study

No, this analogy doesn’t hold up completely because there’s no “counterparty” to the GMAT exam in the same way that there is for stocks and options, but let’s just ignore that for now.

Ask Yourself…

If there’s even a small chance that you might go to business school in the next 1-5 years, then the risk / reward or cost / benefit profile is greatly skewed in favor of taking the exam.

Even if your answer is a definitive “no,” then it could still make sense to take the exam as a sort of “tail-risk” hedge, given how relatively low-cost it is to acquire.

Think about it this way: options can be used both as speculative instruments (betting that the value of an underlying asset will go up or down), but also as insurance or hedging instruments (protecting against the downside of an existing investment).

There are 3 scenarios for the GMAT:

1. If you’re definitely going to business school in search of a better career, you need the GMAT to apply.
2. If there’s a small chance that you may want to attend business school in the future, then it makes sense to take the GMAT as a cheap “insurance policy.”
3. If disaster strikes and you lose your job, have no solid prospects, and everything else is generally falling apart, taking the GMAT is a sort of “disaster hedge” option that will make the business school application process quicker and easier.

One of Warren Buffett’s most well-known quotes is “You should be fearful when others are greedy and greedy when others are fearful,” and the same principle applies here: you should take the exam when things are going well simply to hedge against something like #3 happening.

You’d much rather take the test when you’re not out of a job and under serious pressure to earn a good score, and then have those results on file for several years if and when you do decide to apply to business school later on.

As anyone who lived through the financial crisis can attest to, these “Black Swan” events tend to happen more than you’d think…

Is the Cost Worth It?

To answer that question, you need to look at everything that’s required for business school:

• A solid GMAT score
• Recommendations
• Essays
• Work and leadership experience

You can’t just get “great work experience” overnight, or even in the span of a few months, and the same applies to recommendations and essays: it takes years to develop the relationships and experiences you need as the basis of both of those.

It’s also much harder to use any of those as “insurance policies” because you’re attempting to stand out as much as possible with your recommendations, essays, and work experience.

By contrast, it costs far less in time and money to earn a high score on the GMAT, and it’s something that you can do once and then forget about until you actually apply to schools.

Timing = The Expiration Date?

You also need to consider both the real “expiration date” of your results – GMAT scores can only be used for up to 5 years – as well as how old you are and how much work experience you have.

The “optimal age” for most top business schools is anywhere from 26 to 28, and the trend lately is to skew younger – so you’re at a disadvantage if you’re already 30+ and decide that you want to go back to business school.

On the other hand, if you’re 22 and just out of undergraduate, it’s arguably too early to take the exam because you might be applying to schools when you’re 28 or 29 and your scores would be invalid by then.

But if you’re 24 or 25 or even a bit beyond that, it’s a good time to take the exam because your scores will last until you’re 29 or 30 and will therefore be valid during the “ideal age range” at top schools.

Study Time and True Costs

While the GMAT exam itself costs $250 to take, you might also be wondering about the hidden costs such as the time required to study for the exam, courses and books required for it, and so on.

The good news is that it’s not even close to “CFA territory” – you’re looking at 1 to 1.5 months of study in most cases, as opposed to 500+ hours (months and months) of intensive study. Oh, and the exam fee itself is significantly less than the $1100+ required for the CFA.

And the GMAT is useful even if you decide to go into non-finance fields after graduating from business school (hey, I know it’s a stretch but anything’s possible).

Courses and books can add up, but you won’t end up spending a significant amount of money (i.e. thousands of dollars) unless you spring for in-person courses – which are not the best option if you have a busy schedule and long work hours.

The Bottom-Line

The debate over the “value” of business school rages, and there’s no universally correct answer.

The short version is that it can be very valuable… if you use it for a specific purpose and you know exactly what your purpose is going into it, e.g. making a major career change such as going from marketing into investment banking and leveraging a top school to get there.

