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Fundamental Analysis (Part 2): Qualitative Factors – Internal & External Environment

16 Nov

Qualitative Factors – The Company

Before diving into a company’s financial statements, let’s take a look at some of the qualitative aspects of a company. Fundamental analysis seeks to determine the intrinsic value of a company’s stock. But since qualitative factors are difficult to quantify, incorporating that kind of information into pricing evaluations can be difficult.

On the flip side, as we’ve demonstrated, you can’t ignore the less tangible characteristics of a company. In this section we are going to highlight some of the company-specific qualitative factors that you should be aware of.

 

Business Model

Even before an investor looks at a company’s financial statements or does any research, one of the most important questions that should be asked is: What exactly does the company do? This is referred to as a company’s business model – it’s how a company makes money. You can get a good overview of a company’s business model by checking out its own website or getting more information from the Philippine Stock Exchange (PSE).

PinoyInvestor Academy - Fundamental Analysis - McDonaldsSometimes business models are easy to understand. Take McDonalds, for instance. They sell hamburgers, fries, soft drinks, salads, etc. and this is the same product in any McDonald’s branch. The standardization of products is how they drive down costs, while revenues come from sales of the products and the franchise fee and rental fee of their franchisers. It’s a pretty easy business model to understand.

Other times, however, you’d be surprised how complicated it can get. Boston Chicken, Inc. is a prime example of this. Back in the early ’90s, its stock was the darling of Wall Street. At one point the company’s CEO bragged that they were the “first new fast-food restaurant to reach $1 billion in sales since 1969″. The thing is, they didn’t make money by selling chicken. Rather, they made money from high-interest loans and royalty fees charged to franchisees!

On top of this, management was aggressive with how it recognized its revenue. As soon as it was revealed that all the franchisees were losing money, the house of cards collapsed and the company went bankrupt.

PinoyInvestor Academy - Fundamental Analysis - Warren BuffettAt the very least, you should understand the business model of any company you invest in. The “Oracle of Omaha”, Warren Buffett, rarely invests in tech stocks because most of the time he doesn’t understand them. This is not to say the technology sector is bad; it’s just not Buffett’s area of expertise. He doesn’t feel comfortable investing in this area.

Similarly, unless you understand a company’s business model, you don’t know what the drivers are for future growth, and you leave yourself vulnerable to being blindsided like shareholders of Boston Chicken were.

 

Competitive Advantage

Another consideration for investors is a company’s competitive advantage. Competitive advantage refers to what a company has or does that makes it stand out from the competition. A firm’s long-term success is driven largely by its ability to maintain a competitive advantage.

PinoyInvestor Academy - Fundamental Analysis - competitive advantagePowerful sources of competitive advantage create a moat around a business allowing it to keep competitors at bay and enjoy growth and profits. We have seen this in the case of Coca Cola’s brand name and Microsoft’s domination of the personal computer operating system. When a company sustains its competitive advantage for the long-term, its shareholders can be well rewarded for decades.

Having a distinct competitive advantage means a company is performing better than rivals by doing different activities or performing similar activities in different ways. Thus, investors can expect that few companies can compete successfully if they are doing the same things as their competitors. 

 

Management

Just as an army needs a general to lead it to victory, a company relies upon management to steer it towards financial success. Some believe thatmanagement is the most important aspect for investing in a company. It makes sense – even the best business model is doomed if the leaders fail to properly execute the plan.

So how does an average investor go about evaluating the management of a company?

This is one of the areas in which individuals are truly at a disadvantage compared to professional investors. Fund managers with millions of dollars for investment can schedule a face-to-face meeting with the upper brass of the firm. Individuals or retail investors, however, cannot set up a meeting with management just like that.

Every public company has a corporate information section on its website. Usually, there will be a quick biography on each executive with their background, employment history, and any applicable achievements. Don’t expect to find anything useful here. Let’s be honest: We’re looking for dirt, and no company is going to put negative information on its corporate website.

