Book summary Part-2

ANALYSING A COMPANY.

In this author has given 5 steps to analyse a company.

1) Growth :-

It is very important component to check whether a company is a good company or a bad company. We as an investor mostly wants to invest in a company which has good growth but we forget that good growth attracts competition and hence introduces new competitors which then ultimately take out some piece of company’s profit. But this is something which promoters and management also knows thats why it is necessary to check if the company has good growth then what is the source of that growth, where it is coming from…

We want quality growth and not that growth which comes from cost cutting and accounting tricks.

The author has shown 4 sources of quality growth :-

i) Selling more goods and services as compared to its competitors.(high turnover)

ii) Raising prices of your product if you offer quality premium product and consumers are ready to pay that premium for that kind of quality. This will increase company’s profit margins.

iii) Selling new goods and services by regularly investing in R&D and bringing new innovative products in the market.

iv) Buying another company. Now here a investor needs to be aware that if a company is doing an aquisition then what type of acquisition is that? Some companies do acquisition just for the sake to increase its scale. That would give company a growth but that would not be a healthy growth. A good acquisition is when a company acquire a company which is doing good in its business.

Growth can be shown by a company by manipulating its financial statements which we call using accounting tricks. You as an investor needs to be very careful about it. You need to dig into numbers whenever you find anything suspicious in the numbers.

2) Profitability :-

(How much a company is generating profit from its capital investing)

We need to see what is the source of generating profits of a company. Is it by costing cutting of good or by price hiking or charging a premium for their goods.

Analyzing profitablity is very important for an investor but having a look at the company’s capital structure is also very important. We can analyse a capital structure of a company with the help of following ratios :-

i) Return on Assets (ROA)

Return on assets can be found out by multiplying net profit margins with asset turnover. It shows how much profit a company is earning per dollar of asset. Higher the ROA higher the efficiency of a company.

ii) Return on Equity (ROE)

Return on equity can be found out by (net margins × asset turnover × financial leverage).

This ratio shows how much a company is earning on its shareholder’s equity. Return on equity is good when it comes out from higher net margins and higher asset turnover. It can also be increased by increasing more financial leverage and decreasing its equity through buy back but that would make a company risky.

iii) free cashflow

Free cashflow is CFO(Cashflow from operations) less capital expenditure. It is the cashflow which belongs to the equity shareholder, the excess cashflow available in business. A company with higher or excess free cashflow does not have to depend on leverage for expansion. They can also buyback shares with the excess cash.

iv) Return on invested capital (ROIC)

It is also a better profitabilty ratio as compared to ROE. It takes only income from core operations and core assets into consideration. For example any assets which belongs to any non core activity for example investments are removed from total assets.

It assumes debt interest as equity only therefore there is no interest to be deducted from EBIT. Formula of ROIC is EBIT(1-t)/total core assets.

3) Financial Health :-

Financial health of a company can be analyzed through its financial leverage ratio. Financial leverage shows how much debt the company has in its balance sheet. Higher financial leverage can be troublesome and risky for a company.

i) Debt to Equity Ratio :-

This ratio shows the amount of long term debt company is holding for every 1 rupee of equity. Higher D/E ratio is not advisable for a company.

ii) Times interest earned :-

It is a ratio which is calculated by EBIT/ interest.

This ratio shows times capability of a company to pay its interest. Higher the ratio safer the company.

iii) Current Ratio :-

Current ratio is Current Assets/ Current Liabilities of a company. This ratio shows the capability of a company to pay off its current liabilities. Higher the ratio, better for the company.

iv) Quick Ratio :-

This ratio shows the capability of a company to discharge its current liabilities from its liquid asset. This ratio is calculated by (Current Asset – inventories) / current liabilities.

Bear Case – Before investing in an equity stock you should know all the cases or situation which might lead people to sell this stock. An investor should know all the risk which is related to a stock in which he/she wants to invest so that he can be prepared for the worse situation and save himself/herself from losing money in the equity market.

