Lesson 2 – Understanding the business

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Lesson 2 of the Start Stock Investing E-Course

In this lesson I will discuss the factors that you need to study for understanding the business behind a stock.

More than just price

It is easy to get carried away by the tickers on financial news channels on TV or on the Internet. Stock symbols and prices stream by at different speeds. Many hypnotically stare at the price of a stock as it nudges up by 10 paise or 2 rupees in every ticker cycle.

Remember that, in isolation, the price does not tell you anything about the business. Nor does it tell you whether a stock is a great buy or a stock to sell immediately.

 

Fractional ownership in the business

When you buy or sell a share on the exchange, BSE or NSE, it is an electronic transaction. Earlier it was paper based.

There was still some link to reality because you held a physical share certificate. With electronic transactions that link is severed. It is easy to forget what we are actually dealing in.

The most important part of this lesson is that the moment you buy any stock you are part owner of a business. The business might be doing great or doing average or it might be in dire straits. Nevertheless, you have to now start thinking like a business owner if you are going to invest in stocks for the long-term.

I will now list the aspects of a business you should evaluate in your stock study.

Sector

Every company can be slotted into a particular sector. You need to ask how the sector is doing? Is it growing? Is it shrinking? At what rate?

Generally, a growing sector is good for your business. This is true in most cases.

This is not a firm rule though. There are exceptions. If there is price undercutting in the sector all players in that sector may bleed even when the entire sector grows. It seems strange, doesn’t it? You don’t have to look far if you consider the Indian airline sector.

  • Dirt-cheap fares.
  • Air traffic growth.
  • Entry of new airlines.
  • More aircraft were brought into operations by different players.
  • All of us enjoyed the low fares while they lasted.

Was it good for the different players in the airline sector?

In my opinion, most airlines did badly. Some went under. A prime example is that of Kingfisher Airlines. The sector grew. Yet it was bad for individual companies.

The problem for companies in one sector is that if one direct competitor starts cutting prices irrationally, they have to match prices or perish.

You should also pay close attention to the prospects of the sector. At the end of this lesson, I have shared an article on Moser Baer which you should surely read. Moser Baer started off with manufacturing CDs, essentially optical storage. In due course, CD’s became passe and Moser Baer entered the DVD manufacturing business. Soon USB storage technology hit the market and they started manufacturing USB drives. In each technology shift, they had to pump in money to address a new market. In every market they faced dropping prices which is the case with technology usually. The result was bad for Moser Baer.

Competitors

How many competitors exist in the sector? How are they placed against the company you are evaluating?

A monopoly situation is great for the company. A duopoly (two players) where your company is the bigger company is a good situation. If there are too many players scrambling for the same pie, it can lead to unhealthy price wars.

You should know the strengths and weaknesses of major competitors. Without this you study is incomplete. In fact, in this exercise, you might sometimes realize that an investment in a competitor might be better than an investment in the company that you are considering.

Suppliers

Raw materials or inputs need to be sourced in manufacturing companies. In services companies, this might not be applicable. You need to understand how prices of inputs move. Are they subject to a wide range of fluctuations?

Power companies which purchase coal from the market are more exposed than those with captive coal mines.

Companies for whom raw material cost is a small percentage of sales are less exposed to uncertainty on the supply front.

A very important question is whether the company has bargaining power against suppliers. A company that can stand its ground against suppliers is good on this count.

Customers

Similarly it is good if the company has bargaining power against suppliers. Here, a similar logic plays out. If a company sells to a few customers, they could have the upper hand. Diversified customer base works better for a company only if they have the distribution or reach respectively.

If customer’s are facing problems, the company will face a problem eventually. This again ties in with the sector study.

 

Products and Services

There are conglomerates like an ITC which has presence in IT, paper, tobacco, FMCG and hotels. And then you have companies like a Supreme Industries which only deal in plastics.

You can have a Infosys Technologies which is focused on outsourced IT services whereas an eClerx is focused on the KPO segment. Persistent Systems is focused on outsourced product development. By a broad definition, all come under the IT sector but each of them has different business characteristics.

In general, different business segments might have different profitability and different rates of growth. You need to know the important business segments for a company. A broad revenue breakup should be always studied.

A company with a single line of business is always easier to study. I don’t need to explain this to you. Simple is usually better in the world of stock investing. If there are multiple lines of business you have to keep track of that many more industry sectors and business segments.

 

Management

We will cover management in a later lesson. In this lesson, I will restrict myself to saying that it is a very important factor in determining the success of a business. But not as important as a sustainable competitive advantage.

We will cover sustainable competitive advantages or moats in the next lesson.

Lesson 2 – Summary

  • Stop looking only at price.
  • Dig deeper under the hood to understand the business behind a stock symbol.
  • Get a grip on sector, competitors, suppliers, customers, products and services and management of a company.

Recommended reading on understanding business

Moser Baer article in Forbes India

Airline industry article in CNN

IT companies – Peer study – Moneycontrol

Homework

From the Moneycontrol link, have a look at the table. Please visit the company websites of MPhasis, Persistent, Infosys, Infotech Enteprises, KPIT Cummins and Geometric and study their lines of business. What are their areas of strength?

 

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