Whether you are a portfolio manager pitching on CNBC or a young analyst just out of school pitching a stock in a job interview,¹ the stakes are extremely high. Everyone in the investment business needs to find great ideas and then pitch them to their audience to succeed on Wall Street.

The title of this book contains two critical components—pitching and the perfect investment. In it, we provide a detailed road map to help you identify great investment ideas and a set of guidelines to pitch those ideas with the goal of getting your audience to act. If you don’t have a great investment idea, there is nothing to pitch. If you have a great idea but cannot communicate it, your pitch will fall on deaf ears.

The person making the buy or sell decision is the person to whom you are pitching. That person is most often a portfolio manager whose goal is to beat the market, which means he needs to earn an investment return above the market return after fees and adjusting for risk. The portfolio manager’s most important concern is performance and, to generate good performance, the manager needs to find ideas to put into his portfolio that will beat the market. If a portfolio manager hears a compelling pitch and believes that the idea will outperform, he will begin salivating like one of Pavlov’s dogs.

The ideal outcome of a stock pitch is that your idea is so captivating in both its content and delivery that the portfolio manager feels compelled to immediately “clear his desk” and begin work for fear of missing an opportunity to help him outperform the market.

One of the primary challenges all analysts face is determining the value of a stock, which represents a fractional ownership of a business. The book begins by laying the foundation of how to value an asset, where we discuss the different subcomponents of cash flow: timing, duration, magnitude, and growth, as well as uncertainty and the time value of money, all of which impact an asset’s value, as we show in Figure I.1.

We then address the importance of discounting future cash flows in determining an asset’s value, which is also a critical component in the foundation of valuing a business, as illustrated in Figure I.2:

With the goal of ultimately determining the value of a stock, we start the process with simple examples, and then relax constraints, adding more complexity to the analysis, while building up to real-world examples. We use a simple DCF to value a “plain vanilla” bond, then a perpetuity, and then a stream of cash flows, as we show in Figure I.3.

With these tools, we then take on the challenge of calculating the value of a simple business—a neighborhood lemonade stand. We start the analysis with the assumption that the lemonade stand does not grow or face competition, which makes the initial valuation task much simpler.

However, since all businesses face competition in the real world, we need to relax this assumption and assess the company’s competitive advantage, as it is a critical component when estimating future cash flows and determining the value of growth. We show that without an identifiable barrier that prevents other companies from entering the market, competitive pressures will erode the lemonade stand’s excess returns, which we show will have a significant negative impact on its future cash flow and overall valuation, as seen in Figure I.4.

Once we explain how competitive advantage impacts a company’s future cash flow and return on invested capital, we turn to the very real challenges of valuing growth. Most people believe that all growth is good. We show that the perceived value of growth can be misleading, as not all growth produces actual value. We use several examples to illustrate the difference between good growth, bad growth, and worthless growth, which we suspect might surprise some readers.

We culminate the valuation section by discussing the concept of intrinsic value and defer to Warren Buffett, Professor Roger Murray, and Seth Klarman to explain why it is important to think about the stock’s intrinsic value as a range of values rather than a single-point estimate or number.

We have found that most analysts spend an inordinate amount of time conducting exhaustive research believing the goal is to arrive at a precise and accurate estimate of a company’s intrinsic value. They then compare their estimates of the company’s value with the market price and, if there is a large enough disparity between them, declare the security as mispriced, which they then claim represents a significant opportunity to make money. When the analyst finally pitches the stock to a portfolio manager, they are left dumbfounded that the idea is rejected. The analyst does not know what went wrong with the pitch and usually is perplexed as to why the portfolio manager did not adopt the idea.

The fact remains that all the research in the world will not matter if the analyst cannot articulate why the stock is mispriced. While the analyst might present a convincing argument that his estimate for the value of a stock is correct, the portfolio manager will never feel comfortable adopting the idea without a complete understanding of what other investors are missing.

To address this concern, we begin the discussion of market efficiency by providing tools to more fully understand how the market prices stocks and identify whether a genuine mispricing exists. We first highlight the difficulty of beating the market, discuss the efficient market hypothesis, and then explain what it means for a stock to be efficiently priced. This framework stresses the role information plays in market efficiency and shows that an efficiently priced stock is one that “fully reflects all available information.” From here we establish the conditions or rules required for market efficiency (Figure I.5).