If, on the other hand, you’re just using business school to “take a break” and you wouldn’t advance much by getting the degree, then it’s a tougher case to make (at least if you’re the one paying for it).

However, one thing is certain: regardless of your future intentions to attend or not attend business school, taking the GMAT exam can be a smart “call option” or “insurance policy” that helps you hedge against major risks:

• What if you lose your job as your bank / company collapses?
• What if you decide you want to apply to business school, but you’re in a new role that has made you so busy that you don’t have much time to study for the GMAT by the time you’re applying?
• What if you’ve won a few job offers but don’t have any truly attractive options? If you already have a great GMAT score, you have one additional option to fall back on.

In all those cases, having a good score on record from prior years gives you more options and much-needed peace of mind.

And as in trading, the psychological side to career decisions is huge and should not be underestimated.

It takes some time and effort, but compared to the CFA, getting great work experience, or building relationships with top industry executives, it’s a very modest investment for a potentially high payoff.

And if you’re in your early to mid-20’s, you want to keep your options open and avoid the mistake all too many people make at that age: selling those options and restricting their future plans.

Just ask anyone who graduated in the mid-2000’s and then found themselves in a very different environment a few short years later.

So consider taking the GMAT earlier rather than later – in the worst case scenario, it’s a great way to hedge your downside risk.

And in the best case scenario, you might just benefit from the infinite potential upside – just as you would when you buy a call option in a company’s stock that ends up doubling over and over again.

This article was guest-written by Zeke Lee, a Stanford graduate, former management consultant with Booz & Company and derivatives trader on Wall Street. He founded GMAT Pill, a top-rated online GMAT Prep course designed for busy working professionals who want to study less and score more.

The course is known for its efficient framework approach to GMAT questions and also has a complete mobile solution so you can study during your commute or lunch break — perfect for the investment banker. GMAT Pill is offering a free download of “What’s Inside GMAT Pill” and “Being: A Red Flag Word” to M&I readers.

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The post The GMAT Exam: A Call Option on Your Career? appeared first on Mergers & Inquisitions.

But sometimes oceans, or at least very large lakes and rivers, separate your cargo from its final destination.

Barring the ability to walk on water, you’ll have to use maritime shipping to transport your goods in that case… and just as banks dedicate groups within their industrials coverage teams to capital goods, transportation and logistics, and aerospace and defense, they also have dedicated teams for the maritime shipping sector.

Unlike road transportation, which depends heavily on the consumer / retail sector, or rail transportation, which is strongly linked to commodities, maritime shipping is much more global in nature because clients are often located halfway across the world.

Here’s what we’ll cover as today’s voyage sets sail:

• Who gets into maritime shipping investment banking
• What the maritime shipping sector covers, key metrics, and drivers
• Valuation, modeling, sector, and company analysis
• What exit opportunity port you’ll pull into after your cruise is over (NB: OK, this is IB, it’s more like a ride on the Titanic)

All Hands on Deck

Q: Maritime shipping is pretty niche as far as sector coverage groups run, so what’s your story? Were you always interested in this sector?

A: You’ve brought up attributes common in successful investment banking analysts and associates here before.

I actually like this quote by Cortana, from the Halo series:

“They let me pick, did I ever tell you that? Choose whichever Spartan I wanted. You know me. I did my research. Watched as you became the soldier we needed you to be. Like the others, you were strong and swift and brave. A natural leader. But you had something they didn’t. Something no one saw… but me. Can you guess? Luck…”

Part of the job is being in the right place at the right time; the rest is about being personable, knowing how to sell your value proposition and how to build the best relationships.

I’ve met guys from top schools who are great with spreadsheets and accounting work; these guys claim you need to be super-sharp to succeed, but I don’t agree entirely – yes, you need to know what you’re doing, but at the margin it’s much better to be the most likable person rather than the technical jockey.

I wasn’t a sailor before I joined this group, if that’s what you’re asking. I walked in and was placed in this group very randomly – I just wanted a team that would keep me busy.

