A successful interview essentially boils down to answering hedge fund interview questions that address two aspects of your candidacy: cultural fit and strong technical skill set. A strong technical foundation is important especially if you are just breaking into the hedge fund industry, as you’ll be the heavy lifter in building forecasts and valuing stocks to help your portfolio manager make the right investment calls.
Testing your technical skills typically consists of 2 parts: a set of technical questions in your 1st round process, followed by a 2 – 3 hour modeling test in the 2nd round. During the modeling test, you are given a company’s financial filings and background information, and perhaps access to CapitalIQ, FactSet or Bloomberg, and the task is to value a business using DCF and multiples.
If you get to the modeling test, you are already in the mid to late stage of the interview process. Before you get there however, hedge funds typically will ask you some fundamental questions to test your technical baseline. These technical questions will typically be asked during your first or second interview, and we’ll focus on tackling these questions in this article.
We’ll go through 5 technical questions that are essential for you to prepare. All 5 questions are directly from Citadel’s interview process, and Point72 ask a similar set of questions in its 1st round interview. Because these firms are large and recruit on-campus at business schools, the questions are standardized as to weed out candidates that are less technically sound.
Let’s get started:
“What is beta? What’s your guess of the beta of a company?”
This question is to test your fundamental understanding of beta neutral investing. Beta neutral investing is common among hedge funds including Citadel, Point72, Millennium and UBS O’Connor, which run equity portfolios that has an overall weighted beta of close to 0. Having a portfolio beta of near 0 would neutralize the portfolio’s exposure to the market. Prominent long/short funds mentioned above are famous for generating returns with the beta neutral strategy over the years regardless of how the S&P has performed.
Here you need to be able to verbally explain what beta is. You’ve used beta plenty of times, but how do you explain it to your interviewer?
The beta of a stock measures how it moves relative to the market, and here are 2 straightforward points to remember about beta. Beta has two components: magnitude and direction:
- Magnitude: If a stock has beta of 1.2, it means the stock is 20% more volatile than the market. For example, if the S&P moves up 10% over a year, the stock would’ve moved up 12%. If a stock’s beta is 0.8, it is 20% less volatile than the benchmark.
- Direction: The beta can be either positive or negative. If the stock’s beta is negative, it means the stock is “counter-cyclical” – the stock moves against the market. You can find stocks with negative beta in industries that hold up well in difficult economic times, such as consumer staples and basic metals (gold & silver).
Beta is very useful in hedging. In building a beta neutral portfolio, you want to short a basket of stocks to offset your long positions, which would create a portfolio with beta close to 0.
Here’s an example: Let’s say you are excited about the company-specific prospect of Coca-Cola (KO) and would like to long the stock, but you’d like to hedge out the market exposure. You can neutralize the position by shorting Pepsi (PEP), since they are in the same industry and share similar betas. This is the basic idea behind long/short investing.
A stock’s beta measures how a stock moves relative to the market. For example, high-tech growers such as Workday (WDAY) typically have beta higher than 1, and some consumer staples such as Wal-Mart (WMT) have beta less than 1. Some stocks have negative beta, which indicates they are counter-cyclical to the economy. Beta is important in measuring the risks of the portfolio, and in hedging positions to build a beta neutral book.
“What is the difference between volatility and beta? What makes one company more volatile than another?”
The two sound similar, but measure two different attributes of a stock.
- Beta is the measure of a stock relative to the market. It’s useful for calculating the portfolio’s market risk and for hedging individual positions.
- Volatility on other hand measures how a stock has moved relative to itself during a time period. Think of it as the stock’s percentage change over a time distance – a day, a month, or a year.
Let’s take a high growth bio-tech stock as an example. Regeneron Pharmaceuticals (REGN), has a beta of 1.2. This is much lower than the beta of typical small cap bio-tech stocks, because Regeneron is a large company with an established track record and multiple projects in the research pipeline. On the other hand, it has different historical volatilities for different time periods. For example, we say that REGN has moved 45% over the past 100 days, 40% over the past 50 days, and 36% over the past 30 days.
Stocks with high volatility tend have smaller market cap and more volatile earnings drivers. You would typically see significant movements in small-cap tech stocks after they release earnings. Vice versa, boring large-cap dividend stocks without much quarterly earnings surprise tend to have lower volatility.
Volatility and beta measure two different attributes. Beta measures how a stock has moved relative to the market, both in terms of magnitude and direction. Volatility measures a stock’s rate of change over a time period. Dividend stocks tend to have “low vol”, while high-tech or bio-pharma growth stocks tend to be volatile, particularly around earning releases.
“When do you use EV/EBITDA and when do you use P/E?”
Relative valuation using multiples is the most common valuation method on the buy side, and particularly so for hedge funds. Hedge funds typically focus on near-term earnings and compare companies within the same industry. Using multiples is a quick way to gauge whether a stock is over or under-valued relative to how it has historically traded. Using multiples for relative valuation is also a great way to find shorts to hedge out long positions.
As you have seen in the past, the two most common multiples used are Enterprise Value/EBITDA and Price/Earnings. So as a buy side analyst, how do you decide when to use one over the other?