ANALYZING A COMPANY – MANAGEMENT

It is important for investor to analyze a company’s management before investing in it because it is the management which is running the company and responsible for performance in the the stock markets. Analysis of the management can be done through 3 phases :-

1) Compensation :-

It should be checked that whether the management is paid fairly and are not overpaid. This can be done by comparing their pay with their peers.

It is a good sign if a company is paying compensation on the basis of the performance, this will motivate employees to work harder for the company.

2) Character :-

Investor should check the character of management by focusing on the following points –

i) whether the company is doing most of its business with its relative parties?

ii) whether the BOD is stacked with the management’s family members or not?

iii) If the management has made any kind of mistake then does it hidding its mistake or ignoring them.

iv) whether the management is rolling its employees in order to save its salary cost?

3) Running the Business :-

Check whether management is properly running the business or not. Check the trend of ROA and ROE and check whether high roe is not due to increase in the leverage.

Investors need to check whether the increase is revenue if there is, is due to any kind of acquisition. They also need to check whether they are getting paid over their receivables or not.

They also need to check whether the dilution of equity is happening or not.

The investor needs to make sure whether the company is making proper disclosure of material information or not.

AVOIDING FINANCIAL FAKERY

How can an investor avoid financial fakery?

The author has written about few red flags from which an investor should get an idea about it. These red flags are as follows :-

1) If the company’s cashflow from operation is stagnant or decreasing but their net profit is increasing then this means that the company is doing most of its sales on the basis of credit and its not receiving cash from its debtors very soon. This shows the company’s inefficiency at cash collection.

2) If the company is frequently charging its one time charge then it means it is correcting its numbers by them.

3)If the company is doing too much acquisition of those companies which does not have growth and will not impact the company in large then there might be something fishy about it.

4) If the company is frequenly changing its auditors then its a red signal. Resignation of CFO or the auditor due to some accounting issues in the company is not a good signal.

5) If a company is recording capital gains in the revenue and not showing the capital expense then thats a red signal.

6) Its not a good signal if a company has an undervalued pension fund. This could result in lowering of profits of the company as its an obligation for the company to pay to its employees when they retire.

7) If there is alot of unsold inventory with the company then thats not a good signal because this shows the bad estimation of the company regarding the demand for their product and then they would have to sell their unsold inventory at the cheaper rate in order to clear their stock which will ultimately affect their profit margins.

8) Companies can manipulate its liabilities by not recording proper depreciation and provisions for doubtful debt which can impact their profit margins if all their debtors did not pay them. This manipulation does not show the true and fair view of the company.

9) Company can also manipulates its income statements by not recording expenses which needs to ne recorded. Company might assume some expense as capital expense which might not exactly be a capital expenditure and then they write off it which ultimately lower their expenses. So these tricks needs to be kept in mind by an investor before investing in a company with good financials.

VALUATION – THE BASICS

It is very important for an investor to understand the valuation of a company. From that he can know which stocks in the market are overvalued and which are undervalued. With that he/she can earn handsome returns on his/her investments.

As stated earlier by the author, a good investment is not done by investing in a good business at a higher price but investing in a good companies at attractive prices. If you purchase stock of a good company at an attractive price then that will increase your return on investement alot.

There are basically 2 components of return

1) Investment return

2) Speculative return

Investment return happens because of dividend yeild and earning growth

Whereas speculative return comes from change in PE.

Buy buying a good stock at low price will lower down your speculative risk for your investment.

Valuation can be done using the following ratios :-

1) P/S Ratio (price to sales) :-

P/S ratio is nothing but share price of a company divided by its sales. This ratio tells us that how much an investor is ready to pay a company on 1 rupee of its sales. Higher ratio tells us that company is doing good and people trust that conpany. It is necessary that we compare P/S ratio of companies which belongs to the same industry as every industry has different profit margins.

2) P/E Ratio (Price to earning) :-

P/E ratio is share price of a company divided by its EPS(Earning per share). This ratio is very much used by the people while doing valuation of any company. Just like P/S it is preferable to compare P/E of companies in the same industry. Normally it is assumed lower the P/E, better the company as the company is having good earnings and the stock price is low. But an investor should not make decision on the basis of the current P/E. It is preferable to check the historial P/E also. If the company is having stable growth rate with low P/E in past years then it can be said that the company is good for investment as the company is doing good expenditure for its growth and is undervalued also.

