Developing an Investment Thesis for Your Company
Imagine that you are an investment manager looking to buy just one company in an industrial sector comprised of 14 stocks. How would you choose the best investment?
Would you look at ROE? What about free cash flow, or dividend coverage ratio, or gross margin, debt to EBITDA, working capital as a percentage of revenue, or one of perhaps two dozen other financial ratios?
As an IRO, you do not have to make investment decisions. However, you do need to speak the same language as those who are investing, which means you have to know what metrics resonate with them and how to build an investment thesis using those metrics.
An investment thesis is an evidence-based point of view that answers the question: Why should I invest? In this issue of IR focus, we provide five tips on creating an investment thesis that is right for your company.
Step One: Know Your Industry’s KPIs, They Are Core To Your Thesis
Return on Equity (ROE), or the ‘mother of all financial ratios’ as it is referred to colloquially, is the key performance indicator (KPI) of how well a company uses shareholders' funds to generate a profit. To calculate ROE, take the profit for the year (or net income after taxes) and divide it by shareholders’ equity. So if a company generates a profit of $100 with $1,000 of equity, it would have an ROE of 10%.
Is this a good rate of return and, more to the point, is ROE a relevant metric in your industry? The answer to both parts of that question is…it depends on the industry.
In banking, ROE is a key metric and a 10% ROE would be substandard, as the Canadian Big Bank average in the five years through 2015 was 15.8%. Staying with banking for a moment, key ratios followed by investors include ROE and several others. One is the efficiency/productivity ratio. It is a measure of how much it costs a bank to generate $1 of revenue. The lower the cost (and ratio), the more cost efficient the bank. Other important banking KPIs include earnings per share (EPS) and book value per share and how quickly each is growing. A fourth is earnings retention rate; in other words, how much the bank pays out in dividends. A fifth is Common Equity Tier 1 ratio, which is a Basel III measure of financial solidity used by investors and banking regulators.
All of these ratios are important in banking, but that doesn’t mean they are widely followed in other industries.
Retailers typically promote same store sales as a KPI as part of their investment arguments. This measure excludes sales growth driven by new stores open for less than one year and is widely viewed as an indicator of the effectiveness of the retailer’s merchandising strategy. The same is true of market share, which is about as close to a universal measure of performance as any.
In mining, cost per tonne is key as it must be low enough to carve out a profit versus the price of the commodity mined. In value-added reselling, gross margin is indicative of pricing leverage while Days Sales Outstanding demonstrates how well (or poorly) receivables are managed. For REITs, capitalization rate (which is net operating income as a percentage of property asset value) is a KPI. The list goes on but the point is that part of building an investment thesis that is right for your company is to choose KPIs that investors in your sector care about.
To identify the right ones, start by studying sell-side analyst research and, in particular, the comparative ratios included in those reports. But don’t be shy about adding other KPIs to your thesis if doing so reveals a unique feature of your business. For example, a company that is entering a new market may wish to add to its investment thesis by disclosing bookings generated in that market each quarter.
Step Two: Decide What Those KPIs Mean and Weave A Story Around Them
Chances are, your company will not always show performance leadership on every metric that investors care about. However, even if your company is a laggard, discussing how your management team’s strategies/tactics are designed to improve performance can be an effective part of your investment thesis.
So for example, a mining company may be in the process of making a capital investment that will lower cost per tonne. Or a retailer may have just added a product line that is in high demand with consumers. Or a bank may be poised to cut branch staff to enhance its efficiency ratio.
The point is that by embracing a substandard KPI and describing a plan for improving it, you create a rationale for investing in your business over a competitor's, even if that competitor has better relative performance. In such cases, small upward movements in the relevant KPI over several quarters add credibility to your investment thesis. Armed with relevant internal metrics, the foundation of your investment argument is taking shape.
Step Three: Consider Third-Party KPIs to Bolster the Investment Thesis
An effective investment thesis is not just built on internal key performance indicators. Equally important is finding the right external metrics to buttress the story. Chief among these are statistics that scope the market opportunity for your company’s products/services.
As the expression ‘a rising tide lifts all boats’ suggests, investors are usually more committed to the shares of a company in a growing market than the shares of a business in a declining sector (unless they are pursuing a short selling strategy).
Finding statistics on the available market for your products is usually not difficult if you are in a well-defined sector. Technology is a good example. There are various credible third-party market research sources available to be quoted. If you are unsure about what sources to use, it is best to a) consult with your marketing department b) look at the sources your competitors use to support their investment theses and c) review the research published by brokerage firm analysts.
Chances are, institutional investors already have all the third-party research available to them and do not need you to provide it. However, if your story is not institutional grade, then including third-party facts takes on greater importance. Even in situations where research is widely available, it pays to include it as part of your investment argument as it demonstrates a level of sophistication that investors will find reassuring.
Step Four: Turn Your KPIs Into a Cogent Story
An investment thesis is not just a laundry list of financial ratios, no matter how relevant. It is a point of view – an argument – that must include a description of your company’s market positioning, strategies, competitive advantages, barriers to entry and growth prospects. Sometimes these descriptions cannot be fully or even partially supported with KPIs, but no investment thesis is complete without the ‘story’ that goes along with the right numbers. Once you have your thesis, flaunt it in your communications materials.
Step Five: Recognize that Your Argument Can Attract Different Types of Investors at Different Times
Beyond what you provide, investors will study market KPIs, including your stock’s price-to-earnings ratio, to decide whether your company is a bargain compared to alternative investments, a bargain compared to historical p/e trends or, in their view, is fairly priced or overpriced. Most certainly your investment thesis will help to shape these views but in the end it is the investors’ decision to make.
This presents another consideration: investors with different investing styles (growth, growth with income, momentum, value, deep value, etc.) will be attracted to certain investment theses over others. It is therefore worth defining the target recipient of your argument before developing it.
Overall, an investment thesis is grounded in/supported by facts, but those facts change over time as does the way a company presents them. So keep your investment argument up-to-date and make sure that you can prove your thesis over time with new facts.
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