To make that decision, we first need to know that there are two major differences between EV/EBITDA and P/E:
- EBITDA is Earnings before Interest, Taxes, Depreciation and Amortization. Because EBITDA excludes interest and taxes, EV/EBITDA can compare companies independent of their capital structure and tax regime. Businesses have different amounts of debt, and operate globally with tax rates across the spectrum. EBITDA is a measure that disregards these differences and compare the business profits on the same level. Therefore, EV/EBITDA is a more accurate measure when comparing a debt-ridden company in Norway and an all-equity business in Bermuda.
- EBITDA also excludes depreciation and amortization, which are non-cash expenses. Excluding non-cash expenses puts firms with varying depreciating and amortizable assets on equal footing for comparison. For example, an Internet business will likely have a large amortization of intangibles such as software, patents, brands, while a freight shipping business with a new fleet of vessels would have large depreciation on the income statement.
- With these two differences in mind, we use EV/EBITDA for an equal comparison of firms across geography and industries, because EBITDA excludes interest, taxes, and non-cash expenses.
Another case where you would use EV/EBITDA over P/E is when the company still has negative earnings. These are typically smaller businesses in the growth phase, or maturing and declining businesses headed together reorganization, such as the coal industry. In the case of companies with negative earnings, you can only use EV/EBITDA as a measure.
But when do we use P/E?
P/E is widely used because it’s convenient and accessible. Valuation of the S&P is often quoted in terms of P/E, which makes it easy to compare the P/E of a company to the market average. Oftentimes we are also comparing a stock to its competitors in the same industry, which usually have similar debt leverage ratios. Using P/E provides for a quick and broadly accurate analysis.
Let’s look at the Internet space as an example. Internet businesses typically don’t take on a large amount of debt, have similar ratios of intangible assets relative to their total assets, and typically operate and compete in the same region (think Silicon Valley). The smartphone component supply chain on the other hand are mostly based in Taiwan and China, where they do have higher debt load and have similar depreciation to sales ratios. In most cases where you compare businesses in the same set, P/E is quick and appropriate.
I often use EV/EBITDA for an accurate comparison among businesses, because it puts firms with different capital structure, tax regime, and account treatment on equal footing. However, P/E is convenient when I compare a firm to the S&P average or firms in the same industry with similar capital structure.
“Why can’t you value a company using Enterprise Value/Net Income or Market Cap/EBITDA?”
This is typically the follow-up question after you compare when to use EV/EBITDA vs. P/E.
Enterprise value includes both debt and equity, while net income is net of interest paid to debt holders. In other words, Enterprise Value is the value that both debt and equity holders care about, while net income is purely earnings to equity holders. The ratio of EV/NI is comparing apples to oranges. EV/NI would vary among companies with different capital structures, and does not make sense for comparison.
Vice versa, a company’s market cap is the firm value minus cash and debt. It’s the value of assets attributable to just the equity holders. On the other hand, EBITDA is used to pay interest to debt holders, and accrue earnings to shareholders. A company with a lot of debt could have a high Market Cap/EBITDA, while a debt-free business would have low Market Cap/EBITDA, even if both companies have similar business fundamentals.
Neither multiple compare companies on an apple-to-apple basis. Enterprise Value and EBITDA are both capital structure independent, while Market Cap and Net Income are attributable only to equity holders. Both metrics would not make for a fair comparison between companies with varying debt loads.
“Which industries are conducive to looking at book value as a metric?”
P/B is another important multiple, and typically used for asset heavy, cyclical industries. This is why P/B is beloved among value investors including Warren Buffett, who look at cyclical industries for cheap “cigarette butt” businesses that trade below the hard assets they own.
First, let’s take a look at what Book Value includes. Book Value is the value of a company’s net assets – receivables, inventory, plants, equipment, brand, intellectual property, minus accounts payable, debt, and other liabilities the company carries.
Therefore if you buy the company today for P/B below 1 and sold off all of its assets, you would still make a positive return, even ignoring the income generating power the business has by utilizing its plants, labor, patents, etc. This is why value investors like to use P/B, because they look for downside protection in the event of a bankruptcy. If the Price/Book is below 1, the company can be sold for more value than the stock is currently worth.
Vice versa, if a company is hitting peak earnings, then its Price/Book could be elevated as well, suggesting a potentially overvalued stock.
Book value is important for industries that are cyclical and with “hard assets” – such as industrials, manufacturing, and automotive. Price/Book is important in finding value stocks. I’d look for companies with low Price/Book which provides a margin of safety, and with inflection in earnings for potential upside.
There you have it, 5 essential questions to prepare for in your long/short hedge fund interviews. What other technical hedge fund interview questions are you preparing for? Leave a comment below and we’ll go over those as well.
- Buy side interviews essentially boil down to 2 aspects: cultural fit and technical competence.
- Large hedge funds try to weed out less technically sound candidates with a set of technical interview questions, usually in the 1st or 2nd interviews before your modeling test.
- Citadel and Point72 are particularly known to ask these questions in their interviews, and above we answer 5 questions taken straight from Citadel’s interview process.
- These questions test your fundamental understanding of long/short investing and relative valuation using multiples.
- Prepare for these questions using the sample answers above. Good luck!