There can be other reasons also by which a company’s P/E and inflate or deflate, it is necessary that you eliminate those reasons and then take the P/E into consideration.

Some of the reasons are as follows :-

i) If the company has taken any kind of bigger expense this year which is not normal then that will lower the P/E of the company so that expense needs to be excluded.

ii) If the firm has sold its asset or part of its business then that will lead to decrease in the P/E as the earning would increase for the company. That kind of transaction needs to be excluded from calculations.

Chapter 17: Banks

Bank is one of the most important sectors in every economy because they provide the service of lending money to the businesses. Because the service that bank provide is so vital to long-term economic growth, the banking industry is almost certain to grow in line with the world’s total output. Banking business model is simple.

• Business model of bank:

  Bank is one of the most important sectors in every economy because they provide the service of lending money to the businesses.

• Lend that money to the borrowers.

• Banks earn from the spread/ Difference. This means if bank borrows money from depositor at 3% and lends that money at 6% so the difference between both borrowing and lending rate (3%) is bank’s earnings.

Banks are more capital intensive, they need more equity in order to lend more and be profitable. So, in analyzing banks see high equity portion and enough provisions for bad loan.

Now let us understand the different types of risk which a banking industry faces and how they deal/ manage that risk:

Banks deal with major three types of risk:

1. Credit risk.
2. Liquidity risk.
3. Interest rate risk.

Managing Credit risk: Credit risk is a core part of lending business. which can be estimated by analyzing balance sheet, loan categories and NPA (non-performing asset. Banks generally avoid this risk by either diversifying their portfolio, or through collection procedures or by solid underwriting. Big companies in Banking sector follows this process to avoid this risk:

1. Portfolio diversity (Not giving major portion of loan to a particular company/ Industry).
2. Conservative underwriting and account management.
3. Aggressive collections procedures.

Managing Liquidity risk: Credit risk is considered top level risk in banking industry. Banks are being paid for liquidity service. Less intuitive, but equally attractive from a business perspective, is the role that liquidity management plays. Banks have liquidity risk as they take money from depositors and lend it for short-long term, but what if all the depositors want their money back but bank don’t have money as it has lent it, it is call as asset liability mismatch, which is liquidity risk. Banks offer liquidity management services in many forms. Many businesses pay banks a fee to maintain a back up line of credit. There is no other business in the world where you can take money from people and effectively charge them to take it off. This is why it is important to track deposit levels.

Managing Interest rate risk:

Third and one of the main types of risk faced by banks is interest rate risk. The fear investors avoid investing in banks, is that earnings can be squeezed by the interest rates, which are outside the control of banks. If bank is asset sensitive – i.e. interest rate on asset will changes more quickly than rate on liability –, rising rates will be profitable, but if bank is liability sensitive (falling rates will benefit banks), rising rate can create trouble (as interest margins will get lower).

Economic Moats in banks:

1. Huge balance sheet requirements: There likely is no industry more capital-intensive than banking, which usually earns directly on their asset; hence, having large asset base is economic moat for banks.
2. Large economies of scale.
3. Oligopoly Market.
4. Switching cost for the customers.

Investors before investing in banks should check ROE & ROA ratios and better the ratio more efficient the bank is. From valuation perspective, one should check P/B ratio and compare with its competitors to know whether the stock is undervalued or not.

Chapter 18- Asset management

Asset management:

Asset managers enjoy huge margins and constant stream of fee income. Asset Management firms run people’s money and demand a small proportion of the asset as a fee in return. It requires a very little capital investment. Compensation is the firms main expense. Asset management companies are most unique ones as they don’t depend on capital to grow. For AMC biggest expense is their employees benefit expense/salary one.

Economic moat/ Competitive advantage for AMC are:

1. Diversification
2. Asset Stickiness

Asset management accounting 101:

Asset under management is one of the most important metrics in this industry as companies in asset management industry earns X% revenue from AUM only. This is one of the good indicator to track how well the firm is performing.

