Chapter 10: Qualitative Analysis

Introduction

PREVIOUS CHAPTERS HAVE shown how to narrow down the universe of listed companies based on an analysis of company numbers (i.e., quantitative analysis). This chapter focuses on how to assess qualitative aspects that can influence future performance of a company, which helps to further narrow down the list of investable companies.

Qualitative analysis helps to identify the strengths, weaknesses, opportunities and threats to a company using descriptive information. If a positive narrative about the company is built up from this analysis it will ultimately provide greater confidence to invest in the company. Conversely, if negative company risks are identified, it may deter or limit any investment made.

Financial news

The easiest place to start is to look at what other analysts and commentators are saying about a company. This gives you the opportunity to quickly find out what others think before doing more in-depth research. There are various places to find financial news:

Investors Chronicle

The Investors Chronicle (IC) website (www.investorschronicle.co.uk) contains commentary on small and large companies listed in the UK. It is a useful place to start your research. Searching a company name on the website provides a link to their summary page.

This summary page presents its own view on whether a company’s shares are currently a buy, hold or sell. Ideally the shares you are considering should be buy rated. If shares are rated a hold or sell you will need to take a careful look at the weaknesses and threats to the company, to see if they are sufficient to deter you from investing.

The page also links to financial news articles on the IC and Financial Times. IC articles typically start with the pros and cons of investing in a company and then offer an explanation of their views. Normally the aim of an article is to provide a balanced view, as well as an opinion. If the company shares are rated a sell, you can normally discover the reasons.

From the summary page, you can access several other useful sections.

The profile section includes a short overview of what a company does as well as any mergers and acquisitions that are in the process of being made. A list of peers provides a quick way to identify competitors to research when looking to gain insight into the industry the company operates in. A section on institutional investors reveals who the largest investors are and the size of their positions – it is reassuring if the top shareholders own more than 10%.

The directors and dealings section lists the company executives with a biography and how long they have been with the company. Alongside this is information on the purchase and sale of shares in the company bought by the executives.

The forecasts section shows current analyst views on whether shares are a buy and how this has changed over time. They also provide price forecasts for the next 12 months, which can be a useful frame of reference. (The next two chapters discuss broker and long-term valuations in more detail and how to make best use of them.)

Financial Times and Bloomberg

The Financial Times (www.ft.com) and Bloomberg (www.bloomberg.com) websites provide a range of articles on companies. (They are typically less informative about smaller companies.) Searching for information on the sector and industry of a company on these websites can be a good way to gain a quick feel for the environment the company is currently operating in. Look for information on whether there is growth in the sector and what challenges are facing the industry.

Google financial news and Google search

Google finance (finance.google.com) collates the latest available information published online about most companies. This includes the latest official press notices as well as articles that may have been written on websites and blogs. Searching the company name or its ticker in Google tends to bring up a wider range of articles on the company, which can be informative as they tend to go back several years.

Bulletin boards

Investment bulletin boards are websites where users can post comments on companies and reply to other users’ postings. Investment bulletin boards include ADVFN (www.advfn.co.uk) and Motley Fool (www.motleyfool.co.uk), where you can create a user account and access the boards for free.

The bulletin boards allow you to look up threads on a company and read about other investors’ views. The threads often contain links to interesting articles, which are discussed further in the thread, that you might otherwise miss. These boards are interactive, so allow you to post your own thoughts and ask questions that you might have.

That said, contributions are mostly made by non-professional people interested in investment, so it is worth treating information provided on these boards with some scepticism. However, you can normally verify comments by reviewing other sources of information, including information provided by the company itself.

Company website and annual reports

The company website is usually a treasure trove of information about how the company is run and their general management philosophy. Annual reports will normally be available in the investor relations portion of the website.

The next sections highlight some of the more important qualitative factors that you should focus on as you read the consolidated company reports and investor material.

Business model

A business model refers to what a company does and how it makes money. It is important to understand the business model before you make an investment as otherwise you will not be able to identify the key drivers of future growth. This would leave your investment vulnerable to large losses from negative business shocks that might have been avoidable.

