Over the years, we have compiled down a comprehensive (yet not exhaustive) checklist of how to go about analysing business quality of a potential investment. When you actually go about researching about a stock, you realise that you don't have a proper structure of research which will help you cover all the important points related to the business.
We do agree that researching and investing is an art and not a science which cannot be compiled down to one checklist which will protect you from all the dangers of the investing world. But we do believe that researching with a proper structure and clear path in mind will help you attain more information in a better way as well as process it and understand it systematically.
THE INDUSTRY SPECIFICS
The business quality research should always start with the industry characteristics by which the business is influenced. The first thing to find out is how the industry operates in general, what are its raw materials, how is the competition, how are the margins, its level of cyclicity, how the demand/supply economics of the product/services work etc.
CYCLICAL V/S NON-CYCLICAL
Talking about cyclicity, if the industry is cyclical in nature, it becomes all the more important to learn about the trends and timings of the cycle. Buying a cyclical business during good times can be devastating. In cyclical industries, when the economy grows, cyclical companies do well. Conversely, if the economy experiences a downturn, they perform poorly. They follow all the cycles of the economy from expansion, peak, and recession all the way to recovery. Examples, restaurants, hotel chains, airlines, furniture, high-end clothing retailers, the steel industry, travel, auto and construction and automobile manufacturers. These are also goods and services people tend to forgo when times are tough. When people stop or hold off buying because of a reduction in purchasing power, company revenues may start to fall. In the event of a long downturn, some of these companies may even go out of business. These are exactly the types of industries people avoid when the economy turns sour.
A utility is one example of a non-cyclical company. People will always need power and heat for themselves and their families. By providing a service that is consistently used, utility companies grow conservatively and do not fluctuate dramatically. Non-cyclical securities are generally profitable regardless of economic trends because they produce or distribute goods and services we always need, including things like food, power, water, and gas. Even though they provide safety, they are not going to skyrocket when the economy experiences growth. Level of cyclicity can also be fairly judged from using the factors that influence the demand and supply economics of the products and services.
Coming to margins, a fair sense of the trends and the factors affecting industry products are crucial. Margins for example can be influenced by level of competition, volatility of the raw material prices, cyclicity of the industry etc. For example, for IT industry it is important for businesses to attract skilled employees at a reasonable cost, for auto sector steel, rubber and aluminium prices matter. Ease of availability and cost of procurement becomes essential factors for any company to determine their raw material prices.
FUTURE OUTLOOK AND OTHER DYNAMICS
Other factors like per capita consumption, changing behaviour etc can guide us towards rate at which the industry can grow in the future. Even factors like quality management and good decision making needs to be given more importance in certain industries like banking.
NOTE: It is really important to analyze the business keeping the industry in mind. Point being, you need to consider what all metrics actually matter in the industry. For example, you can’t have a similar process for analyzing an infra company against an IT firm. For infra, cash is king whereas for IT, employees are its assets. (unrelated businesses require different styles)
CHARACTERISTICS OF A GOOD BUSINESS
» Wide profit margins to absorb downturns and keep business profitable
» Favourable industry structure- Monopoly/Oligopoly/Perfect Competition etc.
» Strong economic moat to protect margins and future profits
» Scalability of the business – business should be expandable and have high growth
» Ever growing demand along with a good amount of market potential ready to be captured. Industry should continue to be in demand even after 20 years.
It’s easy to get caught up in fast growth and fat profit margins. But it is crucial to keep in mind the duration of the (normalised) cash flows that you expect to receive in the future. That is why company with moats are preferred as with them investors have more certainty regarding the duration of expected cash flows. For certainty of continued profits, try to think of it as this way – will the seller able to copy my competitive advantage? If yes, then at what cost?
» Some industries structurally have better characteristics than others. Take foe example, retailers on one end and asset management firms at the other end.
» Technological companies can more easily create moats (because of switching costs) than hardware companies. Moats of telecom companies depend upon favourable regulators and presence in areas with niche markets.
» Retailers have a hard time building moat. They have negligible switching costs. Wal-Mart has the low cost advantage which is an exception rather than a rule. Retailers therefore thrive to get repeat business through building loyalty.
» Service providers to businesses and companies in financial industry have wide moats. Financial industry has entry barriers and also has high switching costs. Commodity businesses can only have cost advantages as they lack pricing power.
These moats can be divided into 2 parts, wide moat and narrow moat to reflect the durability. If you can’t identify a specific reason why a company has good returns, the company likely does not have a moat. Retail businesses have no economic moat – easy come easy go.
MOAT #1: INTANGIBLE ASSETS:
» Brands are only termed as competitive advantage if it increases consumer willingness to pay more for similar product or increases customer captivity (customer loyalty).
