How Top Hedge Fund Analysts Build Models
Obsession over key drivers and granular revenue builds
Happy Easter! As we prepare to go deeper into modeling, there are a few important things to understand. The goal of buy-side modeling is very different from that of investment banking or sell-side equity research.
Sell-side models are nothing like actual buy-side models. You may hear conflicting views on whether sell-side models are useful, but in general they are not. There is a fundamental incentive mismatch. In a weird way, sell-side analysts serve both institutional investors (who buy their research and trading flow) and the companies they cover, from whom they need access for CEO/CFO meetings, earnings calls, events. You can imagine how to maintain both relationships, they can’t be too aggressive with assumptions, forecasts, etc. The sell-side is incredibly good at many things, but the model isn’t useful.
So, why build a buy-side model? Because it allows you to quantify the business model, test your hypotheses (and therefore your variant views), and quickly and accurately track incremental changes to the business and their impact on earnings potential.
While we have previously said that the model alone is not a direct source of a variant view, there is an important caveat to that. A good model with the right business drivers and granularity can help you identify critical inflection points, which can be a source (or a starting point) of a variant view. For example, modeling revenue well can help you spot accelerations and decelerations in key drivers of the stock.