Want to stay one up on the markets? Keep an eye on the qualitative variables. You will seldom go wrong
WHAT differentiates winners from losers in a stock market? Some may religiously follow the recommendations of a 'hit' stock broker. And some may even dig a bit deeper to know about the stock and the company they plan to invest in by going through the earnings and valuations multiples. But the real winners could still be a league ahead of such investors. That's because they keep an eye on the qualitative variables. Let's look at them:
People
This is the most important variable. You should know both the promoters and the professional managers who run the company. If the business is managed by a first-generation entrepreneur, check if the promoter is professionally and technically qualified to run the business. Of course, this is not a necessary condition and one has to exercise judgment. If the management consists of professionals, look at their employment history to understand their track record. For instance, before setting up HDFC Bank's operations in 1994, Aditya Puri was a successful country head of Citibank in Malaysia.
The management thinking can be best understood by reading the management discussion and analysis mentioned in the annual report. One can start with reading three year's annual reports. This will allow you to compare the management analysis from past reports with what really transpired in the following year. The next important thing that will help you is the corporate governance details in the annual report.
Management's intentions towards the minority shareholders must be carefully understood. If the business has just been sold, the promoters collecting a non-compete fee does not bode well for smaller shareholders. Some investors find buy back programmes done at suppressed stock prices and unrelated diversifications detrimental to the minority shareholders. Management actions in the past while handling surplus cash can be good signalling device. One quantitative element that comes handy is the quantum of management compensation. One can look at payout to the management as a percentage of the net profit and decide if the management is fair.
Related Party Transactions
Good companies do business with related parties at fair market prices. The same is disclosed in the annual report for the benefit of the shareholders. Few related party transactions, along with high transparency, is an indicator of a good business. Promoters' presence in the same business through a privately-held entity is a clear dampener as the investor in the publicly-listed entity runs the risk of promoter placing the 'cream business' in the privately-held entity.
Business Model
Simply put, it means where and how the company earns its bread and butter. You have to figure out what products the company produces or markets. Five Ws — who, when, where, what, why — will help you understand the raw materials that go in, the time and skill set required, the risks faced by the company and probably all those variables that can influence your returns as a shareholder. During tech boom of 2000, investors poured in their hard earned money into hundreds of dotcom companies. A few avoided these companies as they found that there were no meaningful revenues or they were bleeding at operational level. Undoubtedly those who stayed clear of that boom were the eventual winners. A thorough understanding of the business can help determine the potential of business and the risks the business is subject to.
Pricing Power
If you grasp the business model well, you stand to understand the pricing power. Customers and suppliers can influence the profit if they possess the pricing power. Generally, businesses with a few customers or sole suppliers typically do not have pricing power. Hence it makes sense to stay with companies that have a large customer base and have many suppliers and still a monopoly player in the business.
Power Of Intangibles
Intangibles such as brands play a significant role in the performance of a company. In the long-run, consumer preferences tilted in favour of a brand can bring in high visibility of income for a business. Intellectual property rights are also important as they offer an edge over others. They become the deciding factors in the knowledge-driven businesses. Investors must check the ownership of such intangibles. If the promoters own the brands in the personal capacity, then it is a case of promoters making money at the expense of the shareholders. This is especially true if the business is doing well, as the promoter can take home a sizeable amount of profits by way of higher fees.
