Friday, October 8, 2010

Equity analysis: Beyond corporate stenography

I normally don't write very much about company analysis, because I have spent most of my professional life as a quant. Nevertheless, I was fortunate to have been a small cap/special situations analyst early in my career. That experience from the school of hard knocks taught me that, indeed, different industries have very different value-drivers and therefore different valuation metrics, which was a invaluable lesson for me later in my life as an equity quantitative analyst.

Two recent events prompt me to write this post. Firstly, I volunteered to be a team mentor in the CFA Institutes' Global IRC Challenge, where teams from universities around the world compete by performing investment analysis. As well, I was asked to give advice to a junior company seeking a stock exchange listing on the issues of raising capital and investor relations.

I therefore write this post with those two groups in mind.

The basics of company analysis
The basics of company analysis depend on how an investor answers the following two questions:
  1. What is the company's competitive "moat"? Why does it exist in the first place? For example, a corner grocery store's competitive position is likely it's location - convenience is probably the main factor here. On the other hand, a company like Apple depends mainly on its technology, design and "coolness" factor - which is why customers line up overnight for new releases of iPhones.
  2. How do you value the company? Answering this question depends on how you answered the first question. What kinds of margins are sustainable in that business? If the "competitive moat" is large enough, then the company can extract above average margins and returns on capital for a long time. On the other hand, a corner grocery store in a commoditized business can only earn market rates of return, barring other competitive advantages.
Don't just focus on valuation
IMHO, way too much of the focus in business schools is on valuation. No doubt, corporate valuation modeling is a skill that need to be learned. Once learned, however, it's a highly commoditized skill and offers the analyst little or no competitive advantage over his peers. Analysts who mainly focus on building company financial models often wind up just becoming a stenographer for the company and add little new investment insight.

Adding independent investment insight
I have found that the analysts that really stand out from the crowd are the ones who have effectively mastered the principles in Michael Porter's books Competitive Advantage and Competitive Strategy.

It doesn't mean, however, that the analyst needs to do a 50 page Porter analysis of a company's competitive position, i.e. threats from suppliers, customers, existing competitors and new entrants, etc. It does mean that the analyst should be aware of these issues and flag the positives (competitive advantage) and negatives (risks) faced by the company.

To give an anecdotal example, I recall researching Nokia, a darling stock during the days of the Tech Bubble. It was the American based analysts who were very good at understanding the Nokia competitive position at a top down level. The story at the time, was that Nokia had a leading market share in handsets and a valuable brand. It could therefore use its volume muscle to drive down margins for its competitors and remain dominant.

On the other hand, the European based analysts who knew where all the figurative bodies were buried. They were much better at the bottom-up analysis and the channel checks. I depended on the European analysts for alerts about problems in the telecom business, e.g. relationships with major customers, production lines going down and their possible implications, etc.

Both are forms of competitive analysis. One is strategic in nature and the other tactical. Both are valuable. Without both, financial modeling becomes a GIGO (garbage-in-garbage-out) exercise in fundamental analysis.

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