Chapter 2

Building an Investment Thesis

The world of due diligence is centered around investment theses. A company buys another company, or an individual invests in a company, because they have some deeply-held belief.

I demand ask that all of my employees read the newspaper every day. This is because hedge fund managers do this all the time: they need to be fully-informed on world affairs in order to make a judgment call.

About a decade ago, when millions of Jeff Bezos’ customers at that point had said “I need to buy something, I’ll go to Amazon”, he realized that some enterprise IT customers will say “I don’t want to buy something, could I get it from the cloud instead?” And thus, the insanely profitable Amazon Web Services was borne from the investment thesis that businesses don’t want to build and maintain on-site web infrastructure.

Michael Burry, whose view of the U.S. housing market before the financial crisis of 2018 made him very, very rich, had an investment thesis about the complicated, interconnected world that he claims anyone could have spotted if they just paid attention.

Even my good buddy Ben, upon seeing that Netflix was releasing its own show called House of Cards, told me several years ago “I like that company because of this show. I want to buy the stock.” (Fun fact: if one bought Netflix stock on the day of that announcement, it would have made about a 900% return. He did. I didn’t.)

These are all investment theses.

In its simplest form, it is something you believe that the market does not.

Look at oil companies. The fact that the largest ones still command trillions of dollars of collective market cap means that a lot of people think oil and gasoline markets are here to stay. An investment thesis could be that “electric cars will dominate the market in 30 years and oil companies will go bankrupt as a result." Hence, you’d want to short these companies.

Two truths and a lie

If you’re new to the world of investing, don’t be shy about generating and discarding a lot of investment theses. Fund managers may generate a handful of ideas, do some cursory research to toss out half of them, do more in-depth research to move others ideas to ‘hold,' and finally trade based on the remaining ideas.

Investment theses should be relatively short to write down, even if the underlying idea is complicated. For example:

  • “The student loan market is broken. More regulation is coming. This will harm private sector players.”

  • “The arrival of autonomous cars means more data is flying around. There will be a huge amount of demand for cell tower infrastructure.”

  • “Kids are the fastest-growing demographic on YouTube. Esports and beauty brands are the likely beneficiaries of this trend.”

These are easy to understand and all are less than 25 words. Investment theses may be hard to research and/or hard to trade on, but they should always be relatively easy to articulate.

I don’t know if you know what I know

I defined an investment thesis as something you believe that the market does not. At this point, you probably have the first part nailed (“something you believe”) but you struggle with the second part (“that the market does not”). How do you find out what the market believes?

Here are some easy (but by no means conclusive) ways to answer these questions:

How quickly is XYZ public company expected to grow?

Most public companies have sell-side equity analysts who forecast company performance. And websites like Seeking Alpha will report the consensus of these forecasts (look up a ticker and click on the ‘Earnings’ and then ‘Earnings Estimates’ section). Public companies themselves will issue guidance for future growth. You should reference these and compare it to your own beliefs.

Is XYZ’s product going to experience user adoption?

A lot of investment theses are centered around a company whose new product line will accelerate growth. Owners of Nintendo stock were delighted, upset, and delighted again when the Wii, Wii U, and Switch exceeded, missed, and exceeded expectations over the last decade. As you form your investment thesis, you'll want to gauge the reactions of current and potential users. I love the website Product Hunt for this. Simply type a product or product category and you can get a numerical score for their ‘hotness’ (in the form of a number of upvotes) as well as a qualitative assessment for what they like/dislike (in the form of comments).

Once you've got your thesis formulated, it's time to dive into due diligence. The first step is the subject of our next chapter: Market Sizing.

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