Key drivers of Asset Management Companies:

AUM is biggest driver of revenue in this industry. Money managers charge higher fee to manage equity portfolio than to manage bonds or other money market fund. As we have seen that AUM increases the revenue for the companies but we also need to check the following:

1. AUM is increasing because of which factor/ Component (Equity or Bond).
2. AUM can increase due to market movements too but firms/ Investor must not rely on that thing.

Hallmarks of success of Asset Management Companies

• Diversity of product and investors
• Sticky assets
• Market leadership
• Niche market

Software:

Software industry is intensely competitive. Starting a software company is difficult but transferring software is easy. Software companies are also called cash cows. Segments of software industry:

1. Operating system: All the program performed by computer are run by operating system. It also handles direction from hardware such as printers.
2. Database: This helps computer in collecting data and storing it. Switching costs are high i.e. if anyone wants to move data from one database to another it will be costly. Microsoft, IBM, oracle dominates this market.
3. Enterprise Resource Planning (ERP): ERP help businesses by lowering the burden of back-office work, but it didn’t show high growth as many firms already have installed ERP.
4. Customer relationship management (CRM): CRM is software which keep track of client data, which creates selling opportunities and improves customer satisfaction.
5. Security – With the increase in online data sharing, the data is available not only to employers and customers but also to hackers.
6. There are also some segment like Video games, graphic design software etc.

Economic moat:

Due to rapid technological changes and low barriers to entry, wide moats are tough to make in software industry. To assess economic moat in this industry we need to look at following points:

1. High switching costs – If firm’s place switching costs high, then customers will not turn towards competitor’s product.
2. Network effect – Adobe can be a good example here. Majority of people view file in Adobe Reader. So people try to create documents in acrobat reader only.
3. Brand names – Strong brand names can help company increase their sales.

Hallmarks of successful software companies:

1. Increasing sales
2. Long track record
3. Expanding Profit margins
4. Large Installed Customer Bases
5. Great management.

Hardware:

Factors like product cycles, price competition and technological advances are very intense in the hardware sector. It is very difficult, thus to build sustainable competitive advantage.

What drives the hardware industry?

1. Due to technology evolution, cost for developing hardware become low; that is now you can buy more powerful computer at lower rate than earlier.
2. The hardware sectors central driver is its ability to innovate. 
3. The shift of advance economies from manufacturing towards services.
4.  The relationship between technology hardware and software.

Hardware Industry Dynamics:

1. This type of companies are more cyclical in nature as people don’t purchase at bad times.
2. Cyclical in nature.

Economic Moats of Hardware:

1. High customer switching cost
2. Low cost producer
3. Intangible Asset
4. The Network Effect.

Media:

Many companies in this sector benefit from competitive advantages, such as economies of scale and monopolies, which make it easier to sustain excess profits for long periods of time.Media companies have great opportunity to grow, but picking the correct one is too tough Media is the one which has very broad term, so it is divided into 4 parts:

1. Publishing
2. Broadcasting and cable
3. Cable industry
4. Entertainment industry

Risk in Media sector:

1. Many media companies are still being controlled by a family, which sometimes can’t make decision in the benefit of shareholders
2. Media firms sometimes have cross-ownership holding – i.e. another company has right to contribute in company’s decisions
3. Be wary of the firm which reward executives with ridiculous compensation.

Telecom

Telecom one of the toughest industry as it is a capital intensive industry, makes barrier to entry high. It also has non-existence of moat, dependency on regulations and high capital intensity.

Telecom Economics

1. Building and maintaining a telecom network is extremely expensive and require lots of capital.
2. The emergence of the internet, the opening of local networks to competition and rapid wireless growth allowed new players to grab a piece of the action.
3. Competition is too huge in this sector and everyone is competing with one another either in price or in better services.
4. Companies have perfect competition and near-zero pricing power
5. Companies with huge customer base usually have their hands up, although they can’t increase price due to competition pressure.

Hallmarks of success in Telecom:

1. With the high need of capital investments, free cash flows become more important to see in the firm.
2. Strong financial health is required for firms to be attractive. A strong balance sheet and solid free cash flows are even more important.

Before investing in Telecom have a huge margin of safety otherwise your portfolio will be ruin in future.