It didn’t matter if I’d be looking at machine gun makers or jewelers – I only knew I wanted to get some solid deal experience.

Q: So it sounds like they don’t have a strong preference for certain industry backgrounds?

A: I don’t think so, at least not as much as in a group that’s very different technically such as FIG or metals / mining.

The placement process depends on where there’s the most demand, and where they can put people. The whole match thing is a “nice to have,” but not a “must have.”

Hoisting the Flag: Industry Overview

Q: OK, so then where exactly do you usually see these maritime shipping groups at banks?

A: Depending on the bank, maritime coverage can fall under transportation, industrials, or even oil & gas.

No, there are no harbors in the middle of Texas, but there are plenty of clients who want to transport petroleum internationally. The coverage will be placed within the oil & gas vertical if the group focuses on companies that specialize in oil tankers.

As for the companies we work with, our coverage encompasses all companies that operate vessels to transport goods, including liquids.

Similar to airline companies, these shipping companies may or may not own the vessels themselves. So just as with airlines and restaurants, you run into the “own vs. rent vs. partially own vs. lease” argument here as well.

Geographically, the world’s biggest shipping hub is Singapore and a few others in Asia, such as Hong Kong and Shanghai, are catching up or are at the same level depending on how you measure “big.”

Many IB groups in Singapore focus specifically on maritime shipping since it’s such a huge industry there.

In Europe, the Netherlands also had one of the world’s busiest ports (Rotterdam) until it was overtaken by Singapore.

Q: Great. So before we jump into the technical details of the sector, can you tell us more about the different types of vessels and the various parts of the maritime business?

A: Sure, here are the most common types of vessels:

• Tanker: Mostly of the oil tanker variety.
• Gas [Carrier]: These usually carry liquefied natural gas (LNG) or chemical gases. You might even find them fully refrigerated.
• Dry bulk: Anything you can’t package: think cement, grain, coal, etc.
• Container: These guys carry most of the world’s non-bulk cargo.
• Cruise: These are the ships that roll around the Caribbean or the Aegean and act more like floating hotels rather than like places to take you from point A to point B. For fun, the top cruise line operators include: Disney, Celebrity, Princess, Royal Caribbean, and Carnival.

Here’s a sample list of the makers behind maritime vessels (please note the geography of these companies).

Q: So what drives the maritime sector?

A: I would begin this discussion with the first page of this presentation. It reminds me of the cycle for the economy: there will be ups and downs.

The second page of a similar discussion from the year prior has some great information as well. If anything, these two pages give you some hints on how a sector update might be structured.

Naturally, the health of your client is going to influence how your company performs to a certain extent.

I remember once in analyst training, the instructor asked us about what drove a particular restaurant’s valuation. Well, surprise, this restaurant’s customers consisted of financial professionals – so the health of finance companies could be used to assess the macroeconomic drivers of this particular restaurant’s performance.

In this same way, a company such as Eagle Bulk Shipping lists basic materials, agriculture, and chemicals as cargo, so all of those sectors will influence its performance.

JPMorgan’s Maritime Investment Fund confirms this thought: bulkers are driven by commodity demand, tankers by oil demand, and containerships by consumer retail demand.

Aside from the cargo, where the vessels can port will influence a maritime company’s health. It’s the same issue as airlines having access to certain airports and not having access to others.

The volatility of charter rates is also important when selecting which vessel to specialize in. The number of ships in construction, safety, traffic congestion, and the number of out of service vessels all influence the supply of maritime vessels.

Within the company itself, you actually take a perspective similar to how you would analyze an airline company: how old is the fleet of vessels and how similar are the individual ships to one another?

These two points directly influence the operating costs of the company.

If the vessels are old, obviously they’re going to need more maintenance compared to newer vessels. If your fleet shares a set of common parts, that’s going to be significant cost savings right there. You’re also looking at the capacity of these ships in terms of dead weight tonnes.

