Hedge Fund Investment Process: Measure the performance of an Analyst, VAR, Research

All right. It's important to have a research process that returns the highest levels of value with the least amount of resources. This doesn't mean to skimp on resources. It means that the analysts and the firm should get the highest return from them. The process in general starts with identifying high quality ideas, then performing high value added research on these ideas. Then acquire a level of conviction on the names and be able to communicate the high conviction names for the PM for inclusion into the portfolio. Once in the portfolio, the analyst needs to monitor the names in the portfolio for any changes in the story and also stand touch of the names in the pipeline while generating new ideas. So it's a lot to do for an analyst. We're going to go into each of these areas in some more depth right now. So the first part of the research process is of course, idea generation. Identifying quality sources of new ideas takes both experience and ingenuity. PMs and analysts from different funds tend to share long ideas with each other because there really isn't competition there. There's no competition for these long ideas. There's plenty out there. They can share research, they can share their models. Now the short side though is somewhat different. Funds tend not to share their best ideas because there is competition on the short side. The main reason is that you need to borrow shares in order to short and oftentimes borrow can be a really scarce resource. However, it's important both on the long side and short side for regulatory reasons not to know when the person you're sharing information with will be trading the idea. Do not talk about trading timing. Reading blogs and just being generally in the know about your industry can generate ideas. Also, many of the best investors insist that their best ideas come from within. Setting aside time for meditating and thinking time are crucial for this. Some of the best managers do that. Buffett, Gates, Dalio loves Meditate. Griffin, huge meditator. It's really important to track the sources of your best ideas and score the sources based on the quality of ideas. Why? Because you want to go back to the well for more use technology for this. Also be sure that you compensate those who provided you with ideas so they have incentive to bring you more ideas. This can be through commission dollars, just paying outright, even sharing your own ideas. Encourage creativity to come up with ideas. Retreats, hackathons and contests are all excellent ways to come up with ideas. Retreats are great because they rid you of distractions and therefore can help you to focus and enter the coveted flow. Contests Promote the competitive spirit, invoke accountability and Provide incentives. By the way, we teach all of this at my new firm, Rutot. We even have meditation training. Promote a culture of trust and innovation. Google spent years studying the key performance traits of top teams. And the number one trait they came up with was trust. Why? Trust provides psychological safety for employees to take risks around their team members. There's no humiliating people if they make a mistake. When generating new ideas, it's crucial to have an initial score of quality of the idea. There's an initial score of it. Why need to decide if this is an idea that is worth spending time evaluating? Where's time to spend time pursuing? Remember, time is your most valuable resource so you want to spend it wisely. We also have training on time optimization. My number one course, time optimization. Having a checklist system for scoring to knock out those ideas that won't make it into the portfolio anyways is just good time management. For instance, sometimes an analyst will work for weeks on a short idea only to learn that they weren't able to borrow it because it was unavailable. Had they checked this first, they would have moved on quickly to the next idea. Checklists save time and save lives. Ask any surgeon. One of my favorite books is the Checklist Manifesto. Now, once an analyst has an idea that is worthy of expending resources on, follow a process to understand. Eventually score all aspects of the company that will serve as criteria for the analyst. Conviction level. Second scoring level. There should be formalized checklists. At a minimum, develop a model of the company. During this stage, it's important not to form any conclusions. Keep an open mind. Focus only on the facts. Just the facts. The categories and subcategories will be weighted and scored eventually. Some examples of criteria to research would be to understand management. Their reputation. These are some of the lists that we've come up with. Reputation, their experience and their incentives. Do they know how to allocate capital? Crucial. Understand the industry? Who are the players and is it on the rise or falling and out of favor? Understanding the product and its use. Why is it unique? Best to experience it. Taste the ice cream. Get an understanding of the key competitors and any new entrants that may be in the queue. Understand the company if it's got a long term competitive advantage. Is there a moat around the business? Do you understand the chain of buyers and suppliers? Now some of the sources for this research in order of difficulty to research and that usually means in order of highest value would be competitors and suppliers. Excellent sources of value. This usually takes hard work though to access and analyze Lots of Points for doing that. Rolling up your sleeves. Industry conference is also another excellent source of value added research. Expert networks can be a value. Be sure that you understand all of the compliance issues surrounding your usage of paid expert networks. There's a lot of them. Do you have access to management here? Again, be sure you understand all the compliance issues surrounding interactions with the company's management. Street research from sell side firms is a common source, but not as useful since everybody's reading it. It's not as necess, right? Because most of the information come from the companies themselves were incentivized to slant the bull case. Financial information from public filings is another key source of information to understand. This is just tip of the iceberg. There's a lot of information to accumulate and organize. It's crucial to have a research management aggregator that serves as a central repository to organize all research in one place to make it easy to access and share information, to be able to use it in the most efficient and effective manner. This is a build versus buy decision. Now the next step