» Companies with regulatory licenses have one of the strongest economic moats. Competitors just cannot come in anytime and eat out company’s profits. But remember, regulatory licenses should not restrict pricing of products because if they do, it will be of no competitive advantage for the company.
» For patents, it will only be considered as a moat if the company has demonstrated innovation because patents are expired and can be easily challenged and once they are expired, profits can be easily eaten away. Be wary of companies depending on 1 or 2 patents for their entire earnings.
MOAT #2: SWITCHING COSTS
» Switching cost not only means the exit fee charged by companies but also includes the time spent in switching, the convenience, the hassle and the future problems that could arise after switching.
» Think in terms of customers. If the benefits of switching are outweighed by the costs involved (both monetary and mentally) it is unlikely that consumer would switch.
» Benefits of switching as well can be so uncertain that people tend to stick where they are. Consumer oriented businesses like retailers, restaurants, packaged goods companies usually have very low switching costs.
MOAT #3: NETWORK COSTS
» This type of competitive advantage is usually found in information and technology companies whose value increases with increase in their customer base. If the value of the goods/services increase with the number of people, then the most valued networks will be the one attracting more new users thus creating a vicious cycle and squeezing out smaller networks.
» The benefits of having a network are non-liner i.e. the economic effect of business value increases at a faster rate than the network itself. Remember that for a company to benefit from network effect, it needs to operate a closed network and when this opens up, the network effect can dissipate in a hurry.
MOAT #4: COST ADVANTAGES
» Cost advantages can be durable but they can also disappear very quickly, so it is important to determine if the present cost advantages are sustainable or not.
» In industries with easily available substitutes, cost advantage moats can be found. Even in industries like automobile sector where fixed costs are huge, companies can likely benefit from spreading the fixed costs on units. So the cost of additional benefit per unit will be minimal but it will largely attract the customers due to added benefits.
» Cost benefits can stem from: cheap process, better location and unique assets .
» Process based advantages don’t last forever but they enable the company to make a lot more money than competitors for long. For ex, Southwest Airlines and DELL both have their unique strategy of providing low cost services to their customers. Southwest does this by catering only to second-tier class and specialising in it and DELL has its own distribution channel which enables it to cut the middlemen and save cost.
» Location based advantages are more durable as they are hard to copy. For ex, waste haulers can save a lot on their fuel if their dumping site is close to their pickup site.
» A company can have unique assets in the sense that it might lock in special mining area at cheap rates which has good extracts or low cost extraction from it. Or if a company produces paper pulp in area where trees grow faster than the rest due to climate conditions. It is mostly related to location.
MOAT #5: SCALE ADVANTAGES
» Talking about scale advantages, bigger is only ‘relatively’ better. If you compare 2 of the largest airline producers they won’t have any cost benefit against each other. The higher the fixed costs compared to variable costs, the better the scale advantage.
» Scale advantages can come up from manufacturing, distribution and nice markets. In case of manufacturing, the closer the factory is to 100% capacity, the better as it can spread its fixed costs to larger sales base. For a company with larger sales base, addition cost of providing service is minimal but the benefit perceived is huge.
» For companies in niche market, they can build near monopolies in markets where the market demand itself can sustain a few companies profitability. Other major companies won’t come in the niche industry as they first have to invest a lot and then they chances of profitability is very low. Thus, big fish in small pond have huge advantage of scale.
3-STEP PROCESS FOR CHECKING MOATS:
» Check historical numbers – Has the company shown excess returns? If not, will the company change the future earnings and show excess returns?
» Check the moat – Which moat does the company possess? Why has the company been able to generate excess returns more than competitors/what enables them to do so?
» Sustainability of the moat – How sustainable is the moat? How easy/likely it is for the competitors to copy the moat? For how many years will the moat sustain?
» Great products (not protected or which can be easily eaten into)
» Strong market share (fixed cost advantage not sustainable if competitor takes over)
» Great management (they can go away anytime)
» Operational efficiency (unless protected by something that can’t be easily copied)
Technology enabled firms have the biggest threat to erosion of their moats because they are basically fighting for products which are better/faster/cheaper. Technological change can be unpredictable and unexpected and can change the industry standards overnight.
Key things to watch out for moat erosion:
» Consolidation of once fragmented customers or becoming concentrated (Wal-Mart)
» Change in industry landscape (cheap labor becoming available in India/China)
» Entry of irrational competitor (Rolls Royce cutting prices)
» Trying to enter into areas with no competitive advantage (Coca-Cola/Microsoft)
» If customers start to push back prices (Oracle)
Let's move on to the second part of the Business Quality Checklist! This is the main crux of the business quality analysis which covers areas like:
(i) Understanding the business
(ii) Identifying the type of growth
(iii) Factors affecting demand / supply of product
(iv) Porter's 5 forces etc.
Do check it out. Click here.