We then demonstrate that the wisdom of crowds is the mechanism governing the tenets of market efficiency. Although many investors claim to understand the wisdom of crowds, the concept is often articulated simply as “The crowd will arrive at a better answer than the individual.” This oversimplification misses critical elements of what makes a crowd wise and what factors drive it to madness. We present several examples that highlight different facets to explain how the wisdom of crowds functions. We use stories like the Beatles’ forgotten Aloha from Hawaii album, featuring the infamous fifth Beatle, Clarence Walker,² to show that the crowd does not need much information to arrive at the correct answer, although we also show that false or wrong information can skew the outcome and result in a systematic error.

After establishing a firm understanding of the wisdom of crowds, we discuss how the process applies to the stock market. We explain that for the consensus (the crowd) to arrive at an accurate estimate of value, the following four conditions must be met:

1. Information must be available and noticed by a sufficient number of investors.
2. The group of investors must be diverse.
3. Investors must act independently from one another.
4. Investors cannot face significant impediments to trading, otherwise information will not be incorporated into the stock price.

We then show that the consensus can arrive at the wrong estimate of a stock’s value when errors occur in the dissemination, processing, or incorporation of information, which alone or together can cause mispricings.

We then turn attention to behavioral finance, which is believed by many people to be an alternative to the efficient market hypothesis. We discuss how human behavior can turn the wisdom of crowds into the madness of crowds, but only if the collective’s behavior produces a systematic error causing the market to lose its diversity or suffer a breakdown in independence, which are two crucial conditions that make crowds wise. We also explain how human behavior can limit the incorporation of information, which can also cause a stock to be mispriced.

By this point in the book, we will have established the rules of market efficiency and shown how the wisdom of crowds implements those rules. We also will have demonstrated how human behavior (behavioral finance) can muck up the works and cause the wisdom of crowds to lose its effectiveness. This section ends by demonstrating why behavioral finance is not an alternative to the efficient market hypothesis; rather, is a part of the efficient market hypothesis, as we illustrate in Figure I.6.

Armed with these insights, we show the analyst how to begin his research process with the goal of finding situations where genuine mispricings exist. The book establishes the importance of having a variant perspective, a concept created by legendary investor Michael Steinhardt. We show that developing a variant perspective helps the analyst identify the source of the mispricing and provides a process to establish an advantage or edge in the market. The discussion describes the three potential advantages an investor can develop, which mirror the three tenets of market efficiency:

1. An informational advantage is when the investor has information other investors do not have that has not been adequately disseminated in the market. With an informational advantage the investor can state, “I know this will happen.”
2. An analytical advantage is when the investor looks at the exact same data set as other investors but sees things that other investors don’t see. However, with an analytical advantage the investor can only state, “I think this will happen.”
3. A trading advantage is when the investor can trade or hold the security when other investors are unable or unwilling to take or hold a position.³

We also discuss the concept of a catalyst, which we show is defined as any event that begins to correct the stock’s mispricing. By the end of this section, you will have the tools to determine if you have a true variant perspective, if the perceived mispricing is genuine, and if you possess an advantage or edge over other investors.

We then focus the discussion on risk. The terms risk and uncertainty are used interchangeably in the investment business and often are misunderstood. We discuss the difference between the two terms and explain that uncertainty is defined as a situation where the potential outcome is indeterminate, while risk is defined as the possibility of loss or injury. We then show that financial risk is present only when capital is committed, which is the only time an investor has the possibility of financial loss. We further demonstrate that there are two types of risk when an investor commits capital—being wrong in estimating intrinsic value or in estimating the time it takes for the mispricing to correct, as we show in Figure I.7.

We also highlight how one can mitigate these risks by increasing the precision and accuracy of the estimates of value and time, using the targets in Figure I.8 to illustrate the point and show how the two measures can reduce investment risk, as seen in Figure I.9.

At this point in the book, we will have explained how to:

1. Calculate the range of intrinsic values for a stock.
2. Articulate why the stock is mispriced.
3. Determine whether you have a variant perspective and an advantage over other investors.
4. Assess the investment’s level of risk.

In other words, you will have all the tools you need to vet the perfect investment.

The book then turns to pitching. We show that the portfolio manager has four key investment questions he needs answered concerning any idea he is pitched before he will take action. We explain that the manager’s first instinct, when hearing a new idea, is greed, and the question that comes to mind is, “How much money can I make?” However, fear begins to get the better of him as he shifts his thinking from “How much can I make?” to “How much can I lose?,” which becomes the second question he needs answered.

If the idea offers sufficient return given the level of risk, there is a third factor that needs to be addressed, which reflects the portfolio manager’s unease that the opportunity looks too good to be true. The question the manager asks himself at this point is, “Why me, O Lord?”⁴ and the analyst will need to convince him that a genuine mispricing exists to answer this question successfully.

