The last lens
Investing in shares calls for careful analysis of a company's business, but a company is only a micro unit in its industry and, in turn, in the economy. Its fortunes are driven by external conditions, macroeconomic and industry-specific, that affect every company in the industry. How an individual company performs also depends on company-specific factors. So once the analyst knows how the economy is doing and how the industry is likely to prosper, the company-specific questions begin.
- 1What is the company's business? (This is what defined the industry back in chapter 6.)
- 2What is its business model?
- 3Does it enjoy a competitive advantage over its competitors?
- 4Does it have the capability to exploit opportunities and withstand threats?
- 5Is the management competent enough to identify and execute the appropriate strategy?
- 6Does management have a vision for the future, with visibility into expected short-term performance and long-term goals?
- 7Does the company have a governance structure that makes the board and management act in the best interest of the company and its shareholders?
- 8Is that governance structure properly implemented and executed?
Each answer raises follow-up questions. The analyst should go to the depth needed for relevant answers rather than accept superficial ones, and although many of these questions are qualitative, should obtain data that substantiates the findings.
Understand the business first
Equity investing is part ownership, so understanding the business or business model comes before investing. Qualitative research starts with three questions: what does the company do and how; who are the customers and why do they buy; how does the company serve them.
Successful fund managers repeat one rule: invest only in firms whose business you understand. In the research checklist this is one of the most prominent items, and no analyst should move to the next question without being able to state what the company does in one line with precision and clarity. There are over 4,000 companies listed and active on Indian exchanges; nobody can track them all. Buy shares in a few companies you understand rather than many you do not. Warren Buffett: wide diversification is only required when investors do not understand what they are doing.
Sectors have their own yardsticks
Each sector has unique parameters. For retail, footfalls and same-store sales (SSS); for banking, net interest income (NII) and net interest margin (NIM); for telecom, average revenue per user (ARPU); for hotels, average room tariffs. Analysts need in-depth sector knowledge before they research companies within it, which is what chapter 6's KPI topic was for.
Business models compete, not products
Each company has its own way of doing business, and the efficiency with which it produces and delivers products and services varies from one business to another and drives earnings. The analyst has to understand the entire business model. The syllabus quotes management guru Dr Gary Hamel: competition in the marketplace is not between products and services but between the business models of the competing companies.
Two companies sell the same generic medicine. One manufactures in its own plants and sells through its own field force to doctors; the other outsources manufacturing and sells online direct to patients. Same pill, different cost structures, different customers, different margins, different risks. Comparing the two products tells you almost nothing; comparing the two business models tells you which will earn more.
An option that suggests moving on to valuation while the analyst still cannot summarise the business precisely contradicts the syllabus. The one-line test comes first, and qualitative findings still need data behind them.
- A company is a micro unit inside its industry and economy; external factors hit every company in the industry, but performance also depends on company-specific factors, so the analyst moves from economy to industry to company.
- Eight questions: what the business is, its business model, any competitive advantage, capability to exploit opportunities and withstand threats, management competence to identify and execute strategy, vision with short-term visibility and long-term goals, a governance structure that makes board and management act for shareholders, and whether that structure is actually implemented. Go deep, and substantiate qualitative answers with data.
- Understand the business before investing: what the company does and how, who its customers are and why they buy, how it serves them. If you cannot state what a company does in one precise line, do not move on. With over 4,000 active listed companies, buy a few you understand; Buffett: wide diversification is only required when investors do not understand what they are doing.
- Every sector has its own parameters (retail: footfalls and same-store sales; banking: net interest income and net interest margin; telecom: ARPU; hotels: average room tariffs) and every company its own way of doing business. Gary Hamel: competition in the marketplace is not between products and services but between the business models of the competing companies.