Selecting Value Stock – Step 1
Source: http://www.jarofquotes.com/
Understand the Company
Understanding the company is vital to value investing, without which there is really no way you can measure the real value of the company.
There are 1001 things about each company hence we most definitely will not understand everything about the company. As an outsider, we don’t live and breathe the company’s business so we will not understand the business fully, even big investors, with many analysts at their disposal, get it wrong sometimes. Honestly, we also don’t want to spend all our time analysing businesses as everyone has their own interest in life.
Hence, we just want to know enough for us to make a sound investment decision. With the help of many gurus and my own trial and error, I have consolidated the key aspects of a company that I believed are important for investors to be aware of.
Type of Business
We must understand the type of business that the company is running before we invest in it. This helps us to understand what is the company’s competitive advantage and its foreseeable future. Below are the standard questions that you must ask when understanding the type of business.
How does the company makes money?
Knowing how the company makes money gives you confidence in their business. For example, if you work in the banking industry and you know how banks make money, that will naturally give you more confidence to invest in banks. Understanding how does the company makes money will also help to identify potential rewards and risk of the business. Generally, avoid companies with overly complicated business model. We always invest in what we can understand.
What industry are they in?
The industry is very crucial. It helps to identify the competitors. If it is a highly competitive industry, the company’s market share is likely to be small. In this case, the company must be the market leader in order to do well. For example, Household Appliances is a highly competitive industry, you don’t really see a dominant market leader among LG, Sony, Electrolux, Samsung, etc. Whereas, Delivery Services is not as competitive, you are either with Fedex or DHL most of the time.
How is the industry doing?
No matter how strong the company may be, if the industry is in the downturn, its stock price is likely to be dragged down as well. For example, with the plummeting oil prices, all oil and gas company stock prices are crashing even though some of them are not as affected as others. You should only invest in the industry when it is showing signs of recovery.
Is the revenue recurring or sales-based?
At Investing Always, we prefer recurring revenue. This is because it provides consistency in the revenue which makes the earnings more predictable. For example, telecommunication companies get their revenue from monthly subscriptions which is recurring, in fact most subscriptions are lock-in with a 2-year contract. This means, the telecommunication companies’ future revenue is almost guarantee for the next 2 years. While sales-based revenue is less certain as it depends on the demand of the customers. Examples of sales-based revenue are fashion and F&B companies.
If you could not find the answers to the above questions, it means you do not have a basic understanding of the business. My advise will be to stay away from this company for now until you understand their type of business better.
Economic Moat
Economic moat refers to the company’s ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share. All companies have a market position relative to their industry peers, and as a rule of thumb, the market leaders tend to do much better than market laggards. However, market leaders may not be able to maintain their lead if they do not have an economic moat to keep the competition at bay. Below are examples of an economic moat.
Does the company has a unique way to remain competitive? Is the company able to raise prices without losing sales to competitors?
- High switching costs. It can be quite costly to switch from Windows to Apple if your whole office is already running on Windows. (e.g. Microsoft and Apple)
- Wide distribution network . It is very difficult to compete with an existing company with a wide distribution network of shops because you probably won’t walk an extra 5 km to the cheaper competitor just for a carton of milk. (e.g. Walmart)
- Economies of scale. With large purchasing power, giant corporations will be able to maintain cost advantage and undercut the prices of any competitors. (e.g. Coca Cola)
- Premium branding. Customers will always prefer a premium brand that gives them confidence. Once the brand is well-established, it can be quite difficult for others to compete with. (e.g. Nike and MacDonald’s)
- Patents. If the company’s products or services are patented, the competitors will not be able to copy it. However, do note that patents will expire over time. (e.g. pharmaceutical companies)
- High entry barrier. Companies can maintain its competitive advantages if the industry entry barrier is very high. This usually means a lot of capital cost is required in order to be part of the industry. (e.g. Utilities companies and Railroad companies)
- Regulation advantage. Companies may be protected from competition if the government regulation is very strict or prohibitive in a particular industry. (e.g. Stock exchange operators and healthcare operators)
Foreseeable Future
After understanding the current business and its economic moat, we need to make an assessment of its future. If the future looks bleak, you may want to reconsider investing in that company. This portion is more subjective so here are some questions to guide you.
- Does the company have more room to grow in the future? If the industry is very saturated, it will have limited growth.
- Will the products or services continue to be in demand in the future?
- Do you foresee the company losing its market advantage in the future? Maybe a potential change in regulation or the patent is expiring?
- Does the business face any future risk?
- Technology Risk: Is the business in danger of being replaced by advanced technology? (e.g Digital camera replacing photography films)
- Regulation Risk: Is the business in danger of a changing regulation? (e.g. Uber facing problems over taxi regulations)
- Labour Risk: Is the business heavily depend on low cost labour?
- Single Supplier or Customer Risk: Is the business over-reliant on a single suppler or customer?
- Key Person Risk: Is the business successful only because of one key person? (e.g. Steve Jobs)
Company Management
- Do they have a significant holding in the company? It is better if the management have a key stake in the company for alignment of interest.
- Are they reasonably paid? If they are overpaid with underperforming, it is a red flag of a bad management.
- Do they run the business well?
- Any third party transactions? To avoid any suspicious activities or conflict of interest.
- Any recent resignation of key executives? It could indicate a split in the management team that can affect the business.
With an understanding of the company, you will be able to invest more confidently. Next step, we will check on the Finances.
See you soon!
Investing Always,
Pete