Once this concern is put to rest, the portfolio manager most-likely will raise one final issue—“How and when will the next guy figure it out?”—knowing that he will only make money if other investors eventually recognize and correct the mispricing.

The portfolio manager will adopt an idea only if the four questions are answered to his satisfaction. We show how to use Steinhardt’s framework to structure answers to address the manager’s four key questions and arrive at the perfect pitch, as demonstrated in Figure I.10.

Because portfolio managers expect analysts to supply them with compelling investment opportunities, the analyst’s primary role is to find and present ideas that will beat the market.

However, since the portfolio manager’s success depends on his investment performance, he will be extremely selective about which ideas he selects for his portfolio and will put any new idea under intense scrutiny to identify its flaws. The analyst must be able to defend his analysis to survive this grilling.

Portfolio managers are also extremely busy. They are inundated with information and pitched new ideas throughout the day, and are always short on time. To the portfolio manager, his time is a finite resource and most precious asset. Therefore, he will be also extremely selective in allocating his time and, if the analyst is given an opportunity to pitch his idea, the analyst must be quick, concise, and persuasive.⁵

We provide the tools to overcome these challenges. We show that the most effective pitch is organized into three segments: a 30-second hook, a 2-minute drill, and a longer period of Q&A. The hook must be simple, succinct, and extremely compelling. The goal of the 30-second hook is to capture the portfolio manager’s attention and leave him wanting to know more about the idea, which leads naturally into the 2-minute drill. The 2-minute drill allows the analyst to articulate his main arguments, address the manager’s four questions, and further express the attractiveness of the investment. The objective of the 2-minute drill is to draw the portfolio manager further into the idea and entice him to engage in Q&A, which allows him to ask questions concerning issues and topics the analyst did not address in the first two stages. We have found that this three-segment structure makes the most efficient use of the portfolio manager’s time and maximizes the chance that the analyst’s idea gets adopted.

Most portfolio managers will have their guard up concerning any new investment idea they are pitched. Imagine that they have a highly alert, slightly paranoid, heavily armed⁶ sentinel in their head to protect them from bad investment ideas and from individuals wanting to waste their time. We can call this guard Dr. No.⁷ This layer of protection produces obstacles that the analyst must overcome to get her idea adopted.

We show there are three primary components to the structure of a pitch: security selection, the content of the message, and the delivery of the message.

A typical pitch plays out like a scene from the movie Wall Street, when a young Bud Fox finagles his way into Gordon Gekko’s office and gets a precious few minutes of Gekko’s time. Gekko quickly gets down to business, stating, as he looks up at Fox, “So what’s on your mind, kemosabe? Why am I listening to you?” In the movie, Fox pitches his first idea: “Chart breakout on this one here. Whitewood-Young Industries. Low P/E, explosive earnings, 30% discount to book value, great cash flow, strong management and a couple of 5% holders.” Gekko shuts him down, “It’s a dog. What else you got, sport?”⁸

Interestingly, art imitating life as this scene is all too common in the investment business. Fox may have done extensive research on Whitewood-Young, but it was clearly not the right stock to pitch to Gekko.

Portfolio managers have a template in their mind of what their perfect investment looks like, called a schema. A schema is a type of mental model comprised of the manager’s implicit checklist of investment criteria. The manager’s investment schemas are shaped by their domain-specific knowledge, which is comprised of the facts and experiences they have accumulated over their lifetime.

When evaluating a new idea, the portfolio manager compares it to their schema through the process of pattern recognition⁹ to see if the idea matches a favorable pattern or should be rejected.

The critical first step in the analyst’s process is to find an idea that fits the portfolio manager’s schema. Determining if an investment idea will appeal to a portfolio manager is like determining if the portfolio manager would find a bacon sundae appealing.¹⁰ Similar to a schema of the perfect investment idea, the manager probably has a schema for the perfect sundae. When the manager is presented with a “new idea” such as a bacon sundae, they use their “sundae schema” to decide if the new sundae appeals to them, as we show in Figure I.11.

As we emphasize throughout the book, it is critical for the analyst to find an idea that fits the portfolio manager’s schema. Most young analysts make the understandable mistake of pitching an idea that they like rather than one that the portfolio manager will like. This approach is like concluding, “I like bacon sundaes, so the portfolio manager will like them, too.” However, whether you like bacon or bacon sundaes is irrelevant. The only question you need to answer is, “Does the portfolio manager likes bacon sundaes?” This insight stresses the importance of identifying and understanding the criteria that comprise the portfolio manager’s investment schema, which we show in Figure I.12, and then selecting an appropriate stock to match it.