Instead, here are a few ways for you to get a feel for management:

 

1. CONFERENCE CALLS

At the very least, the Chief Executive Officer (CEO) and Chief Financial Officer (CFO) host quarterly conference calls. The first portion of the call is management basically reading off the financial results.

What is really interesting is the question-and-answer portion of the call. This is when the line is open for analysts to call in and ask management direct questions. Answers can be revealing about the company, but more importantly, you need to listen for candor. Do they avoid questions, like politicians, or do they provide forthright answers?

 

2. MANAGEMENT DISCUSSION AND ANALYSIS (MD&A)

The Management Discussion and Analysis is found at the beginning of the annual report. In theory, the MD&A is supposed to be frank commentary on the management’s outlook. Sometimes the content is worthwhile, other times it’s boilerplate.

One tip is to compare what management said in past years with what they are saying now. Is it the same material rehashed? Have strategies been implemented? If possible, sit down and read the last five years of MD&As; it can be illuminating.

 

3. OWNERSHIP AND INSIDER SALES

PinoyInvestor Academy - Fundamental Analysis - Bill GatesJust about any large company will compensate executives with a combination of cash, bonuses, and stock options. While there are problems with stock options, it is a positive sign that members of management are also shareholders. 

The ideal situation is when the founder of the company is still in charge. Examples include Bill Gates (in the ’80s and ’90s), Michael Dell, and Warren Buffett. When you know that a majority of management’s wealth is in the stock, you can have confidence that they will do the right thing.

As well, it’s worth checking out if management has been selling its stock. This has to be filed with the Securities and Exchange Commission (SEC), so it’s publicly available information. Talk is cheap – think twice if you see management unloading all of its shares while saying something else in the media.

 

4. PAST PERFORMANCE

Another good way to get a feel for management capability is to check and see how executives have done at other companies in the past. You can normally find biographies of top executives on company web sites. Identify the companies they worked at in the past and do a search on those companies and their performance.

 

Corporate Governance

Corporate governance describes the policies within an organization denoting the relationships and responsibilities among management, directors and stakeholders. These policies are defined and determined in the company charter and its bylaws, along with corporate laws and regulations.

The purpose of corporate governance policies is to ensure that proper checks and balances are in place, making it more difficult for anyone to conduct unethical and illegal activities. Good corporate governance is a situation in which a company complies with all of its governance policies and applicable government regulations in order to look out for the interests of the company’s investors and other stakeholders.

Although there are organizations (such as Standard & Poor’s) that attempt to quantitatively assess companies on how well their corporate governance policies serve stakeholders, most of these reports are quite expensive for the average investor to buy.

Fortunately, with a little research and the right questions in mind, investors can get a good idea about a company’s corporate governance. Here are some factors to assess covering the arena of corporate governance.
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1. FINANCIAL AND INFORMATION TRANSPARENCY

This aspect of governance relates to the quality and timeliness of a company’s financial disclosures and operational issues. Sufficient transparency implies that a company’s financial releases are written in a manner that stakeholders can follow what management is doing and therefore have a clear understanding of the current financial situation.

 

2. STAKEHOLDER RIGHTS

This aspect of corporate governance examines the extent that a company’s policies are benefiting stakeholder interests, notably shareholders’. Ultimately, as owners of the company, shareholders should have some access to the board of directors if they have concerns they want addressed. Therefore, companies with good governance give shareholders a certain amount of ownership voting rights to call meetings to discuss pressing issues with the board.

Another relevant area for good governance, in terms of ownership rights, is whether or not a company possesses large amounts of takeover defenses or other measures that make it difficult for changes in management, directors and ownership to occur.

 

3. STRUCTURE OF THE BOARD OF DIRECTORS

The board of directors is composed of representatives from the company and representatives from outside of the company. The combination of inside and outside directors attempts to provide an independent assessment of management’s performance, making sure that the interests of shareholders are represented.

