Sound investments ought to be based on strong underlying business fundamentals. But when analyzing a company as a potential investment, one can easily neglect to ask a basic question: how the company makes its money.
Value investors know the importance of investing within their circle of competence—companies in which they are confident tend to be easy to understand and have a simple business structure.
The better an investor knows a business, the better the chances of success. A savvy investor takes the time to understand a company’s business model, its revenue sources, and its operational details—like cash flow, labour relations, pricing flexibility and capital allocation needs.
Examining a company’s history and long-term prospects allows investors to more accurately interpret corporate and industry developments and, therefore, to make better investment decisions.
The business model
A sound business model remains the bedrock of every successful investment. To understand the business model is to understand how a company operates, what assets it needs to hold, its targeted market, and, most importantly, a company’s revenue sources—including the amount and frequency of receivables.
These nuances are not always obvious. It’s not enough to know a company sells burgers. Investors should also take the time to understand the details. Does a company own its retail space—as McDonald’s does—or does it lease?
Shaving industry icon Gillette is happy to sell its refillable razor handles at or below cost because it more than makes up for that loss with the profits it makes on the sale of razor blades.
Or consider General Motors before the 2008 financial crisis—more than half its earnings were produced by its financial division. The auto manufacturer made more money lending money to customers than it did selling cars and trucks.
Beyond understanding the business and industry the investment operates in, there are a few more questions to address before taking the plunge. Does the business have a consistent operating history and favourable long-term prospects?
Company history
Predicting the future success of a business is far from foolproof. There are a few common indicators of good potential investments:
- A consistent record of earnings growth;
- A history of financial stability;
- The core products or services are distinct, sustainable and generate sufficient demand to command pricing power.
We suggest avoiding companies that sell indistinguishable products (e.g. easily copied or commoditized), are undergoing a corporate reorganization, or are facing a turnaround situation, because there’s no measurable track record for success.
Investing in a reorganized or refocused company requires the investor to understand the catalyst for change. Is it to take advantage of a promising opportunity, for example, or a desperate move to change course from an unsuccessful strategy?
Competitive advantage
Companies that have competitive advantages tend to have long-run, robust earnings. These include a key executive, superior materials, patents, supply chain processes or any other unmatched or unique capability within the industry. But investors need to know if that competitive advantage is sustainable.
A good indicator is how a company has responded to industry or economic change in the past. A complacent and static response opens the door for future competition. On the other hand, companies that have several competitive advantages—working together as part of a dynamic strategy—tend to be more sustainable.
Investors have little control over a company’s stock price or fluctuations in the market. But those who thoroughly understand a business can invest with confidence and potentially reap rewards.
Susy Abbondi is an equities analyst at Duncan Ross Associates.