Thursday, June 25, 2009

Analysing Companies Before Investing

In investing; the three most fundamental aspects are research, research and research! says Securities Industry Development Corp.

IN REAL estate, the three most important factors are location, location and location whereas in investing; the three most fundamental aspects are research, research and research!

In a bearish market, the stock prices for many fundamentally good companies can drop to a very low level. It is during times like these that investors should search for good quality companies that can be invested in for the long-term.

As an investor, one of the most critical steps in identifying good stocks is the understanding of the business. The ever famous investment guru, Warren Buffett has clearly stated that there is no fundamental difference between buying a business and buying shares in the business. In fact, there is a clear link between the two as "if a business does well, the stock eventually follows". These were Buffett's words.

In keeping in tune with Buffett's sentiments, investors need to make stock purchasing decisions by approaching it from the perspective of a business person. You need to have the same mindset as a business person when it comes to evaluating stocks.

Here are some guides on what to look for in a business:

In analysing a business, there are a number of key factors that you need to scrutinise and these can be categorised into two main areas; the company itself and the people who run the company. (Remember,the secret in business today is not about money, technology or ideas alone but its people - really good people!) .

The company

* Product: Single or diversified?
You need to know what a company's business is if you intend to invest in that company. Knowledge of what the company produces is crucial in giving investors an insight into the company's potential and ability to perform. If a company relies purely on a single or very narrow range of products, then you have to evaluate the product carefully in terms of its market dominance, economic characteristics, cost of production and entry barriers. A company focusing on a single product has the ability to tap on its strength. However, despite this edge that such companies have, there is a downside as you will have to analyse whether the product is positioned strongly enough in the market to fend off competition. The risk that companies focused on a single product have to face comes from competitors. The possibility of other products taking over its market position is extremely high, especially in the realm of fast changing technology or fashionable items.

As an investor who intends to avoid such risk, companies with diversified products and long history of successes will be more favourable. Such companies will have the ability to sustain themselves despite the presence of substitutes for one or a few of their products. The availability of substitute goods introduced by competitors may take away a portion of the company's share in the market, but it will have other products that are still strongly positioned in the market to keep itself steady.

A company's future prospect is also highly dependent on the type of products it has. If a company provides a product that is an essential item, one that is needed during good or bad times and it is highly differentiated, then its future prospect is most promising. Such companies will thrive on the fact that substitutes are not readily available, thus not jeapordising their market share. This type of business usually has the power to command the price in the market even when the demand is flat.

* Operating history: New or seasoned?
"Wisdom comes with age". While this is commonly said about people, the same can apply to a business as well.

Companies that have been around for years will be able to provide you with a track record of their performance. With that, you can zoom in to companies that have managed to produce consistent results and those that have weathered tough economic situations. Companies such as these coupled with the ability to manage cost effectively are companies that come with lower risk as compared to their younger counterparts; companies that are still new or have been experiencing changes in business directions and are trying to turn around.

* Ability to grow: Organic or stagnant?
Ability to grow: Organic or It is when the economic situation is weak that investors get the chance to judge whether a company is a growth company or not. Normally, if a company is able to maintain or grow its sales during a weak economic situation, it will very likely be able to grow its businesses even further during an economic recovery. In fact, if a business has been able to grow organically, through innovative products and sensible business strategy, then it has shown that the business itself has the room for future growth. However, if the growth has been achieved through mergers and acquisition, then you will have to be careful as historically, the success rate in marrying two companies with different cultures has been poor. Ideally, you best look out for a company that is able to grow organically and at the same time make strategic acquisitions to strengthen its market position and product offerings.

The people behind the company

* Ability to act in shareholders' interest
A successful company inevitably depends on its management team. Ideally, the management must be able to make strategic decisions in increasing shareholders' value. Their ability is reflected in their track records, performance in their previous companies or investment decisions being made in the current company. When companies retain earnings for the purpose of re-investment, the type of projects they invest monies in and the return on such investments will tell you whether they are putting priority on shareholders' interests or not.

Decisions to hit unrealistic short-term earnings targets might please the market and make the current management team look good, but, in the long-run, this move may hurt the company's prospects, which will in turn affect shareholders.

* Ability to control cost
Exercising tight cost control at all times is something that management needs to practice. However, members of management sometimes have the tendency to build up costs over time. These sometimes fly out of control, and will result in them taking a one-time action to reorganise and restructure. This action will also mean that the shareholders will have to suffer exceptional asset write-offs and severance costs due to redundancies, which might not have happened if careful planning on hiring and capital expenditure control were exercised at all times.

* Corporate governance and uncompromised integrity
A management team with uncompromised integrity means that you can be sure that the management team is always acting in shareholders' interest and they will not be breaking any codes just to satisfy their own interests. Management who share these values are highly valuable to a business and they are the ones you want managing the company you're interested in.

At the end of the day, the results of the factors that have been mentioned above will be reflected in the company's financial performance, which matters most to all investors. Knowing the business will help you to understand the financials better when you move on to the next step of valuing the stock itself.

1 comment:

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