Brett Caughran

Brett Caughran



ASSESSING YOUR DOWNSIDE There are all sorts of methods & frameworks out there for selecting stocks on the buy-side, but I've found that the most common is the tried & true risk/reward ratio (which should be called the reward/risk ratio, but it doesn't quite roll off the tongue)

What is a R/R ratio? A R/R ratio is a measure of how much I will make if I'm right against a measure of how much I'm likely to lose if I'm wrong. Generally, the stock market is incredibly efficient, so even top traders are only correct 52-54% of the time (some less), R/R is key.

To create a R/R ratio, I first want to forecast my return on the stock. I generally baseline this with a 12m return, or where I expect the stock to be trading in 12 months. What P/E will this stock trade at in the fall of '23 on '24 EPS? Against that upside case, I will

think through my Risk case - what happens if things go wrong. In investing, we are looking to stack the odds on our side. If we can find a coin that pays $2 for heads and we only lose $1 for tails, we are flipping that coin all day! That coin has "positive expected value (EV)".

We are looking for positive EV situations on an individual basis (positive R/R's, situations with attractive asymmetry). Makes sense. But your R/R ratio is only a reliable indicator if you return and risk inputs are accurate. I've had too many students in class pitch me a +75%

return against a -7% risk and say "hey this is a 10:1 R/R". Yet the stock has 30% annualized volatility. Sorry kid, no bueno. An accurate assessment of your risk case is critical to calculate an accurate R/R ratio but also to assess your risk budget on a stock.

I've trade very stable, cash flowing large caps and I've traded very spicy cash burning biotechs. My bias is always to size based on volatility, or stock based Value at Risk. So in my mind, these two stocks are of equivalent attraction, both 2.0x R/R, and both positive EV

situations where I should be investing. Yet Stock A has 2x the downside risk of Stock B, so Stock A should have a max sizing of half stock B. Again, personal decision (though if stock A is a 10% position and Stock B is a 5% position, stock A is 4x as important to your P&L).

As a junior analyst, doing a good job of analyzing risk cases is an important part of the job (PARTICULARLY if your PM is a VAR sizer like me). Don't be the new analyst who goes in and says "this stock only has 7% downside". DEVELOPING A RISK CASE

I like to break stocks down to the basic pricing formula of P/E times EPS = Price. In this formula, there are two areas that can hurt you on an equity: 1) a reduction in forecast EPS (or EBITDA/Rev) 2) a reduction in the valuation multiple applied to those profits

So as I'm thinking about my Risk case, I usually start on profits, or EPS. I'd venture to guess that 90% of the weakest decile of stocks over most 12 month periods have had some sort of profit issue - guidance cuts, sell-side negative revisions, reduction in margins, slowing

profit growth. So as we assess a stock's risk case, we first want to think about Risk scenarios to profit. How will I do that? First, I'll study the history of the business (which the model, with it's historical data, makes it wonderfully easy to do). I'll ask myself:

- How steady and stable have profits & free cash flow been in this business? - Has the biz gone off the rails over the last 15 years? What happened? - Where are the fragilities in this business model? - How did this business fare in the GFC? or Covid? - Seek out case studies

Isolate the KEY DRIVERS of the business and start to build intellectually honest sensitivities around how bad things could get in a risk case. I like to actually create a copy of my MOD tab and have a MOD-RISK where I run through these risk case KDs. What revenue/EBITDA/EPS

metrics result from that risk case. In conversations with management, seek guidance on the risk case. As a junior analyst, I might even blame my PM "hey, my PM asks me to run risk cases on all of our investments, how bad could XYZ factor get in a risk case or recession?".

The responses may be illuminating (good or bad. Generally CEOs/CFOs defensive to this question raise red flags for me). Once I've developed a risk EPS, I will think through my risk P/E. As silly as it is, so often stocks trade peak on peak (high P/E when things are going well)

and trough on trough (low P/E when things are going poorly). Look at the past trough levels of P/E on both an absolute & market relative basis, and apply that to the Risk EPS as a starting point. Also, critically, I want to see in the model how the risk case runs through the

BS and CF. Does a bit cut to revenue flow through profits at a high decremental, shifting net debt / EBITDA from 4x to 7x and blowing covenants? Well, that's a problem. Think two steps ahead on how cuts to profits can impact liquidity. Does a profit short-fall make mgmt think

about doing a dilutive raise such as a secondary or convertible? Try to conceptualize this ahead of time in your risk case. 10 BEST PRACTICES FOR DEVELOPING A RISK CASE 1) Isolate the precise factors that could go wrong and assess probabilities around those factors correctly.

2) Understand how a change in the external environment (GDP, inflation, housing starts, etc) or internal assumptions (volume, ASP, cost) impact idea underwriting. I like to have sensitivity tables on these variables. 3) Ask whether management has made the right decisions in

tougher periods in the past, and whether you trust them to steer the ship during a difficult period (or will they exacerbate the issues with a desperate M&A deal, for example). 4) Embrace a wide range of outcomes. When businesses crack, they often crack way harder than you would

expect. Especially if there is debt on the balance sheet, the equity can get really bad. Actual or perceived funding gaps kill equities. 5) Fully understand the bear case on your longs. Don't just give it lip service. Seek out someone who is short. Or for a key position, elect

someone on the team to pitch the bear case (when done well, a sign of a good investment culture, in my opinion). 6) Do not rationalize or allow thesis creep. If you see signs that your risk case is materializing, SELL NOW. Conceptualizing the risk case

ahead of time, in my experience, can actually help you recognize it when it happens. Have your risk case in your thesis. Pull up your trading plan. "oh crap, the risk case is playing out". Sell. 7) When industry conditions are changing (supply/demand, nature of competition,

regulatory), individual companies will be viewed as guilty until proven innocent, not vice versa. 8) the first miss is rarely the last miss. Businesses take time to adjust to changing environments, CONT'D

very rarely do managements assess a first miss correctly and align their business accordingly. 9) Understand the explicit & implicit bets underlying your investment, which generally include both a fundamental (profit forecast) and valuation bet (what you are willing to pay)

10) Firmly understand and assess a downside valuation case. What creates your floor? Tangible book value? Replacement / break-up value? FCF yield? Where has valuation support clicked on in the past? Lastly, again, create a realistic risk case. I will often look at reward/vol as

well as reward/risk. Analysts, your PM has been around the block and knows mistakes will happen. If you, in your initial underwriting, said "this stock has 40% upside if I'm right and 20% downside if I'm wrong" and the 20% downside case hits, and you accurately called the KD

impact, the valuation adjustment, and the resulting stock price reaction, in a perverse way that situation might earn you a bit of respect. You were wrong, but you did it well. HOPE THAT HELPS!!

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