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Industry/competition

Aside from having a general understanding of what a company does, you should analyse the characteristics of its industry, such as its growth potential. A mediocre company in a great industry can provide a solid return, while a mediocre company in a poor industry will likely take a bite out of your portfolio.

Of course, discerning a company’s stage of growth will involve approximation but common sense can go a long way: it’s not hard to see that the growth prospects of a high-tech industry are greater than those of the railway industry. It’s just a matter of asking yourself if the demand for the industry is growing.

Market share is another important factor. This does not mean that a company in a near monopoly situation is guaranteed to remain on top but investing in a company that tries to take on the “500-pound gorilla” is a risky venture.

Having a portfolio of brands diversifies risk because the good performance of one brand can compensate for the underperformers

Barriers against entry into a market can also give a company a significant qualitative advantage. Compare, for instance, the restaurant industry to the automobile or pharmaceuticals industries. Anybody can open up a restaurant because the skill level and capital required are very low. The automobile and pharmaceuticals industries, on the other hand, have massive barriers to entry: large capital expenditures, exclusive distribution channels, government regulation, patents and so on. The harder it is for competition to enter an industry, the greater the advantage for existing firms.

Brand name

A valuable brand reflects years of product development and marketing. Take for example the most popular brand name in the world: Coca-Cola. Many estimate that the intangible value of Coke’s brand name is in the billions of dollars. Massive corporations such as Procter & Gamble rely on hundreds of popular brand names like Tide, Pampers and Head & Shoulders. Having a portfolio of brands diversifies risk because the good performance of one brand can compensate for the underperformers.

Keep in mind that some stock-pickers steer clear of any company that is branded around one individual. They do so because, if a company is tied too closely to one person, any bad news regarding that person may hinder the company’s share performance even if the news has nothing to do with company operations.

Assessing a company from a qualitative standpoint and determining whether you should invest in it are as important as looking at sales and earnings. This strategy may be one of the simplest but it is also one of the most effective ways to evaluate a potential investment.

Stock-picking strategy: value investing

It is one of the best known stock-picking methods. In the 1930s, Benjamin Graham and David Dodd, finance professors at Columbia University, laid out what many consider to be the framework for value investing. The concept is actually very simple: find companies trading below their inherent worth.
The value investor looks for stocks with strong fundamentals - including earnings, dividends, book value and cash flow - that are selling at a bargain price, given their quality. Value investors seek companies that seem to be incorrectly valued (undervalued) by the market and therefore have the potential to increase in share price when the market corrects its error in valuation.

Value, not junk!

Before we get too far into the discussion of value investing, let’s get one thing straight. Value investing doesn’t mean just buying any stock that declines and therefore seems “cheap” in price. Value investors have to do their homework and be confident that they are picking a company that is cheap given its high quality.

Keep in mind that some stock-pickers steer clear of any company that is branded around one individual

It’s important to distinguish the difference between a value company and a company that simply has a declining price. Say for the past year Company A has been trading at about Rs.25 per share but suddenly drops to Rs.10 per share. This does not automatically mean that the company is selling at a bargain. All we know is that the company is less expensive now than it was last year.
The drop in price could be a result of the market responding to a fundamental problem in the company. To be a real bargain, this company must have fundamentals healthy enough to imply it is worth more than Rs.10 - value investing always compares the current share price to intrinsic value not to historic share prices.

Buying a business, not a stock

We should emphasize that the value investing mentality sees a stock as the vehicle by which a person becomes an owner of a company - to a value investor profits are made by investing in quality companies, not by trading. Because their method is about determining the worth of the underlying asset, value investors pay no mind to the external factors affecting a company, such as market volatility or day-to-day price fluctuations. These factors are not inherent to the company and therefore are not seen to have any effect on the value of the business in the long run.

Contradictions

While the Efficient Market Hypothesis (EMH) claims that prices are always reflecting all relevant information and therefore are already showing the intrinsic worth of companies, value investing relies on a premise that opposes that theory. Value investors bank on the EMH being true only in some academic wonderland. They look for times of inefficiency, when the market assigns an incorrect price to a stock.

Value investors also disagree with the principle that high beta (also known as volatility, or standard deviation) necessarily translates into a risky investment. A company with an intrinsic value of Rs.20 per share but is trading at Rs.15 would be, as we know, an attractive investment to value investors. If the share price dropped to Rs.10 per share, the company would experience an increase in beta, which conventionally represents an increase in risk.

If, however, the value investor still maintained that the intrinsic value was Rs.20 per share, s/he would see this declining price as an even better bargain. Better the bargain, the lesser the risk. A high beta does not scare off value investors. As long as they are confident in their intrinsic valuation, an increase in downside volatility may be a good thing.

(To be continued next week)