Transport contract length and terms also drive a company’s performance.

Generally, the shorter term ones (1-3 years) provide a higher utilization rate and less cash flow volatility. Most of the time, you see fixed semi-monthly payments in advance with those.

You may also see profit-sharing arrangements in order to distribute the risk of the journey.

Maritime companies approach profit maximization by balancing long-term transport agreements with short-term transport agreements; these companies will also spread their fleet across a variety of routes that are exposed to different sectors.

You could say the route from Brazil to China is fueled by commodity prices, for example, or that the route from China to the US is fueled by consumer prices.

Vessels without fixed charter rates may have their rates tied to a particular index, such as the Baltic Supramax Index, and may keep their agreements to one year or less. A shipping company’s clientele might also include other shipping firms, simply so they can expand their shipping capacity.

Adjusting Your Sextant: Financial Analysis, Valuation, and Pitch Books

Q: So let’s talk technical, what do you look at? Any exotic metrics or multiples?

A: When it comes to intrinsic valuation, we’re talking: DCF – no, not Discounted Cash Flow, but rather Distributable Cash Flow.

It’s basically EBITDA less Capital Expenditures. For a maritime company, capital expenditures can be extremely high and they may include: reserve expenses paid, replacement capital expenditures, and dry docking fees.

CapEx can be so high for shipping companies that it’s even more misleading than usual to use EBITDA as a “proxy for cash flow,” so you see Distributable Cash Flow more often.

While you use the Cost of Equity or Weighted Average Cost of Capital for the discount rate in most sectors, certain maritime companies will look more to the “required rate of return,” particularly those firms with Limited Partners.

You can determine the value to General Partners by calculating distributions made to them.

Many maritime shipping companies have this GP/LP structure, which is completely different from most other companies; this structure is something that you usually see at PE/VC funds and hedge funds.

Public company comparables analysis also differs from other sectors. For starters, the equity value can be separated into what’s attributable to General vs. Limited Partners.

Next, operating leases can influence the net debt calculation because many operating leases need to be re-classified as capital leases in this sector.

You see Debt / Capital, EV / EBITDAR, and Price / DCF as common multiples here.

Q: OK, so you mentioned a few things there I want to ask about, but let’s start with EBITDAR. I’m assuming you use that since companies rent their vessels and others own their vessels?

A: Yeah, exactly. EBITDAR adds back the rent or operating lease expense; you also see this metric when you’re analyzing a set of airline companies where some own and some rent, and the point is to normalize between different accounting standards, not to “approximate cash flow.”

The decision to rent vs. buy is mainly a decision about what will influence cash flows: if you own the vessel, you are going to deal with the usual depreciation expense, and if you don’t – you escape that line item, but now you have the annual rental or lease expense to deal with.

Q: Great. And then on the operating vs. capital lease issue, I’m assuming you look at that in-depth in this sector?

A: Yeah, you could say that. Sometimes, we’ll analyze and model each ship individually, or maybe take an “average ship” that a company owns in a specific class and then multiply by the total number of ships in that segment.

Occasionally, you’ll see cases where the total value of the company’s ships minus liabilities might be greater than its current equity value, or even the implied NPV from a DCF.

It’s important to get the lease issue correct because you also use a Net Asset Value (NAV) model in this sector.

To make things confusing, this NAV model is once again different from the variations you see in oil & gas, metals/mining, real estate, and insurance.

It’s probably closest to the real estate and insurance variations, though: you estimate the value of the company’s assets and then subtract out associated liabilities.

These sometimes include a discount if they are privately held (there is a valuation premium for information and liquidity).

There are a lot of uses for NAV once you calculate it, from using it in a replacement cost analysis to estimating the appropriate purchase price or disposal value in a deal, or simply comparing the valuation it produces to those from other methodologies.

Q: Sounds pretty good.  Anything more to add on valuation?

