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Blog > How to Master the Hedge Fund VAR Process

The Arootah Return Blog

How to Master the Hedge Fund VAR Process

Value-added research in a hedge fund may be one of the most important elements of the investment process. This step will require the utmost care and attention to detail.
How to Master the Hedge Fund VAR Process

Value-added research (“VAR”) in a hedge fund may be one of the most important elements of the investment process. This step requires the utmost care and attention to detail. If done correctly, it will uncover the variant perception that is needed to achieve great returns.

It’s important to have a research process that derives the greatest amount of value from the least amount of resources. In general, the process starts with identifying high-quality ideas. Value-added research on these ideas is necessary to make sure they are worth pursuing.

This type of research allows an analyst to determine the level of conviction they have in an idea. That conviction must then be communicated to the Portfolio Manager who must decide whether or not to include it in the portfolio and if so then decide on the sizing of the position. It is essential that the PM is given the best information possible in a consistent format to make the most informed decision.

VAR is essential in order to select only the highest quality positions for a portfolio. In addition, it leads to the ability to produce consistent results over time. Let’s take a look at what should be included in the research process.

Foundational Research

The first step in the process occurs when the analyst begins identifying possible key elements of the research story. This step comes prior to delving into the numbers. Having a strong understanding of what the company does, their products or services, and why people actually buy them, gives a strong foundational base upon which to build the rest of the research.

    • Empirical Experience: One of the best ways of doing this is through firsthand experience. There is a tremendous difference between reading about riding a bike and actually riding it. Read reviews and watch demos online to get a feel for how consumers interact and enjoy (or dislike) the product. Consider going to the company’s stores, talking to their customer representatives, and getting an overall feel of any “buzz” circulating through.
    • Industry Knowledge: In addition to understanding the company itself, having extensive knowledge on the industry, its layout, and the ecosystem it lives in is paramount to the process. This includes knowing the industry’s suppliers, buyers, and competitors.
    • Operations: Before moving on from background research it is necessary to fully understand the company’s operations from beginning to end, the industry and its supply chains, and how the company makes and spends money.
    • Open Mindedness: Don’t be too quick to form conclusions. Keeping the mind closed off to other possibilities will be detrimental to the rest of the research process. Think in the form of questions rather than answers to prevent this.

 

Four information sources for background research are:

  1. Regulatory Filings
  2. Industry Data
  3. Media Articles
  4. Company Information

 

Criteria

It is necessary to follow a process that will score all aspects of a potential investment to help the analyst provide a clear conviction level. This will serve as criteria to present to the PM; since they would have already decided that the idea is worth pursuing.

    • Management: Take time to understand the management, reputation, and experience of the company. Do they know how to allocate capital? How good of a grasp do they have on their own management process? When reviewing management keep in mind the quality of their skills, incentives, character, and how they manage resources. Pay close attention to how they operate the business and allocate capital
    • Industry: Be sure to gain a deep understanding of the industry. Who are the main players in the industry? What are the key market trends facing the industry? Is this company on the rise or falling?
    • Product or Service: Be sure to thoroughly understand the product being produced or the service being offered and what it’s used for. Why is it unique? Take time to experience the product or service.
    • Competition: Who are the main competitors? Are there any new entrants that may be in the queue?
    • Competitive Advantage: Assess if the company has a long-term competitive advantage. Is there a moat around the business? What is the value of the intellectual property? This also includes:
      • Cost Advantages – economies of scale, learning curve, proprietary technology
      • Customer Advantages – switching costs, habit forming, network effects
      • Regulatory and Other Advantages – patents, licenses
    • Chain: Gain a deep understanding of the chain of buyers and suppliers around this business. Be aware of any surprises that might be hidden in these chains, such as supply shortages.

 

  • Financials: Develop an accurate and complete understanding of the company’s revenues, cash flows, and valuation. Look retroactively to get a good idea of company trends.

It’s important to keep an open mind and look objectively at all the criteria presented by the analyst. Categories and subcategories will be weighted and scored later, but for now, look at just the facts of the criteria.

Sources

Take time to dig into the most difficult sources to get the highest quality information to bring to the Portfolio Manager. Here are some examples of various sources of research.

    • Competitors and Suppliers: This may take a great deal of legwork, but there can be a big payoff for the quality of information. By understanding exactly where this company is situated in its industry, how it compares to its competitors, and its relationships with its suppliers, it can be determined whether or not it’s a good fit for a portfolio.
    • Management Meetings: Come prepared to these with difficult to answer, open ended questions. Warren Buffet famously always asks two very telling questions:
      • If you had to go away for 10 years and put your entire net worth in one competitor and couldn’t sell who would it be and why?
      • If you had to sell short one of your competitors, who would it be and why?
    • Users: The end user of a company’s product or service can also provide valuable information in the research process.
    • Industry Data: Industry conferences can also be an excellent source of VAR. Accessing IBIS reports is another resource that should not be overlooked and can provide valuable information.
    • Financial Screens: Well-defined financial screens, leveraging data sources such as FactSet or Bloomberg, help narrow down a broad universe of securities that meet the criteria for inclusion in a portfolio.
    • Expert Networks: Expert networks can also be a great source for research. Be sure to understand all of the compliance issues around the usage of paid expert networks.
    • Management: If it is possible to get access to the company’s management or build a relationship with them, this can be a great source of information, but again, make sure to have a good understanding of the compliance issues surrounding interaction with the company’s management.
    • Street Research: Street research from sell side firms is a common source, however it may not always be the most useful since everybody can read it. The information may not be as reliable, since it comes from companies themselves, which are incentivized to slant the bull case.

 

  • Press Releases/Public Filings (10-K, 10-Q, 13(d) etc.): Financial information from press releases and public filings, including insider buying or selling, is another key source of information to understand.

All of this is just the tip of the iceberg, since there is so much information to accumulate and organize. Be sure to have a research management aggregator that serves as a central repository to organize all research in one place so that it is easy to access for everyone involved.

The quality, depth, and understanding of the research conducted will help the analyst present a helpful conviction to the Portfolio Manager. For the sake of all involved, the value-added research needs to be thorough and objective to help the PM make the best decision for the firm.

The Bottom Line

A value-added research process is essential for acquiring high-quality positions for a portfolio.
Value-added research is essential for the success of any firm, but so are proper leadership and management skills. Developing these skills is necessary to put the team in the best possible position to make the hedge fund successful. We invite you to take a look at our Executive Coaching, to truly give yourself an edge in this industry.

So, what does your research process look like? What do you still need help with? Let us know in the comments.

 

 

Sources:

https://www.schweser.com/cfa/blog/career-information/the-9-portfolio-manager-skills-required-for-success

https://arootah.com/top-10-insider-trading-prevention-tips-to-avoid-the-fate-of-mckinsey/

https://www.statista.com/statistics/271771/assets-of-the-hedge-funds-worldwide/

https://arootah.com/business-coaching/executives/

https://arootah.com/upgrade-your-business-and-career-with-a-mission-statement/

Disclaimer: This article is for general informational purposes only and is not intended to be and should not be taken as professional medical, psychological, legal, investment, financial, accounting, or tax advice. Arootah does not warrant or guarantee the accuracy, reliability, completeness, or suitability of its content for a particular purpose. Please do not act or refrain from acting based on anything you read in our newsletter, blog or anywhere else on our website.

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