Source of sales and profits

The first step towards understanding any company is to work out what business interests the company has; it might focus on a single business, or it may have substantial interests in several businesses. List these businesses and look at what products and services they offer. It should be possible to determine the various business activities of a company from its annual company reports.

Look at sales and earnings for each business and ascertain which activities are currently the most important by size. You want to make sure that the key business activities are profitable. Where business activities are unprofitable, you need to understand why this is and whether it’s likely to change soon. For example, if the business activity is a new start-up with good growth potential and only a small part of the company, you may have fewer concerns about current unprofitability.

Discontinued operations

Sometimes losses from discontinued operations appear in the income statement. If the losses are for a significant amount you will need to identify which operations have been discontinued (comparing reports and/or commentary on the discontinued operations).

You will then need to understand why the operations were discontinued. For example, this might be because it came to the end of its natural life or the activity was better delivered in a different way. This was the case for Tesco, a UK supermarket, which sold off its US business, Fresh & Easy, because they couldn’t make it profitable. After many years of trying, Tesco decided to cut their losses and focus on other more profitable areas.

Business segment analysis

Companies are required to provide a breakdown of the different parts of a business (referred to as segments). Reportable segments are determined by geographical area; business class; 10% or more contribution to revenue; profit or assets; sector differences in terms of return, risk, growth or development potential for investors. Each reportable segment is required to disclose its sales, profit, costs, net assets and associated undertakings. The totals for each segment will equal the totals shown in the consolidated accounts.

Segmental reporting provides an opportunity to identify which parts of the business are growing and which are contracting through a simple comparison of sales and earnings over the last few years. You can then look at what the company’s executives have said about growth and decline in its various markets and assess how credible their comments are.

Geographic diversification

Looking at the segmented reports you can work out the percentage of sales coming from different regions or countries. Using knowledge of which countries’ economies are doing well with regional exposure can give an idea of what proportion of sales is likely to be hampered by a poor economic climate; or, conversely, the proportion of sales that might benefit from a better economic climate. For example, at the height of the Eurozone crisis companies that had a large regional exposure to the Eurozone suffered during the aftermath with poor sales and profits.

Of course, this type of analysis may not always work due to company idiosyncrasies. However, it is still a useful exercise to think about, especially for retail companies.

Customer and supplier base

Using information on the company website, you need to consider who is supplying the business with resources to manufacture products or provide services. You also need to identify who the key customers are for each business and who the key competitors are. Ideally you want to avoid companies that are too dependent on one supplier or customer for the generation of a large part of its revenue. When a company is reliant on one supplier or customer, there is a greater chance of disruption to the profitability and future growth prospects of the company.

Business focus

Ideally a company should be focused on its main area of interest, focusing on businesses that naturally complement each other. This allows its management team to concentrate on what it knows and understands well. A streamlined business focus is likely to provide more opportunities to exploit potential synergies between the different business activities, which helps to lower costs and maximise profits. For example, a business-focused company can achieve cost savings by reducing duplicated services and adopting the best business processes across their businesses, which would not otherwise be achievable if the businesses operated as separate entities.

Conversely, if a company’s business activities are too diverse and have operations in different areas, management may not be able to effectively organise the separate activities and maximise profits. If the businesses sell to different customer bases and/or use different suppliers, the businesses may need to continue running separately. This will mean there are fewer opportunities to exploit cost savings through synergies and economies of scale.

Furthermore, the expertise required to run the different divisions is likely to be very different, making it harder for senior management to control the direction of the overall company. This is especially true for companies with many small, obscure businesses with low profitability, as they are likely to be poorly managed or of uneconomical scale. These are the type of companies that you want to avoid as the amount of diversification is likely to be too challenging for a single management team.

Growth strategy

Company growth in sales and profits is achieved by organic growth, when a company grows from within by reinvesting some of its profits, or by acquisitive growth, when additional businesses are acquired. Both forms of growth can be healthy. However, organic growth is typically less risky as it is a natural by-product of the management’s effort to run a company well. Acquisitive growth poses more challenges and is therefore perceived to be riskier.

