Bottom-Up Relative Value Stock Selection
Find profitable bargains, correct the numbers, forecast upside, then price risk
- Difficulty
- Advanced
- Time to result
- ~months to results
- Steps
- 7
- Confidence
- 98%
This bottom-up process begins by screening individual companies for the combination of inexpensive valuation and solid profitability rather than making broad country or regional bets. Analysts then inspect financial statements and footnotes, correcting material accounting distortions that could make a company appear cheaper or more profitable than it really is. Candidates that remain attractive advance to a three- or four-year forecast of business fundamentals, with particular attention to profitability. That forecast supports a price target and an estimate of potential upside. Before inclusion, the upside is discounted for macroeconomic, political, and corporate-governance risks. The final decision is relative: a candidate must offer risk-adjusted upside competitive with positions already held in the portfolio.
Origin
Extracted from Masters in Business, where Lazard Asset Management's James Donald described the relative value process used for emerging-market equities.
Core principles
- 01Start with individual stocks rather than country forecasts
- 02Require attractive valuation and credible profitability
- 03Correct material accounting distortions before forecasting
- 04Estimate fundamentals over a multi-year horizon
- 05Discount explicitly for macroeconomic, political, and governance risks
- 06Compare risk-adjusted upside with existing portfolio holdings
How to run it
- 1
Screen for value and profitability
Identify stocks that appear inexpensively priced while demonstrating reasonably strong profitability. Use this as an initial filter rather than a final purchase signal.
Pro tip Apply consistent definitions of valuation and profitability across the investable universe.
Watch out A superficially low valuation may reflect weak accounts or risks not yet recognized.
- 2
Audit the reported accounts
Read the financial statements and footnotes closely to identify accounting treatments that distort valuation or profitability.
Pro tip Prioritize adjustments that could materially change the investment conclusion.
Watch out Comparing unadjusted accounts across jurisdictions can create false precision.
- 3
Re-test the adjusted valuation
Correct material distortions and verify that the stock still appears compelling. Reject candidates whose apparent cheapness disappears after normalization.
Pro tip Document each adjustment so the revised figures can be challenged and updated.
Watch out Do not preserve the original thesis by minimizing inconvenient adjustments.
- 4
Forecast multi-year fundamentals
Project the company's fundamentals, especially profitability, over the next three or four years. Connect each forecast to identifiable business drivers.
Pro tip Use scenarios where economic sensitivity or currency exposure creates a wide range of outcomes.
Watch out Emerging-market forecasts can be undermined quickly by economic crises or policy changes.
- 5
Derive a price target
Translate the normalized forecasts into a valuation and calculate the prospective upside from the current price.
Pro tip Keep valuation assumptions consistent with the company's profitability and strategy.
Watch out A high target based on optimistic assumptions is not a margin of safety.
- 6
Discount for external risks
Reduce the estimated value for relevant macroeconomic, political, and governance risks. Treat these risks as part of valuation rather than as an afterthought.
Pro tip Use direct country visits and regular updates to detect changing risks.
Watch out Political decisions can affect ownership rights, capital access, currencies, and individual corporations.
- 7
Compete for portfolio capital
Compare the candidate's remaining risk-adjusted upside with existing holdings. Add it only when it improves the portfolio's opportunity set within exposure limits.
Pro tip Allow countries with no attractive candidates to receive no allocation.
Watch out A cheap stock should not enter merely to fill a country allocation.
In the wild
An emerging-market manufacturer screens as inexpensive and highly profitable. Footnote analysis reveals that a nonrecurring gain inflated earnings, so the analyst normalizes profitability and recalculates valuation. The revised upside no longer competes with existing holdings, and the stock is rejected.
→ The process avoids buying a company whose apparent value depended on distorted earnings.
A Russian company appears cheap after its accounts are normalized and its operations are forecast. The analyst derives a strong price target but then discounts it for governance concerns and the possibility that political action could affect the corporation. The remaining upside is compared with safer holdings before capital is committed.
→ The portfolio recognizes political and governance risk directly in the investment decision.
Common mistakes
Treating cheapness as sufficient
A low valuation without sustainable profitability, clean accounting, and adequate risk-adjusted upside does not satisfy the process.
Ignoring accounting differences
Using reported figures without checking statements and footnotes can make companies from different markets look more comparable than they are.
Adding risk after the decision
Political, macroeconomic, and governance risks must reduce the valuation before the stock competes for portfolio capital.
Is it for you?
Best for
It is best for patient active equity investors with the resources to analyze company accounts and country-specific risks.
Not ideal for
It is not ideal for short-term traders, passive allocators, or investors unable to conduct detailed fundamental research.
From the transcript
“most of our strategies are more bottom up than top down, so we tend to start by identifying what looked like compellingly attractive stocks.”
“We then look closely at their financial statements and footnotes to see if there are distortions that are caused by that, and adjust for any…”
“That's where we look at some of these other type of factors like macroeconomic and political risk and governance risk as well, very important for…”
From the episode
James Donald Discusses the Sensitivity of Emerging Markets
James Donald