The key word when looking at the board of directors is independence. The board of directors is responsible for protecting shareholder interests and ensuring that the upper management of the company is doing the same. The board possesses the right to hire and fire members of the board on behalf of the shareholders.

A board filled with insiders will often not serve as objective critics of management and will defend their actions as good and beneficial, regardless of the circumstances.

 

We’ve now gone over the business model, management and corporate governance. These three areas are all important to consider when analyzing any company. We will now move on to looking at qualitative factors in the external environment in which the company operates.

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Qualitative Factors – The Industry

Each industry has differences in terms of its customer base, market share among firms, industry-wide growth, competition, regulation and business cycles. Learning about how the industry works will give an investor a deeper understanding of a company’s financial health.

 

1. Customers

PinoyInvestor Academy - Fundamental Analysis - customersSome companies serve only a handful of customers, while others serve millions. In  general, it’s negative if a business relies on a small number of customers for a large portion of its sales because the loss of each customer could dramatically affect revenues.

For example, think of a military supplier who has 100% of its sales with the U.S. government. One change in government policy could potentially wipe out all of its sales! For this reason, companies will always disclose in their annual reports if any one customer accounts for a majority of revenues.

 

2. Market Share

Understanding a company’s present market share can tell volumes about the company’s business. The fact that a company possesses an 85% market share tells you that it is the largest player in its market by far.

Furthermore, this could also suggest that the company possesses some sort of “economic moat,” in other words, a competitive barrier serving to protect its current and future earnings, along with its market share.

Market share is important because of economies of scale. When the firm is bigger than the rest of its rivals, it is in a better position to absorb the high fixed costs of a capital-intensive industry.

 

3. Industry Growth

One way of examining a company’s growth potential is to first examine whether the amount of customers in the overall market will grow. This is crucial because without new customers, a company has to steal market share in order to grow. In some markets, there is zero or negative growth, a factor demanding careful consideration.

PinoyInvestor Academy - Fundamental Analysis 3

For example, a manufacturing company dedicated solely to creating audio compact  cassettes might have been very successful in the ’70s, ’80s and early ’90s. However, that same company would probably have a rough time now due to the advent of newer technologies, such as MP3s. The current market for audio compact cassettes is virtually nonexistent compared to the peak of its popularity.

 

4. Competition

Simply looking at the number of competitors goes a long way in understanding the competitive landscape for a company. Industries that have limited barriers to entry and a large number of competing firms create a difficult operating environment for firms.

One of the biggest risks within a highly competitive industry is pricing power. This refers to the ability of a supplier to increase prices and pass those costs on to customers. Companies operating in industries with few alternatives have the ability to pass on costs to their customers.

A great example of this is Wal-Mart. They are so dominant in the retailing business that Wal-Mart practically sets the price for any of the suppliers wanting to do business with them. If you want to sell to Wal-Mart, you have little (if any!) pricing power.

 

5. Regulation

Certain industries are heavily regulated due to the importance or severity of the industry’s products and/or services. As important as some of these regulations are to the public, they can drastically affect the attractiveness of a company for investment purposes.

PinoyInvestor Academy - Fundamental Analysis - Manila WaterIn industries where one or two companies represent the entire industry for a region (such as utility companies), governments usually specify how much profit each company can make. In these instances, while there is the potential for sizable profits, they are limited (in theory) due to regulation.

In other industries, regulation can play a less direct role in affecting industry pricing. For example, the drug industry is one of most regulated industries. And for good reason – no one wants an ineffective drug that causes deaths to reach the market. As a result, the U.S. Food and Drug Administration (FDA) requires that new drugs must pass a series of clinical trials before they can be sold and distributed to the general public.

However, the consequence of all this testing is that it usually takes several years and millions of dollars before a drug is approved. Keep in mind that all these costs are above and beyond the millions that the drug company has spent on research and development!

All in all, investors should always be on the lookout for regulations that could have an impact on a business’ bottom line. Investors should keep these regulatory costs in mind as they assess the potential risks and rewards of investing.
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Posted by on November 16, 2014 in Academy

 

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