I break my investment decisions into two questions :
- What to business to buy?, and
- At what price?
The "What business to buy" question is more crucial than price. You can view the what business question as strategic and price as tactical. Cheap companies are not worthy, if their business is not economically superior to competitors. The quality of a business and its operations will determine growth and investors return more in the long run.
In deciding what business to buy I have developed a questionnaire to aid me in the decision. Most of the items covered in this template are qualitative in nature and concern itself with competitive advantages and quality of management. The questions may not apply for each business you research but it will give you a structure for your analysis process.
Is the company in an industry of good economics?
· Is the industry characterized by few competitors?
· Does the industry compete on price points? Is it a commodity business?
· Are competing firms have differentiated products?
Are the company/ industry customers concentrated in or from one industry or several others? It is a risky proposition if company’s products serve only one industry or concentrated for one industry.
Compose a map of the industry different segments and large players. The goal is to detect symptoms of dominant players:
· Calculate ROIC (stripped of cash and cash equivalent) over the last 10 yrs. is ROIC stable and the company enjoys a high return on capital, adjusted for excess cash.
· Who was the dominant company in each segment in the last 10 yrs, has been constant changes or the same company was dominant?
· Was there any successful new entry to the market over the last 10 years? Or was market share stable over time.
Does the Company have good business and sound operations?
Does company have access to distribution channels or do they get squeezed by competition with larger networks (Sales force, consultants, partners ...etc)?
Sustainable Competitive advantage, does the company have any of the following:
1. Economies of scale to be a cost leader
2. Customer captivity: due to strong preference, habit and loyalty, high switching costs, or high search costs
****(1 and 2 must be present to be considered competitive advantage)
3. Access to cheap unique resources or proprietary technology protected by patents or secret formulas
4. Brand Name: Does the company have a consumer monopoly or brand name that command loyalty and lock consumer buying habits? Is the brand name for commodity product then it does not represent an advantage. Brands of frequently purchased items are more likely to lead to franchises than those of long lasting capital goods. I think the key here is that you are more likely to be brand loyal with low cost items, since it takes too much effort to research alternatives each time you buy them. Long lasting goods are purchased less frequently, often cost a lot, and you are therefore more likely to take the time to carefully consider your options before purchasing.
Does the company sell long life products or ones with limited life span?
Long lasting products purchase options can put on hold. Companies selling short-life products have an advantage, at least in a soft economy does the company product line wear out fast or used up quickly, and merchants have to carry to stay in business?
Is it a repetitive consumer service that consumers are consistently in need of (for example media and communications)?
Is the company free to adjust prices for inflations?
High ticket products and services are tough to increase in revenues in slow economic times. Companies selling cheap items have an advantage in tough times over firms with expensive products.
Firms with small customer bases can take a serious hit if only one customer switches to a competitor.
companies selling only a few products are riskier bets than those selling thousands of different items
Business should not have high maintenance cost of operations. Low capital expenditure or investment cash outflow. This is not the same as investing to expand capacity.
Earnings Quality Analysis:
Are the earnings and revenues on an upward trend? Monitor the 5 yr positive yr over yr growth.
Earnings/ Revenues predictability: Companies with predictable revenues may be able to better plan their growth and function independent of economy swings.
Are Profit Margins consistent quarters over quarter yr over yr?
5 yr positive yr over yr growth?
What is the earning yield (EBIT/ Ent. Value) trend over the past 5 yrs? Is it growing or at least stable?
Is common statement analysis shows stable expense ratios over 5 yrs? Is it consistent with recent quarters?
Low debt to equity ratio is preferable to for flexible operations.
What is the business Cost of capital?
Is it higher than the returns on invested capital (EBIT/ working capital+ net tangible fixed assets)? If it is, then the company is generating value for its shareholders.
Is common statement analysis shows stable current assets and liabilities ratios over the past 5 yrs? Is it consistent with recent quarters?
Strong and consistent Operating Cash Flow (OCF)
Consistent positive growth in OCF year over year.
Is quarterly net income exceeds OCF? If there is wide differences between the two and it varies from year to year, then there is a need to examine accounting policies as this is an indication for earning manipulation.
Is the growth rates in income does not match the growth rate in OCF?
Does the company maintain positive Free Cash Flow? Is the trend consistent? Is it growing? 5 yr positive yr over yr growth?
Management track record
Does company reinvest retained earnings in good business opportunity? Track record doing this?
Are retained earnings used to grow earnings?
Who are the business management?
Over the past 5 yrs did management produce consistent Return on invested capital that exceeds weighted average Cost of capital ( cash return on invested capital)
ROE is consistent over its history and high compared to industry? Is it more than 12%? Does the company have high and consistent Return on total capital?