Tell me about the Background of the Company
- Does what?
- Has a market share of?
- Does it how (capacity, assembly, service, etc)?
- Sells it how (partners, in-house sales, clients come to it)?
- Does and sells it where?
- Quick and dirty business Split
What are the Investment drivers?
- Quality, how is the model sustainable? How are returns defensible? Is this focus and differentiation or is it scale — or what?
- Growth, what sort of growth — organic or market share increment? What rate will the company show?
- Value is it cheap or expensive. Show the measure which supports your case most strongly.
- Theme: is this sector in favour — Or is it about to be? Is the management trustworthy — has it just changed? Is recent performance relevant?
What are the Investment Risks?
Company background information
- What are the company’s products?
- How much revenue does each supply?
- How does each contribute to margin structure?
- Are they growing at different rates?
- Draw the organogram
- Identify the different companies
- Identify the share ownership
(This helps us to understand management dynamics)
- Show where distribution outlets are located
- Show where capacity is located
- Show whence revenue is derived the different companies
Who owns the shares?
This section covers our four Value Drivers in full detail — they need not necessarily be called “Quality, growth, value and theme” but they should address them, and you should demonstrate your intention to address these issue by indexing them at the start of the section – to whit:
- Competitive analysis — the company has quality
- The outlook for growth — what is driving it; the various impulses
- Why this is cheap —DCF, Multiples and the “financier’s test”
- What is current thinking — how powerful is the theme
COMPETITIVE ANALYSIS IS THE FUNDAMENT FOR THE ENTIRE PROCESS.
There are two elements to this sort of analysis:
- the macro /big picture framework
- the micro issues in play.
The macro framework
It is very important that we have a basic understanding of what drives business returns in young marketplaces.
There are distinct phases:
- Emergence: Growth rates (because of the basis effect) are extremely high. Effectively early stage demand dramatically exceeds supply. Competitive influences are therefore extremely low. In consequence pricing environment is attractive and returns can be extremely high.
The attraction of these high levels of return is such that the industry becomes the focus of attention for much fresh capital.
The participants in this stage of the market can rarely command “real” quality. Quality is really only evident in the form of the extent to which their strategy recognises and prepares for the longer term changes in environment discussed below.
- Critical size:The resultant explosion of competition accelerates development of both product and market such that critical size is rapidly reached and demand and supply start to balance.
This rapidly leads to an intensification of competition and a consequent erosion of returns. Successful participants defend ROCE by increasing capital turn – “sweating assets”. Fundamental is therefore the fact that sufficient investment has been made in phase A for these assets to be able to produce the required volumes. This sort of strategic forethought is persistently a feature of successful companies (see later analysis of ROCE).
Companies unable to work assets like this fail to participate in growth to the same extent as they had expected — in other words, companies miss their forecasts. This is the first real evidence of the Unsustainability of business models and the indefensibility of returns unless backed by an APPROPRIATE (to both the product and the environment) business model.
IT IS UNDERSTANDING AND AUDITING THIS MODEL WHICH IS THE KEY TO SUCCESSFUL COMPETITIVE ANALYSIS
In this phase, the level of competition, its intensity and the effect it has on returns and earnings visibility means that companies rarely offer much in the way of short term investment quality. The demands of the environment are simply too much and the cost of the “fight” too high.
- Commoditization. This process begins surprisingly rapidly — although rarely simultaneously for all the component parts of an industry. It applies to the way in which the product is of value to the customers. It is generally caused by such that it is widely available, in very similar forms and thus the technology of itself is of reducing value to suppliers.
It results in a shift in the “value” of the product away from the technology towards such features as:
Reliability / credibility
speed of implementation
These changes necessitate changes in the nature of business models such that strategy reflects and responds to the new dynamics of the market place.
IT IS GENERALLY ONLY THOSE COMPANIES WHO HAVE ANTICIPATED THESE CHANGES (in the form of, say investment in global service and distribution networks, in the R&D necessary to convert a fledgling technology into a reliable, scalable, standardized package) WHICH EXPERIENCE SUCCESS IN THIS ENVIRONMENT.
In this phase, the “real” quality of participants starts to emerge. Pricing stabilizes, as do returns, and the — usually still strong growth — takes its proper position in subduing competitive pressure. Many companies will still be “alive” in this phase — particularly if they have gained artificial life spans from over generous financing rounds at bull market valuation levels. The trick, as in all these phases is to select the long term survivors.
…AND THIS TRICK COMES FROM UNDERSTANDING THE QUALITY
(NB niches are an important variant of this thinking. They are generally characterized by small size, so small in fact that the normal threat of heavyweight entry is subdued. These can be enormously profitable. They tend to suffer from limited upside potential since beyond a certain size, niche status is lost along with its associated competitive security).
At the micro level
Within the phases studied outlined above, business success is driven by micro strategy — INFORMED by macro dynamics. The one is useless without the other.
Successful analysis identifies the micro strategy and examines it in the context of macro conditions, giving rise to a judgment as to the likely success or otherwise of the business.
Thus in phase “A” strategy must differ from that in phase “B” and again in phase “C”. In order to do this effectively, the following features — drawn from Michael Porter’s work — must be understood. There are five competitive forces. These are:
- existing competitors, and
Every company must address these issues. At the micro level there are various practical issues which need to be considered. More significantly these issues have to be addressed in a specific macro context called STRATEGY. That is to say the way the company intends to exploit the specific conditions it faces to its own (and its shareholders’) benefit.
It is imperative that the relationships between ALL of these variables and the company (i.e. its strategy) are examined.