A healthy acquisition policy is to acquire businesses that are a good fit with the existing company structure. This includes buying out competitors or acquiring businesses that offer services or products that complement the existing range of services and products. The safest areas into which a business can diversify are closely related to what it already does, so there is pre-existing expertise and infrastructure available.

When a company buys another business, it must either make the purchase with available cash or raise the capital by issuing new shares or borrowing the money. If money is borrowed, it must generate sufficient profit to repay the loan and earn a profit similar to the existing business. If shares are issued, current shareholders’ holdings are diluted. This is only in the interest of shareholders if the acquired company is more profitable than the existing business, or is made to be using synergies. This is more likely to be the case if a healthy acquisition policy is followed, as management will be able to leverage their management expertise and current infrastructure.

Diversifying outside of its core area of expertise may be a sign that a company is losing its way. In theory, this type of diversification might reduce the chances of financial damage if one area of the business lags. However, in practice, it tends to present challenges and disadvantages that can hamper overall company performance.

A company that expands into a totally unrelated field is likely to have fewer opportunities to streamline business processes and fewer economies of scale to exploit. As the businesses are very different, management will most likely want to retain expertise from the original company, since company operations may require very different skill sets. (If expertise is not retained, the original management may struggle to run the company effectively and, at worst, might find themselves in possession of a business they can’t run profitably.) This type of acquisition is therefore likely to incur much higher costs as additional staff and infrastructure need to be maintained. There is therefore a greater risk that high costs might impair the value of the company.

For example, if an ice cream producer takes over a car sales company, the skills to run the business are very different. The senior management would most likely want to retain the staff for both businesses, as people who make ice cream are unlikely to be able to sell cars well, and vice versa. The process used to produce and sell ice cream have no overlap with the marketing and sale of cars. The fixed assets used to produce and distribute ice cream are of no relevance to a business selling cars. Ultimately, there are next to no synergies to exploit between the two businesses, so both will have to be run independently.

In summary, you want to skew your investments to companies with a business model that is easy to understand and where management focus is on a core area of expertise. You want to avoid companies that have over-diversified into a broad range of businesses or are looking to acquire businesses outside of their core area of expertise. Where a company is in the process of acquiring a new business, a careful assessment of whether this will add value or dilute the company’s profitability and growth potential needs to be made.

Future direction and outlook

A good way to assess the outlook for a company is to first evaluate the key accounting numbers (as proposed in previous chapters) to build a picture of historic performance. You can then read the comments made by the chairman and directors in the annual reports (and other investment presentations) to gain a sense of whether their comments are in line with the actual performance achieved. If the forward-looking views tally, the executives’ views on the immediate future are likely to be a fair reflection of the outlook.

In bad years, you should look to see if the executives discuss the problems of the business and the mistakes made. This action should be viewed positively, as a company that is willing to identify and admit its failings is more likely to learn from and avoid these mistakes in the future. Such qualities will usually make the company a better investment, as opposed to a company that blames circumstances outside of its control, such as the weather. If the company made a large loss and statements from the chairman or directors are overly positive without addressing the underlying problems, this should raise some concerns about investing in the company.

For growth companies, if statements from the chairman or directors are pessimistic, a careful assessment of the growth story needs to be made as earnings growth may be at an end.

Competitive advantage

A company has a competitive advantage if it has attributes or abilities that are difficult to duplicate or surpass, providing it with a superior or favourable long-term position over competitors. As discussed in chapter 8, the most reliable evidence of a company with a competitive advantage is the ability of management to employ capital at a high rate of return while maintaining a high profit margin and decent free cash flow. This can be ascertained by looking at company numbers.

A company with a sustainable competitive advantage can compete effectively against its competitors while enjoying growth and profits. Thus, when a company can achieve a competitive advantage, its shareholders are likely to be well rewarded over the long term.

Conversely, a company in a sector that exhibits intense rivalry between competitors will find it hard to establish or maintain a competitive advantage and remain profitable. This problem is likely to be compounded if the products or services are easily substituted by products or services offered by competitors.

