Stock Pathshala — Module-III
Hello readers, Welcome back to part 3 in my series on stock investing. In the last part, I covered the concept of Value Investing. In the forthcoming modules, we will learn how to implement the ideas in Value investing.
“Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.” — Benjamin Graham
How to analyze the stocks to filter the good ones
Life as we know it is highly unpredictable. But, if you stay disciplined and focused, you can manage the significant components of your life like success, health, and family goals. Likewise, if you approach investing with a focused approach, you can create enormous wealth.
Now let us break down the process of analyzing a stock in detail. Value investing in stocks break down into the following components:
- Industry analysis
- Business analysis
- Management analysis
- Behavioral analysis
- Valuation analysis
Industry analysis:
A fish is always limited by the size of its pond. So, as an investor, you don’t want to be a part of an industry that isn’t growing. You need to understand its happenings, how it is performing, and its positives and negatives. All this will sum up to give you a fair idea of how prospering this industry will be in the future, which will ultimately decide your investment’s profits.
Each industry has a set of parameters to gauge its performance. For instance, a company’s book value is significant in banking or real estate stocks, while it is not required in the IT sector. Likewise, average revenue per customer is considered for telecom companies, while for the commodity sector, the production cost or book value is looked into.
Porter’s five forces model helps you to figure out the parameters required to gauge an industry. I have covered it later in this article.
Business Analysis:
“Buy a business that even an idiot can run because someday, an idiot will run it” — Warren Buffett.
As an investor, you need to develop a keen eye to analyze businesses that you pick up. Every business comes with its own set of pluses and minuses. For example, Tech Mahindra focuses on the telecom sector, while Accelya makes software solutions for airline industries. Whether you should buy Mahindra or Accelya depends on whether you are optimistic about the airline or telecom industry. So while both these companies fall in the IT sector, the reality is much different because one IT company can contrast to the other.
Management Analysis
“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
How to evaluate the management of the company?
Honestly, The average is not easy to assess a company’s top management, as most aspects are intangible. Fortunately, you have a checklist at your disposal to keep you safe and secure from a bumpy investment ride. First, you must look for honesty, transparency, competency, and passion as traits reflected from their management practices. These are the four pillars on which the firm foundation of a company is built.
Behavioral Analysis
As individuals, we make rational decisions to support our living, but many of our judgments prove wrong when acting in our best interests. This is so because we take decisions from an emotional space deep inside. The most significant setback of having these biases is that these biases overshadow the facts and misguide our strategy. Have you ever noticed that any loss pricks you harder than your gains? In stock investment, too, “ the loss of an investor pricks him twice as hard as the joy of gains.”
In the financial world, this belief is put across in the form of Prospect theory. As per this theory, our perceived loss is different from our perceived gain. The fact remains that the loss and gain arouse different intensities of sadness and comfort in an investor. But, of course, it is the feeling of pleasure and pain, which influences your next investment move.
Valuation Analysis
Valuation analysis is done to estimate the approximate worth of a business. It involves the scientific approach to analyze the assets of a business. Valuation analysis helps in figuring out the intrinsic value of a share. It is a great tool to compare two or more companies’ performance within the same industry. The financial valuation of a company involves analyzing its annual report. It helps an investor to understand whether the stock price is overvalued, undervalued, or rightly valued. This information is of paramount importance in choosing to invest in stocks.
“The stock market is filled with individuals who know the price of everything, but the value of nothing.” — Phillip Fisher
Michael Porter’s Five Forces Framework for industrial Analysis:
The five forces model is an analytical tool to understand the economic viability concerning its industry. This model will help you to analyze the weakness and strengths of various sectors. Such analysis serves as a tool to pick the right companies while choosing to invest in stocks.
The success of a business in an industry is dependent on the following five factors:
- Barriers to entry
- Bargaining power of buyers
- Bargaining power of supplier
- Industry Rivalry
- Threat of Substitute
Barriers to Entry:
Barriers to entry are the challenges that bring difficulty in entering a new business market. One exciting example of a high threat to entry is Facebook. Particularly after the accusations of Whatsapp and Instagram, it is the leader with a dominant market share in the social media industry. Due to its excellent network, it is difficult for new players to enter the industry.
Another example is the Civil explosive manufacturing units industry, which offers an excellent barrier to new entrants. The government is stringent in issuing licenses to manufacturing explosives, and so the existing players earn enormous profits.
