Security Selection:
The development of student competencies
Student managers have an opportunity to develop key analytical skills in the process of managing the SIF, detailed below.
Identifying Promising Companies
Financial Statement Analysis
Earnings Forecasting
Calculating Intrinsic Value
Identifying Promising Companies
Each student manager identifies promising companies for investment from an assigned industry sector (Financials, Consumer Discretionary, etc.). For each prospective investment, students calculate an intrinsic value, based on a thorough fundamental economic analysis of the company. An attractive candidate will be in a business with a stable or growing long-term sales trend; declining industries are generally avoided.
In estimating long-term sales potential for a company, demographic trends are considered, including both the age distribution and geographical distribution of the population. The fund’s investment style precludes high price/book stocks from consideration.
Student managers endeavor to find companies with sound fundamentals that are currently out of favor, or have growth potential not fully recognized by the market. Given the relatively small size of the fund, student managers can easily trade in and out of smaller companies that are “under the radar” of many large institutional investors and Wall Street analysts.
Financial Statement Analysis
Students reformulate both the income statement and balance sheet into separate operating and financing components. In some situations, financial transactions can mask underlying problems in the business. Viewing reformulated statements makes it easier to identify underlying strengths and weaknesses of operations, and trends over time.
Students compare key financial ratios with those of close industry competitors, both in terms of levels and trends. They look for companies with low to moderate debt levels, stable or improving profit margins, and stable or improving asset turnover.
Earnings Forecasting
Student managers create pro forma income statements and balance sheets for the company for future years. Since the key to value creation is the ability to earn a return on equity above the cost of equity capital, students evaluate the company’s past record at creating value from its capital investment (and R&D) decisions, and develop forecasts for the future.
Forecasting sales and profit margins requires an analysis of competition and barriers to entry in the business, the potential for cost savings through use of technology, the macroeconomic outlook, and the company’s operating leverage.
Earnings quality is emphasized in the course. Students use several diagnostics, some utilizing information from the statement of cash flows, to test for earnings manipulation. Appropriate corporate governance and compensation policies are other proven elements in long-term investment success. Companies with high levels of managerial stock ownership, reasonable salaries and bonuses, highly independent boards, and takeover-friendly corporate charters are favored.
Calculating Intrinsic Value
Calculating intrinsic value requires students to estimate costs of debt and equity capital for the company. Student fund managers recommend purchasing stocks with an intrinsic value well above the market price, thus providing a sufficient margin of safety. Student managers recommend sale when the market price exceeds the current estimate of intrinsic value, either because of a change in prices or fundamentals.