Unfortunately, achieving this insight is not an easy task. We explain that while some of the manager’s criteria will be objective and articulated clearly, other criteria will be subjective and open to interpretation. Making the task even more challenging is the fact that the manager often has additional criteria that are unstated. The lack of specificity in the subjective criteria makes it difficult for the analyst to uncover, decipher, and satisfy all the requirements in the manager’s schema. The fact that some of the criteria remains unstated makes the task all that more challenging.

An experienced portfolio manager’s schemas have been refined through decades of investing and become more complex and nuanced as the manager gains additional experience. Over time, a manager’s investment criteria get so ingrained in his mind that it becomes second nature and almost impossible to articulate fully.

Because the criteria have become second nature, there is no explicit checklist in the manager’s mind that the idea must match; rather, he gets a certain “feeling” when he hears a good idea. Consequentially, most seasoned portfolio managers often are unable to fully articulate their criteria. A quote from legendary investor Leon Cooperman epitomizes this phenomenon perfectly:

We try to find some set of statistics that motivate us to act. The analogy I have always used is that when you go into the beer section of the supermarket, you see 25 different brands of beer. There’s something that makes you reach for one particular brew. In the parlance of the stock market, there’s some combination of return-on-equity, growth rate, P/E ratio, dividend yield, and asset value that makes you act.¹¹

Although satisfying the portfolio manager’s objective criteria will get him to at least listen to the pitch, the manager will reject the idea if it fails to satisfy his stated subjective and any unstated criteria, as shown in Figure I.13. We show the analyst how to assess the different criteria necessary to get the portfolio manager to adopt his idea, with careful attention paid to cracking the code of his subjective criteria.

Once the analyst has selected an idea appropriate for the portfolio manager and completed the necessary research to fully understand the opportunity, the information must be organized carefully into the content of the message. Using the Toulmin model of argumentation, we show how to structure this information to create persuasive and convincing arguments. We then walk through the most effective way to stress test, and then present, these arguments to maximize their impact when presented.

Finally, once the analyst has organized the message, constructed the arguments, and battle-hardened all elements of the content, he is ready to deliver his pitch.

We stress the importance of keeping presentation materials simple and focused on answering the portfolio manager’s four key investment questions. We also show that most information gathered through the research process is extraneous and unnecessary to the pitch.¹² Despite this fact, most analysts insist on packing too much content onto their slides. They are either trying to demonstrate the exhaustive research they have performed or do not know what information is most relevant to their pitch. This approach often results in the analyst losing the forest for the trees as their main arguments become lost in a sea of data. Unfortunately, a presentation that contains superfluous information increases the portfolio manager’s cognitive load significantly and forces them to extract the relevant message themselves. Faced with a disorganized, albeit data intensive presentation, most managers will throw up their hands in frustration, abandon the pitch, and lose interest in the idea.

We emphasize the fact that multitasking is a myth and explain that a portfolio manager can pay attention to only one thing at a time. Therefore, if his attention is absorbed in trying to decipher a data-packed slide, he is not listening to the analyst, which undermines the effectiveness of the pitch. Therefore, when choosing accompanying information to present, the analyst should stay focused on keeping the slides simple and addressing only the key points to the message, as seen in Figure I.14. We encourage the analyst to heed the sage words of Judd Kahn, “Less is more.”

Since the analyst is the one delivering the content of the message, the impression he makes can have a significant impact on the portfolio manager’s receptivity to his recommendation. We use envelopes to illustrate this point. Imagine the manager has asked you to send a write-up of your analysis and recommendation ahead of the meeting. You can choose either of the following two envelopes. Which one would make a better impression?

You might ask, “Why should the envelope matter? They both contain the exact same message. Isn’t it the content that is most important?” The answer is, “Yes, but . . .”

It is obvious which of the two envelopes makes a better impression. We use the example to bring attention to the numerous nonverbal factors that will affect the portfolio manager’s receptivity to the analyst and his pitch. While having nothing to do with the content of the message, these additional considerations will influence the portfolio manager’s perception of the analyst’s capability and credibility. We discuss important factors such as eye contact, physical gestures, posture, dress, hair style, and, believe it or not, how the wearing of glasses makes you look intelligent. After all, if the content of the message is the same, whose recommendation would you take?

Let’s begin the journey. We hope you find that this book helps you succeed on Wall Street.