Generally speaking, strategy should fall somehow or other in to the following areas:
- companies with a particular FOCUS will always address these issues more successfully than those without
- those companies whose products are DIFFERENTIATIED, provided that differentiation is both VALUABLE to the customers, as well as PERCEIVED by them, will always have a greater chance of success.
DIFFERENTIATION = VALUE + PERCEPTION
Those companies whose products are not differentiated must employ alternative techniques to persuade customers to take product. The principle technique here is the DISCOUNTING OF PRICES and to use it successfully, the company must have high standards of COST CONTROL and/or the advantage of SCALE
There are a range of other influences including:
The DEMAND environment – i.e. GROWTH SUBDUES COMPETITIVE RISK
The market itself — i.e NICHE markets may be easier to defend because of the absence of heavyweight competition
TIME — all of these factors — especially differentiation, move with the times. (For example technological leadership in the early phase of an emergent marketplace is rapidly replaced by features such as speed of implementation, scalability, reliability).
Many industries — for whatever reasons — do not allow for high standards of competitive quality. Underlying technology may be widely available, supply may exceed demand, assets (especially human ones) may be difficult to retain and customer habits may change. Businesses in these environments are inherently poorly defensible.
A good example is the toy industry. Toys come into fashion and become unfashionable over a 9-month period. The business is thus characterized by risk — no buyer can be sure that what he stocks will sell until it is far too late. No manufacturer can invest in capacity since it will be broadly useless 9 months later. Hence toys are made in China by manual means.
Together these factors mean that sales visibility is low, volatility is high, returns are low (because of inefficiency) and there is regular entry and departure of capital. The exception which proves the rule is Barbie. The strategy of the major exponents (Hasbro and Mattel) remains diversification — which makes this about the only industry where that remains a viable proposition.
Hence, we MUST look for companies whose strategy is based around DEFENSIBLE RETURNS.
This is a very simple concept. It means that the company has developed/won some way of defending its competitive position. As a result of this its basic returns — driven by pricing — are sustainable and it can focus on exploiting growth for growth’s sake. As analysts it is very important that we can clearly explain how this is the case:
- Branded clothing companies do it by investing in advertising to develop a brand — if it’s not Armani it won’t do. Customers come looking for Armani — it is not the other way around.
- Capital goods companies do it by investing in developing a head start in core skills. This can be extremely expensive and time consuming for the competition to copy and delay tends to allow first movers time to develop other virtues such as reliability, next generation products etc.
- Commodity players do it by investing in scale which is equally difficult for competitors to imitate (tesco, Sainsbury’s etc being very good examples).
- Service companies invest in the quality of their service offering and the depth of relationship with customers.
This sort of thinking can easily be applied to any business — with practice it becomes second nature and it is certainly what differentiates a good analyst from a poor analyst. It is therefore in this environment one of the ways in which we must differentiate ourselves.
The analysis is however by definition simplistic. There are many different presentations of the basic variables. For example, technology companies in basically commodity/”phase C” markets may focus on innovation, thus retaining their differentiation strength by focusing on miniature, short-lived ‘phase A” markets. This has its price in the form of high R&D expenses and huge directional sensitivity (investing in the wrong market can be critical). What is important is that analysts THINK. Find out what it is that makes the company tick; ask the management (not the Controller or IR).
Growth is not — actually – about sales growth. This is merely one part of the equation. Growth is actually about what happens to earnings — and ultimately cash.
This number is in principal a function of several factors which include:
- market growth which influences top line growth POTENTIAL sales
- competitive strength which influences pricing strength and market share
- volume capacity which allows or prevents the ACTUAL sales result
- management of gross, operating and financing costs which influence EARNINGS. (Since gross costs are generally factored into the pricing equation, these can safely receive less attention, and financing costs are an entirely separate issue, what matters are OPERATING COSTS.
COMPETITIVE ANALYSIS THEREFORE FORMS AN IMPORTANT PART OF THIS ANALYSIS TOO. NONE OF THESE HAS BEEN COMPLETELY UNDERSTOOD WITHOUT THE OTHERS.
Again this is a very important tool for us to use to differentiate ourselves from the competition.
Competitive analysis allows you to judge these variable as follows:
- whether the company is likely to see its prices falling. (If it is highly differentiated and demand is growing, it is not going to see price erosion)
- whether the company is likely to see volumes falling, slowing etc (provided the product is valued by the client and perceived by the client and growth whether from organic means or market share growth is continuing this is unlikely)
Price x volume, coupled with a fair understanding of market share changes and organic growth supplies sales forecasts
- whether operating costs are set to increase proportionately (eroding returns) or decrease proportionately (allowing return growth). A proper understanding of what the company has to do to SUSTAIN the defensibility of its model will supply the answer.
Technological leaders will have to retain technological leadership — which means investing in research and development. If heavyweight competition is about to enter, then scale is likely to become important which is likely to mean accelerated spending to keep up with the power of larger R&D facilities
Branded companies have to compete on the advertising front — Adidas is driven by advertising spend. It is something like 10x bigger than Puma (which was formed by Adi Dasler’s — Adidas’ founder – brother). The latter cannot realistically expect to compete with the former unless it accelerates its advertising spend accordingly — without the former’s scale to offset this, returns will suffer.
Volume growth applied to asset base/revenue generators supplies the basis for operational gearing — or the efficiency of use of fixed overheads margin change
These factors are the basis for accurate forecasting. This simply CANNOT be performed with any degree of integrity without:
- The understanding identified above
- The spreadsheets contained within this note — and in particular use the key ratios page
The result is the sales, earnings and cash growth specific to the company
This is vital. This operation is about identifying analyzing and marketing high quality growth. If it doesn’t represent high quality, high level growth, don’t do it.
To be continued….