While looking at company numbers can confirm the presence of a competitive advantage, it is a useful exercise to try and articulate what these competitive advantages are and whether they are likely to continue over the medium term. Sustainable competitive advantages are essential for a company to thrive in today’s competitive global environment and be successful long term.

Competitive advantages, sometimes known as business franchise or economic moats, arise in several different ways:

Cost leadership/low pricing

Cost leadership occurs when a company can offer the same quality product as its competitors at a lower price. A company’s ability to deliver goods and services at low cost stems from economies of scale, operational efficiencies, proprietary technology or location, all of which allow the company to produce or sell goods in a more efficient manner.

A company that is the cheapest provider of a good or service makes it difficult for competitors to compete. This may provide sufficient pricing power, as well as competitive barriers to entry, which allow the company to generate a high return on capital over a long period of time. In addition, consistently low pricing can build brand loyalty, which is a further competitive advantage.

Cost leaders are typically large companies that have been able to exploit economies of scale to the point that they have little competition. If they are making a reasonable profit margin it is likely they are selling high volumes of common products or services that are needed at regular intervals or by most people at some point in their life. Low cost producers and sellers cover many kinds of businesses, such as insurance, furniture, groceries, carpets, etc.

Product differentiation

Low cost is only one of many factors that allow a company to compete effectively. A company that can positively differentiate its products or services by offering one or more marketable attributes (such as better quality, more features at a certain price point or better customer service) can help set them apart from their competitors. Offering a unique product or service, one that better meets the needs and desires of customers, helps build customer loyalty and is therefore less likely to lose market share to a competitor.

When assessing whether a differentiation strategy is a sustainable competitive advantage, one has to consider how easily company offerings can be imitated. If competitors can’t offer the same degree of differentiation, the competitive advantage is likely to be sustainable.

Established position in niche market

A company may decide to focus on a niche market, marketing a product or service to a particular segment of the economy as opposed to the entire population. This strategy aims to gain a competitive advantage by being the cheapest provider in that segment (although not necessarily the cheapest overall) or offering tailored products or services to meet the needs of the segment better than its competitors.

For example, a large supermarket operator may open smaller outlets in inner city areas that aim to be the cheapest in the local area. However, the stores do not need to be the cheapest overall, since they can take advantage of a captive local customer base and offer customer convenience instead of the cheapest prices.

Adapting product line

A product or service that never changes can become vulnerable to competition. In contrast, a product (or service) line that can evolve by improving the existing offering, or by adding complementary products or services, can help to keep and build a loyal customer base.

For example, Apple offers regular updates to their mobile phone, tablet and computer lines which leads to a regular cycle of customers upgrading at regular intervals. In addition, for their mobile phone and tablet range, they are now starting to offer complementary devices, such as watches that help monitor fitness or interact with home appliances and cars. Combined with their iTunes store and software environment, it provides a compelling reason to stay loyal to the brand.

Excellent brands

A company that has an excellent brand offers products or services that customers are willing to pay more for because they believe the offering is of higher quality and can be trusted. A good brand is invaluable as it causes customers to prefer the brand over competitors. Being the market leader and having a great corporate reputation can be part of a powerful competitive advantage. There are lots of companies with strong brands, like Coca-Cola, Pepsi, Apple, Adidas and McDonald’s, to name but a few.

Strategic assets

Another way for a business to gain a competitive advantage is to utilise strategic assets to defend revenue and profits. Strategic assets, such as patents, trade secrets, copyright and long-term contracts provide a sustainable competitive advantage by making competition illegal or very difficult. For example, pharmaceutical companies such as AstraZeneca and GlaxoSmithKline patent blockbuster drugs to prevent generic pharmaceutical companies from producing them. This allows them to recoup their R&D costs and make a profit.

Dominance in a market (tolls)

A company with both a dominant market position and exclusive control over a large share of the market has the ability to collect a toll from anyone needing that product or service. Typically, a company has the dominant market position because of economic barriers that prevent or greatly impede a potential competitor’s ability to compete in the market. Economic barriers include economies of scale, capital requirements, cost advantages and technological superiority.

