In case you didn’t know, “For Dummies is an extensive series of instructional/reference books which are intended to present non-intimidating guides for readers new to the various topics covered. The series has been a worldwide success with editions in numerous languages.” …Wikipedia
We have often been asked by the investing fraternity about how we can go about evaluating stocks. Why do we always get it wrong and why is it so complicated that non-professionals can’t understand. Ancient philosophers would have dealt with this problem simply by asking more questions and debating them, thereby stimulating critical thinking and removing predispositions. Those who moved beyond the crowd did exactly that. They were the ones who asked the right questions, kept things simple and clearly understood the problem. Rest remained Dummies!
So, we decided to present a set of 5 questions in an attempt to simplify the process of evaluation, clear the garbage, structure the thought process and thereby enable stock selection.
What does the company do – this is so Basic
Do you understand the product or service offered by the company, to whom it is offered in terms of geography and profile of customers? Have you experienced the product or service offerings yourself? How vital is the company’s products/services for its clients? Are they easily replaceable?
If you find it challenging to answer this basic question then you are either under researched or the company has a complicated business model both of which should make you wary of investing. Develop a grasp on the economics of the business as its CEO would desire by studying how the business grew into its current shape since its inception.
Spend time contemplating the significance of the company from the perspective of its customers also look into satisfaction levels and how well the business retains them. Companies that understand their customer base well will keep track of how their needs are evolving. Incorporating that know-how towards product development will enable them to maintain their relevance factor in the long term to its customers.
Does the company have sustainable competitive advantage – is it special
Is the advantage sustainable? Can others recreate them, in how long? How profitable and competitive is the industry? How does the company handle suppliers? What are the risks posed by substitutes?
A sustainable competitive advantage enables the firm to protect profitability against competition for a longer period. It would be imperative to understand the key roles played by patents, licenses, brand loyalty and intangible assets which are common sources of these advantages. Keep in mind that the best returns are made from investing in businesses that are developing these advantages.
Today we witness several businesses burning cash to develop these advantages. Check for increase in customers and if continued importance is given to R&D, as these are signs that their efforts are fruitful. Pay attention to these advantages and look out for any declines, common threats include improvements in technology and rapidly growing industries.
This is an all-encompassing question which will also delve into the peer relationships, strengths, weakness, pricing and quality of the company’s offerings.
Quality of Management – tricky one
The prospects of any company is defined by the bandwidth of the promoters/top executives. Gauging the quality of management in a company is very important. There are a few indicators which might prove useful in understanding the worthiness of the decision makers in an organization.
First check out how the senior management is compensated? Are they buying or selling stock? Pay attention to disparities between company performance and management compensation
Managements with a long track record are more likely to be successful. Nowadays, reputed companies interact with the investment community on an on-going basis. Tracking down the narrative along with the follow up action provides significant insights and any mismatch can be easily captured.
Constitution of the Board is a key aspect, more independent qualified Board members auger well for better capital allocation decisions, integrity and shareholder protection.
Growth – Random variables X, Y and Z
How fast is the top line growing compared to peers and why? Is its growth organic or through M&A’s?
How has the company grown historically? How did management and companies previous M&As perform?
There are several variables to consider here. Statistically putting it in an equation with X, Y, Z… will not really help. Instead go deeper and identify the real reasons for growth. Growth supported by innovations or industry trends are more sustainable. Identify growth slowdowns by monitoring if business is targeting new customer bases, changing business models or paying higher proportions of earnings towards dividends.
Investors need to watch out for companies hastily entering new businesses that do not have much in common or in other words deviate from their vision. M&As are likely to be successful when managements have a history of successful acquisitions, displayed resolve by refusing overvalued ones and show an in depth understanding of the business being acquired. This is important especially in the current scenario when we are witnessing both start-ups as well as mature companies overpaying for acquisitions. Focus on cost savings and increase in revenue to ensure that the synergies claimed by management actually materialize.
Numbers say it all – Crunch and munch
No narrative will be complete unless financials are effectively scrutinized. Number crunching is generally considered a boring and tedious process, but it need not be the case. Filters can be used to skim out majority of the accounting shenanigans.
Strength of the balance sheet is measured by three important line items – Net worth, debt and cash levels Profit & Loss is evaluated based on the stability of margins, growth of top and bottom line Valuation can be compared using – Price earnings, Price to book, return ratios
The stocks that satisfy these filters are generally above average and report consistent profits. Adding the qualitative analysis to this result will throw out a decent number of companies which you can add to your portfolio. The relationship between growth, competitive advantages and intrinsic value is central to understanding when it’s worth paying up for a business.
There was a time long-long ago, when lack of information resulted in limited knowledge about a subject. Today we live in an exactly opposite scenario where we are bombarded with an incredible amount of information on a daily basis; but our knowledge level continues to remain pretty much the same. Screaming TV anchors are trained to ask questions that sensationalise rather than invoke any sense. The right questions will help decipher any problem and enhance decision making capability. It will encourage deeper introspection and improve the entire process of learning.