In value investing, you are not buying a stock but you are owning a business. Always think like a business owner and your mind will think in the right direction.
Assessing a business lies at the heart of stock market investing.
Broadly speaking, business assessment can be divided into two categories
Quantitative assessment of business focuses on the financial health of the company. Meaning the financial statements, financial ratios, and other number crunching that we discussed in our last email.
(You can also refer my article 7 smart steps to invest in stock markets to know in much detail on how to filter out businesses using a set of financial information.)
Coming back to qualitative assessment, this form of assessment focuses on non financial factors such as
- the nature of business
- the industry in which it functions
- product appeal
- brand power
- moats (competitive advantage)
- management quality
and so on…
Let me share some examples of qualitative factors that you must assess before investing in a stock.
Scalability of business
A scalable business is a business that can be expanded and grown to capture a larger market share.
Consider the market for consumer goods in India. As the market grows because of increased consumption, the demand for consumer goods automatically increases.
Take the case of Britannia industries. It’s a high potential scalable business.
Increased consumption for biscuits, cakes and breads drives more demand for its products, increasing its market share, making the business scalable.
The stock gave 10X returns in the last 5 years as consumption driven demand increased in India.
A strong brand doesn’t require much convincing and has a huge recall value in public memory.
The products of such brand are easy to sell resulting in huge sales consistently.
Take the case of Maruti Suzuki, one of India’s most trusted brand and the go to choice in the car segment.
Maruti Suzuki has built its brand power over the years through affordable pricing, wide distribution, and great customer service.
The stock has moved from Rs 125 to Rs 10,000 delivering a staggering 80X returns.
In business terminology, Moat is the competitive advantage that one company has over the other within the same industry.
The wider the moat, the larger the competitive advantage of the company and more sustainable the company becomes.
It would be difficult for the competitors to displace that company and capture its market share.
Take the case of L&T, one of India’s best Infrastructure companies. The company has very strong expertise and capability to execute infrastructure & construction projects that other companies find very difficult to match.
Industry outlook helps in understanding the current and future trends in the economic environment your industry operates in. Meaning you will uncover key trends, challenges, opportunities, and other insights that will influence the business you are interested in.
A business can be really good in its industry but it’s never insulated from the industry specific problems.
For example, the airlines industry in India. The industry is plagued by problems of high capital, low profit margins, high aviation turbine fuel costs, intense competition, price sensitivity to name some.
Which means even market leaders like IndiGo airlines are not insulated from these problems and their profits have shrunk massively making it a disappointment for its investors, particularly in recent times.
Fraud management is one of the reasons some people do not trust stock market with their savings. There have been many cases in the past where management of listed companies did shady deals, committed accounting frauds, misled shareholders & SEBI, causing a lot of monetary loss to investors.
A famous example being Ramalinga Raju of Satyam.
Even in 2018 there are many such examples of bad managements like Gitanjali gems (Chairman- Nirav Modi) because of whom shareholders lost a lot of money.
Therefore, it is very important that the stock/company you plan to invest in is run by honest, transparent, and competent management.
Companies with competent managements sail the company through tough times and are true wealth creators.
Like Avanti Feeds, a frozen sea foods exporter company that has delivered 7000% returns in the past 5 years creating huge wealth for its investors.
Beyond qualitative assessment, one way of finding good companies is to ask whether their product/service will undergo any change over the next 10 years.
In the words of the Warren Buffett
“We will never buy anything we don’t think we understand. And our definition of understanding is thinking that we have a reasonable probability of being able to assess where the business will be in 10 years”.
Meaning, you need to be able to understand a company’s business and be able to look out how a company is going to do 5 or 10 years ahead.
To quote Buffett again
“We do think we know what Coca-Cola or Gillette or Disney is going to look like in ten years. We care a lot about that. So, we focus on that.”
Similarly, I am passionate about technology which makes it easy for me to understand the tech businesses, the reasons for their growth, and predict how the future could turn out to be.
Furthering Buffett’s logic, I can safely say that it is better to avoid companies selling products that can one day become obsolete or replaced by technology.
Businesses like physical book stores, fax, CD/DVD players, scanners, digital cameras, travel agents, traditional taxis to name some have all taken a hit because of smartphones and technology. Either they are extinct or struggling to survive.
On the contrary, what are those companies that will continue to sell the same product and technology will have no or minimal negative impact?
Think Britannia Industries (biscuits), Dabur (ayurvedic products), Godrej (locks), Shalimar Paints (paints), ITC (cigarette), Tata Steel (steel) to name a few….
These companies have been selling the same product over the last 100 years.
And they have proved their mettle by delivering very good returns to its investors.
Has technology or internet based companies displaced them?
Can they just evaporate?
I don’t think so.
So, from Buffett’s logic point of view, these are good businesses.
Technology or Internet is not going to change how we eat biscuits. Yes, there could be lot of newer companies manufacturing biscuits but the way we eat them will not change.
And it will take a lot for new entrants to displace a company like Britannia that has a market cap of 75,000 crores.
You can see that we have to use common sense more than finance knowledge.
When assessing a business, apart from qualitative factors also try to study where the business will be in the next 5 or 10 years.
In stock market, assessing & identifying a good business is not enough. You need to understand the right valuations so that you know the price you are paying for that company is reasonable or not.
I will cover this topic in my next lesson.