of the process is to arrive at a conviction level for the idea. This is a weighting and scoring process based on the research criter at the analyst level. The analyst has been aggregating and assessing this during the bar stage of the process, value added research stage of the process. Now it's time to score the company based on the research. There are different factors of course, based on whether position is a potential long or short idea. On the long side, first you look at the business model. Is the tam, the total adjustable market sufficient for growth? Are there significant barriers to entry? What is unique about this product or service? And look at the management. Do they set a high quality goals? Have they been able to execute on those goals? Are they good capital allocators? Are they ethical? Is the idea original? What is the level of varying perception? Or in other words, does the analyst have a different differentiated view from the view of the company on street? This is really the only way a position is going to make money. If there's a different view from what others think to be the case, right? Those numbers are theoretically baked already into the stock price. Another test of originality is whether the stock is a popularly invested name already invested by other firms. It's often referred to as a crowded name. If so, this drives the originality score lower. It's crowded. Is it uncorrelated with other names in the portfolio? Then it gets a higher score. Uncorrelated is good. You already have that exposure. And for risk management purposes, we'll see. So as you'd expect, the short side is pretty much a carbon copy opposite of the long side Criteria in terms of scoring there are two important differences however, and those are timing and the borrow. Timing is a key criteria for the short side for a number of reasons. It can be expensive in terms of borrow costs and risky to hold shorts, so the sooner they implode the better. The idea is to look for triggers that will take place in the near term future. Some questions to ask in order to accurately score this criteria are can the company be delisted in the future? Is their debt coming due? Are there other hardships that the company might be facing in the future? Is there a way for the company to extend its timing, thereby postponing its inevitable demise? In other words, the best short is a short that is running out of time. In order to short security, the security must first be borrowed from the firm's prime broker. There needs to be sufficient supply to do so as we discussed, and the cost of the borrower should be not so onerous as deed into the estimated return. These should be factored as part of the conviction score of security. Now, once the analyst has a clear sense of conviction on the position, it's up to the analyst to clearly communicate that level of conviction to the portfolio manager. The firm should establish a consistent process for efficient and effective presentation of ideas to the pm. In terms of efficiency, there should also be consistent presentation process amongst all analysts. Using the form of templates, the PM can compare ideas to each other, not have to figure things out each time that an idea is presented. Need to make it easy for the PM to get a conviction level and compare it to the other ideas vying for entry into the portfolio. The key is being able to break down the complex into the simple meaning. The PM needs to see it and get it right away. Remember that timing can be of the essence in getting a position into the portfolio. Any delay can cost the firm money or even the entire opportunity in order to be effective in this part of an analyst role, an analyst must have the skills to influence, read Dale Carnegie's book on this or attend a course. By the way, this is Warren Buffett Buffett's number one suggestion to anyone Read the Dale Carnegie book for Investing for anything. It's their number one piece of advice. I've read it Gone to the course. The analyst must also be able to debate with others on the team to get the level of conviction and idea to the portfolio manager. Bull versus Bear Case Both influence and debating are important skills for an Analyst to possess. Now, once a position has been added to the portfolio as an existing position, it's important that the analyst really is not done with that. Analyst role is to monitor the current positions in the portfolio and then also the pipeline positions. You got to stay on top of both of those as well. In addition to finding new positions really important monitor the positions in the portfolio. Understand that you're also looking for new positions in the portfolio. Really important that you do both of these tasks now. There are various ways to measure the performance of an analyst over time. In essence, this is the conviction level that the PM will have for the analyst. Here are a few broken down by tangible and intangible measurements. This is what a portfolio manager is also going to look at in terms of the performance of an analyst. Batting average Count the analysts winning positions over total positions. This metric allows the PM to evaluate how often an analyst has right versus wrong Slugging ratio. The analyst P and O their winning percentage over their losing percentage. This metric allows the PM to evaluate how much more an analyst makes when they're right as opposed to when they're wrong. How much they lose when they're wrong. Number of new ideas in the portfolio. Count of how many new ideas the analyst has added over a certain period of time. This metric allows the PM to evaluate the breadth of idea creation over a period of time. Some of the analysts P and L over a period of time. That one's obvious. The average alpha. The average stock price return of an alpha is compared to the average industry's relevant index. The metric allows the PM to evaluate an analyst identifying outperformers in their respective industries. Gross Exposure Rank this is long market value and short market value associated with a particular analyst. This metric demonstrates the analyst contribution the composition of a portfolio at a specific point in time. Net exposure the calculation here is long exposure less short market value associated with a particular analyst. This metric demonstrates the analyst's ability to contribute to both sides of the portfolio. Finding quality shorts is far more difficult than finding positions on the long side. So this will tell if an analyst is focused on both sides. A high gross exposure and a low net exposure is ideal. There's also some intangible measurements like teamwork, communication and grit. Really important that an analyst has those as well.