For example, Mastercard and American Express can charge a toll on every transaction its customers make, as they have a first-mover advantage combined with superior technology and high sunk costs. Utility companies require a large upfront investment of capital to deliver their services, which limit the number of companies in an industry. Consequently, water, electricity and telephone companies are all able to levy tolls on their users.

Strong balance sheet/cash generative

Companies with low debt and a high positive cash flow have the flexibility to take advantage of investment opportunities when they arise. They do not have to worry about gaining access to working capital, liquidity or solvency. The balance sheet is the foundation of the company, allowing it to fund future investment at low cost.

This helps provide a competitive advantage over companies with weaker balance sheets that must rely on external financing at higher cost when trying to take advantage of investment opportunities. For example, the global financial crisis meant that it was very difficult for companies to raise external finance and would have prevented companies with weak balance sheets from taking advantage of investment opportunities when they became cheap.

Switching costs

If a company plays an integral role in your life, switching to another company’s product or service may not be worth the trouble. Switching costs may involve a monetary cost, but can equally take the form of costs on time, effort or social pressure.

Monetary costs may come directly in the form of an incumbent company levying a charge for switching, such as bank closure fees, or it may come indirectly through consumers having to purchase replacement add-ons and extensions for the new product or service due to incompatibility. For example, blades for Gillette razors are not compatible with Wilkinson razors, Canon’s DSLR lenses are not compatible with Nikon lenses, and Apple’s mobile apps can’t be used on android phones. Locking customers into a product ecosystem may be an effective way to retain customers. In addition, a company may offer loyalty incentives, such as frequent flier miles, coupons or other ‘membership’ bonuses, which are lost if the consumer switches to a competitor.

Other switching costs include the time and effort required to transition to another product or service. For example, moving to an iMac from a PC, or switching from an iPhone to an android phone, requires a certain amount of learning before becoming a proficient user. Social factors such as brand loyalty or being part of an elite group (nobody wants to be seen using a BlackBerry device when iPhones and android phones are so superior) may also be a factor when deciding when to switch.

A company that is solely reliant on high switching costs may only have a weak competitive advantage. However, if this is combined with other competitive advantages, switching costs may help reinforce an overall sustainable competitive advantage.

When performing a detailed assessment of a company’s competitive advantages you need to consider how they align with the most urgent and important needs of customers in the market, as well as the strengths and weaknesses of competitors. It is useful to try and prioritise the list of potential competitive advantages in order of likelihood of delivering a sustainable competitive advantage that can be used to differentiate the company over the longer term.

Try to articulate the most promising competitive advantages that you have identified for a company into a concise statement. This statement should ideally highlight the distinctive advantage a company has that cannot easily be replicated by others. This is a useful exercise as it helps you gain a deeper understanding of the fundamental strengths of a company, while forming a case to invest.

Management

The backbone of every successful company is a strong management team. Management is a key factor in the success of a company as it makes the strategic decisions and therefore serves a crucial function in determining the fate of the company. Great management can help steer a company to financial success as they are better able to construct and execute a good business plan, which helps achieve its main aims and goals.

Leadership

The first step in looking at management is to identify the key people running the company. This includes the chairman, chief executive officer (CEO) and chief financial officer (CFO), as well as operational managers. Every listed company has a corporate information section on its website about the management. This usually includes a biography on each executive with their employment history, educational background and any applicable achievements.

You want to see executives that have either been with the company a long time (and possibly worked their way up the business hierarchy) or have a transferable background to the company they are working for. If an executive has had a long tenure with the company, it is likely that the manager is a successful and profitable manager (as otherwise the board of directors would have made changes). What you don’t want to see are executives on the board that do not have a relevant background for the company or sector they are currently working in. It is worth identifying where executives have worked previously to see how they have performed. It is a good sign if executives saw positive results during their tenure with other companies.

When a founder or chief executive has been the driving force behind a company for many years you need to consider what succession plans are in place as well as how the business will cope once the key manager steps down from that position. When the change of management happens, you need to review growth assumptions and potentially make them more conservative to reflect the loss of leadership. You should be wary of companies where the succession risk is high.

