We need to be completely clear about the fact that, the quantitive analysis we do is based on past results of a company. One basic question in fundamental analysis is whether the company will be able continue superior performance in the future. For this we need to be very clear about the source of the superior performance – is it the brand the company has created? is the business model of the company the root of the excellent economics? Are current regulations unfairly gives the company a monopoly?
Note: Unfair advantage is not a bad thing. In fact, as investors, we should look for companies with some kind of unfair advantage.
Only after we understand the source of superior performance, we will be able to deduce whether the past financial results make any sense in light of changes in the company or the macro environment. So, let us see what are the factors we need to consider.
COMPANY LEVEL FACTORS
1. Business Model
Business models are the way resources are structured to tap a market opportunity. The goal is to generate profit in a sustainable basis with a satisfactory level of risk.
Consider your market research suggested that there is growing interest in suburban India about high quality Italian food. Now, here are some of your options
a. Build and own everything – from the real estate to equipments. You also have to hire all the workers, train them and manage them. This is capital intensive option, slower to scale and highly risky because of holding a lot of assets in the balance sheet. But, also at the same time, quality control is easier, difficult to replicate because the capital investment creates an entry barrier etc.
b. Growth using a franchise model – You create a brand (which may require setting up some restaurants yourself and standardize the menu and processes) and invite people to use your brand but do not hold all the assets on your balance sheet. Less capital intensive for growth, better scalability, but at the same time quality control is difficult.
c. Produce canned Italian food. It involves very different skill sets of preservation and supply chain. Apart from that the initial investment required is substantially high. You can start by taking help from various distributors and in the long run may create own distribution channels.
All these suggest different business models to tap the same opportunity. Business model influences the capital efficiency in the business along with the scalability.
The value of the management is not about competence to deliver a short term superior result, but sustaining and increasing the value of the company building good reputation and taking decisions balancing the short term performance with long term sustainability. The management is the public face of the company. So, a strong reputation of the management team adds to the reputation of the company and increases the sustainability of its performance.
The basic strength of a brand is in the ability to increase prices without losing volume - gaining a Price Inelasticity. Let us admit it – every company needs to increase prices even just to deal with the inflation. Many companies face challenge in increasing prices because they do not build strong brands.
According to IDC, the market share of Apple in the smartphone market by volume is around 12% compared with 21% of Samsung and around 16% of Huawei. So, by volume iPhone is not the market leader. But, they can increase the price without getting a dent in their volume. For example, in the December 2017 quarter, Apple shipped only 19% of the market volume, but captured 87% of the profits in the smartphone market. This is the value of a brand.
Also, brand is the first line of defense from the new competition with deep pockets. A company which plays only on cost will see their market share depleting along with profit margins when a new competition launches a price war.
4. Other Competititive Advantages
Some other competitive advantages, apart from a strong brand, are regulatory protected, large scale, technical know-how, operational excellence etc.
In many countries, the government allows only a few companies to play in the telecommunication sector. The argument is that - because it takes a large capital investment to build a telecommunication company, the company should be allowed to enjoy better profitability by restricting competition. Anyways, this creates monopolies or oligopolies for these companies and results in sustainable profitability.
Large scale also creates a natural entry barrier because only few companies will be able to match large investments to enter the market. Ability to innovate gives the ability to keep on creating better products than the competition and enjoy higher margins. Operational excellence also gives the ability of enjoying better margins, but by reducing costs.
Superior performance is often attributed to a combination of factors, not a single factor. These factors are interdependent. For example superior technical know-how may create a strong brand which strengthens the profitability of the business.
...to be continured