The intelligent investor looks for industries with less scope of new entrants as it means more significant profit shares for the existing players.
Bargaining power of suppliers:
Bargaining power of suppliers refers to the negotiating ability with the suppliers to dominate their terms and conditions on the buyers. One real-life example with the high bargaining power of suppliers is Intel. Intel holds the majority of the market share to manufacture processors for laptops and desktop computers. So, laptop manufacturers like HP, Apple, Dell, etc., have to purchase processors on the pricing given by Intel.
Another example of the low bargaining power of suppliers is Indian Railways that is owned by the public sector in India. Even though many companies manufacture wagons, railways are the only buyer. Thus, the supplier cannot dictate their pricing terms to the railways, and they end up earning low-profit margins.
The low bargaining power of suppliers helps the companies work on their terms, inviting better profits for investors.
Bargaining Power of Buyers:
The bargaining power of buyers refers to the negotiating power of the buyers to dominate their terms and conditions on the suppliers. One real-life example of the low bargaining power of buyers is the railways and pharma sector in India. In the case of pharma or FMCG companies, all 130Cr Indians use their products. Hence, due to a vast customer base, the companies consistently make huge profits, even when their customers switch to competitors’ products. Therefore, the bargaining power of customers, in this case, is significantly less.
The bargaining power of buyers must be low, so they do not dominate the companies, which otherwise would hit the investor’s profit.
Competitor’s Rivalry:
The competitive rivalry of any industry depends on how profitable or competitive an industry is. Having too much competition can give a severe blow to your business. Hence to stay safe, try to find out the following:
- How many competitors exist in the market?
- What is the current size of the industry?
- What is the rate at which the industry is growing?.
- What is the size of the existing top, medium, and lowest competitors?
- Are there any threats of horizontal integration
- What is the level of promotional campaigns and advertisements done to sell the products?
These are some of the fundamental questions that give you a fair idea about the industry and its current valuation and expected valuation in the future.
Competitor’s rivalry must always be low to allow companies to make a more significant share of profits, which favors investors.
The Threat of Substitutes:
The threat of substitutes arises when the buyers choose to settle conveniently with another alternative without spending much more. For example, tea and coffee are highly compatible substitutes; if one is not available, the buyer happily settles for the other. One real-life example of the beverage industry with a high threat of substitutes is beer and wine. Another example with a danger of substitutes is natural gas and petroleum.
The threat of substitutes must be more minor for companies to make good profits, which acts in the investor’s favor.
How to Use Porter Model to your Advantage?
Step 1: Gather information:
The more you research about the industry, the more you get to learn about it. Therefore, your most crucial decision-making tool for stock investment is acquiring as much knowledge as possible.
Step 2: Analyse the information:
Once you have gathered all the data, you have to analyze it by posing the questions discussed above.
Step 3: Make strategies:
The information and analysis drawn so far will help you to come up with the right strategies. Here are a few examples of how this information will help you to formulate the method:
- If there are too many players or competitors in the market, it indicates the industry is slow. The industry is heading towards saturation with not much scope of survival for new entrants unless there is strong product differentiation.
- If the suppliers are dominant, the profit margins are highly constrained and connected to the supplier policies — for example, the petroleum industry.
- If the entry cost is too high, the stakes or the risk of taking up the business is very high. In such cases, you need to look at the industry growth, demand of products, existing players, nature of the Industry, etc. For example — opening a posh hotel, opening a car showroom, or a branded jewelry showroom.
Applying Porter five Forces model to the Airline industry:
Barriers to Entry — It is high for the airline industry
Bargaining Power of Supplier- It is also very high since there are only companies into commercial aircraft manufacturing, namely :
- Airbus
2. Boeing
Bargaining Power of Buyers — It is high for the airline industry.
What do we look for while buying the air tickets? Would you prefer airline over price? Of course, not.
The threat of substitutes: It is on a medium level in the airline industry.
The nearest substitute for the airline industry can only be railways. But the situation is set to change, particularly in the post-Covid era where business prefers to have a virtual meet in a place of actually visiting a distant office.
Industry Rivalry — It is a medium for the Airline industry.
We have the following players: Indigo, SpiceJet, Air India, Go Air, Vistara, Air Asia, and other regional players. So, these airlines fight firmly to get the best high traffic time slots, frequently traveled routes, etc.
So this is how by using porter’s five models, you can analyze any industry.
Thank You
