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.

Fundamental meets technical analysis

The mark of a good fundamental analyst is the ability to dig and look for data points that the rest of the market hasn’t really focused on. So it is with great interest that Jeff Matthews, who often has good fundamental insights, indicated that the economy may be improving or poised to improve because of extremely low inventory levels that he is seeing on a bottom-up basis. In addition, FedEx had reported improving volumes back in September, another sign of economic improvement.

Matthews concluded that this argues for buying transportation stocks and went on to speculate that this was one of the reasons why Buffett wanted to buy Burlington Northern:

But given the fact that he stands at the center of an economic supply chain that stretches from a candy maker in South San Francisco to a high-tech machine tooling supplier in Israel, we think it’s no wonder Warren Buffett decided the time was right to buy the rest of Burlington Northern.

There’s going to be a lot of—to be technical again—stuff that will need to be getting moved around in the next twelve months.

It’s the inventories, and Buffett isn’t stupid.

Where is the market consensus?
One of the failings of fundamental analysis, however, is that fundamental analysts may be correct in their analysis but they can get their timing wrong. So is Jeff Matthews early?

To get an idea of the market consensus, the chart below shows the ratio of the Dow Jones Transportation Average relative to the Dow Jones Industrials Average. As you can see from the chart, the Transports show no sign of life on a relative basis and could be argued that it is in a minor downtrend.

Is Jeff Matthews mistaken? early or what?

For Buffett to be so tactical with an investment the size of a Burlington Northern would be out of character for him. As for Matthews' call for a growth surprise, I prefer to wait for some confirmation that market perception has turned before hopping on board his train.

To each his own.