A: Hmm… precedent transactions are pretty standard and include a date, transaction value, and the relevant multiples for each deal.

But some exhibits can include specific acquisitions by category such as minority buy-ins. The more qualitative issue is what sort of control is associated with buying a significant, but not majority, stake in a company.

Q: Well, that was quite comprehensive, thanks for the detailed explanation.

Got pitch books?

A: Sure do! Here you go:

• Overseas Shipping Group by Lazard
• Arcade Acquisition Corp / Conbulk Corp. by Lazard
• Maritime Update by Bank of America Merrill Lynch
• Capital Markets Update by FBR Capital Markets

Signaling Friendly Ships: Major Industry Players and Readings

Q: So what major firms specialize in this sector? And where are they located?

A: These days, the biggest shipbuilding companies are in Asia (Japan, South Korea, and China), but New York sees a lot of activity when it comes to deal-making.

As I mentioned before, Singapore is another major hub for maritime shipping IB and you see a lot of firms and groups specializing in it there.

Finally, Greece also sees a lot of shipbuilding and maritime activity. Yes, the same Greece that is perpetually bankrupt on land thrives at sea and has one of the world’s top industries – in fact, it’s one of the few industries that has held their economy up through various crises.

Several of the top boutique banks, merchant banks, and investment firms in the industry include AMA Capital Partners (merchant bank), Dahlman Rose (acquired by Cowen – formerly a boutique that worked across commodities, transportation, and other sector), Clearwater Maritime Investments (invests in marine services, ships, and property), Eurofin Group (IB and corporate banking), and the Seabury Group (works across aerospace and transportation).

Q: Awesome, thanks for sharing.

What do you read to stay ahead in this sector?

A: For a good introduction to the sector, check out this equity research report from Dahlman Rose.

Note that the equity comps list there does not include firms with a military presence. Originally, the firms that produce submarines or aircraft carriers were independent.

At the time of this article, one spun off from Northrop Grumman and called itself ‘Huntington Ingalls Industries’ and the other is still part of General Dynamics.

This is significant because any proposed deal gets additional due diligence to check for national security issues.

Tradewindsnews.com is another great resource if you’d like to follow through on this sector.

The presentations section of the Marine Money site is also a great resource and they frequently post presentations from banks there.

Marine Money Offshore can also be helpful if you want to learn more about ships with an oil/gas focus.

Lastly, Capital Link also hosts online talks that include capital markets updates. There is even a “State University of New York Maritime College.” Yeah, that is new to me…

Exit Opportunities: Time to Abandon Ship?

Q: So suppose you arrive at your destination in the maritime coverage group, what’s next?

A: A lot of people, especially headhunters, come to the conclusion that because you covered maritime transport for two years, you are somehow an “industry expert.”

It makes some sense, but not in a way that would limit you. I’ve seen maritime analysts move into tech companies, or even go into hedge funds with a focus on energy. And then you also see people from maritime companies join banks and vice versa.

The advantage of this group is that there’s a lot of overlap with other sectors such as oil/gas, consumer, and even transportation and defense, so you have more exit opportunities than you might think.

Q: Any specific examples of how you’ve seen people moved around?

A: So here’s a specific example: the maritime group head from Jefferies left to do corporate development at a maritime company, while a different maritime company CFO joined the first guy’s old group to become the head.

It’s a very specific sector at the senior levels, so you do see a bit of a “revolving door” effect.

Q: Great, thanks for your time and all these tips. Any parting words?

A: In all of your endeavors: Godspeed.

Luis Miguel Ochoa has worked in investment banking for several years covering the industrial sector. In addition to being an avid mentor for his alma mater, he volunteers for the Association of Latino Professionals in Finance and Accounting. In his spare time, he is fencing, and attends networking events in New York. He has graduated from Stanford with a BA in Economics.

The post The Industrials Group (Part Three): Maritime Shipping Investment Banking appeared first on Mergers & Inquisitions.