If the company has recently experienced a period of poor performance, management restructuring may be a positive sign that changes are being made in the hope of improving that outlook. However, if several changes to management have been made over the previous few years it is indicative of a company in real trouble and should therefore be avoided. A management team consisting of people who come from completely unrelated industries should raise questions about their competency.

Management discussion and analysis

Management discussion and analysis (MD&A) is the section of a company’s annual report in which management discuss a broad range of different aspects of the company, both past and present.

Reading through the MD&A sections of consecutive annual reports can provide a feel for management style. You want to look for frank, worthwhile commentary on the management outlook that is refreshed at each annual report. It should be taken as a bad sign if the commentary is standardised and doesn’t change much from report to report. When reading the MD&A you should try to work out whether there is a capable management team in place that is able to deliver positive results.

Ideally, management style should be open, flexible and transparent about the running of a company. Good management think and act in the best interests of the company and shareholders. They focus less on the short-term pressures and more on the long-term health of the company, following their core mission statement and business plan. Comparing what MD&A said in past years and what they are currently saying helps to gain an insight into the strategies being pursued and whether they have been implemented well.

Management should be able to demonstrate that they understand the business and their customers as well as present a realistic view of the company and the industry it operates in. Key strategic and investment decisions should be covered in the MD&A section. Management should provide a solid rationale for the decisions and strategies adopted, which should be reflected in resources being used wisely, with expenses kept under control.

A sign of good management is often more evident when a company encounters business issues and problems. Good management should communicate quickly and honestly about the problems, dealing with them as quickly as possible by making the necessary changes.

Conference calls

Every quarter or half year management will host conference calls for analysts to discuss the performance of the company. The calls are normally advertised on the investors section of the company website. (If they are not, you can email the company explaining that you are a shareholder and that you would like to be invited to future calls.) In addition, recordings of previous calls may also be made available on the website.

The first part of the conference call is usually a discussion of the company’s financial results. However, the more interesting part is the question and answer portion of the call. Analysts and shareholders call in to ask questions of management, often regarding clarification over key decisions and strategies or for concerns to be addressed. The answers provided can be quite informative about the company.

In addition, these calls provide insight into management style. You should look for management providing candid, forthright answers that are easy to understand. It should raise concerns if management avoids answering questions and is generally evasive.

Management pay

It is worth checking whether the remuneration for management is excessive or not. The company’s latest annual report will contain information on salary and bonuses for key management. You should beware of ‘lifestyle companies’, where management have been in place with large salaries for many years but where the business has performed poorly.

Shareholder ownership

Executives are compensated by cash, equity and options. It is a positive sign if members of management own a significant number of shares. The ideal situation is where the founder of the company is running the company, or it is a family-run business with a substantial shareholding. When you know that a majority of management’s wealth is invested in shares, you can have greater confidence that they will operate in the interest of shareholders.

That said, you don’t want to see a single person or entity with majority control over the available shares in a company as this may result in the company being run for the benefit of a small number of large shareholders who are main board directors. This can create a major conflict of interest, where minority shareholders have little influence over how the company operates. Your preference should be to invest in companies where the main board owns less than 50% of the issued share capital and where there is large institutional investment.

The exception to this guideline is where there is large ownership from a founder or it is a family-owned business where the business is being run in the shareholders’ interest as a whole. That said, it’s possible for companies to offer attractive investment returns where the main board controls over half of the issued share capital. You just have to be aware of the risks this poses.

Director dealings

Few people are better placed to evaluate a company’s prospects than those who run it. This is why many investors regard directors’ share dealings (or insider dealing, as it is sometimes referred to) as a key indicator of future prospects. If key members of the management team (such as the chairman, CEO or CFO) have all been selling large amounts of shares you should be wary of investing in the company. The Investors Chronicle and FT both contain summaries of director dealings over the past 12 months, which can be used to check whether this has happened.

Summary

The aim of qualitative research is to produce a list of strengths, weaknesses, opportunities and threats to the company you are thinking about investing in. This list should contain your thoughts about what the company does, how it makes money, the competitive advantage of the company and the effectiveness of management. This should help provide a sense of whether the company is an attractive investment.

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