All newcomers to share market investing quickly learn that the most widely used strategy for share picking is fundamental analysis. Regardless of whether you are an aggressive high-risk growth investor or a conservative and cautionary value investor, you want to invest in shares of a company that you can judge to be fundamentally sound.
In the initial stages of learning the basics of share market investing it is common for one to assume fundamental analysis stops with the numbers. However, analyzing the numbers is in actuality the first step in fundamental analysis – Quantitative Analysis.
The second step, Qualitative Analysis, looks beyond the numbers you find in the company’s financial statements. The Price to Earnings (P/E) Ratio tells us nothing about the nature of the company’s business or its competition. It tells us nothing about its management philosophy or its corporate culture.
In short, every company has intangible yet vital attributes one cannot determine from the numbers alone, yet they are essential for the stability and growth of your investment.
Quantitative analysis uses financial ratios to put a company’s annual report, its statement of financial position, its statement of comprehensive income, and its cash flow statement under a microscope. But how does one go about evaluating the subjective qualities that contribute to the company’s performance both now and in the future? How can you measure these qualities?
To provide a contrast with the “hard” nature of numbers, some investors refer to the qualitative components of a business as the “soft” side. While it is not possible to assign numerical values here, some basic business knowledge and a little detective work can yield surprisingly insightful results. So let us begin to look at some of those qualitative intangibles that help determine the fundamental soundness of a potential share market investment. Here are the four most important:
1. The Business Model
2. The Competition
3. The Management Team
4. The Corporate Culture and Governance
The Business Model
What does the company do to make money? All corporations exist by providing products or services to a market. With some companies, the business model involves providing both products and services.
The starting point for your search to understand the business model behind the share you are considering as an investment is the company’s annual report. There you can learn what the company does, and equally important, who buys what they have to sell.
A company engaged in selling a very small number of products or services is more susceptible to economic downturns than a company with a wide and deep array of revenue-generating offerings.
Similarly, a company that sells to a small number of customers could find itself in deep trouble should a major customer decide to take its business elsewhere.
Many highly successful investors over the years have a hard and fast rule when it comes to evaluating a company’s business model – if you as an investor cannot understand what the company does to be profitable, look elsewhere for an investment opportunity.
Finally, always remember that all companies present their story in the most positive light possible in their annual reports. Your search should not stop there. You need to look for and read analyst reports, industry publications for the business the shares are in, and anything you can find in the business literature.
At first glance, one might assume a company with very few competitors is in a solid position. Unfortunately, that is only half of what you need to know. You also need to think about the future. How likely is it the company you are researching will face new competition in the future? A company with 70 or 80% market share in an industry with declining demand is not in a good competitive position. New entrants into the marketplace can only grow by eating away at the dominant company’s share of the pie.
American investor Warren Buffet speaks of a competitive advantage he looks for when share investing called an economic moat. Think of the company in which you are interested. Is it surrounded by a “moat,” offering protection from competitor attacks? How wide and deep is the moat?
Basic economics tells us successful companies breed rivals that try to imitate or improve on the business model. Some technological innovations are easily replicated, providing the originator with no protection from copycat products. On the other hand, some companies have brand recognition so widespread that competitors find hard to penetrate.
The goal here is to first identify the quality of the company’s competitive advantage and then consider its longevity.
The Management Team
Many intelligent investors feel the quality of the management team is the most important intangible to consider. In actuality, management quality is more tangible than you might think. It is a simple matter to explore the biographies of the management team. If you are considering investing in a mining company and the Chief Executive Officer (CEO) has minimal or no experience in the industry, that tells you something. If you were looking into shares of a Biotech firm, one would expect to see some PhD’s in the management team, from prestigious institutions.
Company websites will have full biographies of all members of the management team. In addition, the annual report has a section called Management Discussion and Analysis (MD&A) where you can read how corporate management explains present performance and its outlook for the future.
Just as you would not limit your quantitative analysis of a share to financial ratios from a single year, it is a good practice here to read the MD&A for the past several years to see whether management’s prior outlooks achieved fruition. If you read pronouncements of anticipated growth in market share that never happen, that tells you something.
You can use your favorite Internet search engine to search for additional information on members of the management team as well.
Corporate Culture and Governance
Of all the intangibles, corporate culture and corporate governance are the hardest to evaluate. A company’s culture is essentially the character of the company – its beliefs, values, and operating standards. Today, you will find Mission Statements on company websites that serve to tell the world how the company sees itself.
Corporate governance is the set of policies, procedures, and rules that delineate the relationship between the stakeholders in the company – the board of directors, the management team, the shareholders, and the employees. Of particular interest to share market investors is how management is compensated.
Intelligent investors always look to see share ownership on the part of members of management. These days, most company’s compensation policies include rewards for share performance. However, look to see whether incentives reward short-term performance with little regard for longer-term growth.
Finally, with both culture and governance, there is often significant difference between what a company says, and what the company actually does. Many companies speak of the value they place on high levels of customer service, but investors who search the Internet can often find evidence of poor customer service. Quality companies practice what they preach.
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