Stock investing must be practiced within ones circle of competence.
What does it mean?
Value investing is not only about Stock Analysis. It deals more with the core business.
Analysts who understand core business of a company, tend to do better stock analysis.
Value investing is about understand the “underlying business” behind a stock.
What it means by understanding underlying business?
It means, the investor must have a basic know-how about the company.
What are those basic know-how’s? We will discuss them in this article.
The same has been presented in the form:
“Questions to be answered about the company”
What is the purpose of answering these question?
It gives an overall feeling & a general understanding about the company.
A person must invest only in those companies whose business is understandable to him/her.
This is what is called as investing within once circle of competence.
How to know what is in my circle of competence?
Look for companies operating in same sector as your employer.
Suppose your employer is “Infosys”. It operates in “IT Services and Consulting”.
Which other companies operate in this same sector?
- HCL Tech.
- Tech Mahindra etc.
This is the way a person can start testing his/her circle of competence.
After some experience, one can even try to expand it.
Lets see how one can build upon ones circle of competence.
#1. How to build circle of competence?
A person who works for in a IT company tends to know more about how TCS and Infosys works.
The can judge operations of these companies in a more informed way.
Profiting in stock investing is all about “personal judgement”.
The more a person is informed, more accurate will be the judgement.
This is why investing within ones circle of competence results in more profits.
Apart from ones work-area, there is another area where our circle of competence is inbuilt.
The products that you use in your everyday life.
Products can be like toothpaste, shaving kit, refrigerator, television set etc.
As we use these products, we tend to have more knowledge about its company.
The best thing is, we actually use these product. We exactly know how good or bad they are.
A product which is good, always makes money for its company.
And buying stocks of a profit making company is always better, right?
So you can see, you already have a circle of competence.
Try answering the below questions about your chosen company.
You will be surprised to see how easily you are picking information about them.
What is essential is to keep a watch on your companies.
Even if you have zero understanding about it, by just watching them will fetch you key insights.
#2. Questions to be asked about the company
Here are few important questions that all investors must ask before buying value stocks.
These are those questions helps to test ones circle of competence.
Moreover, answering these question highlights few key insights about the company.
- What are the products and services of the company?
- Who are its end users?
- These products and services in high demand?
- How stable are its demand?
- The products and services are unique in comparison to its competitors?
- How strong is its brand recognition?
- If the company will raise the selling price, will their sales volume go down?
- How big is the company now, compared to its competitors?
- How big is its customer based? Dependent on only few customers?
- How does the company sell its products and services?
- Geographical where are the products and services of the company get sold?
- During economic slowdowns, the turnover is affected?
- How satisfied are the employees of this company?
- The company operates in a sector which is regulated by government?
- Is it an established company, or it is a new start up?
The 15 questions helps to perform the qualitative check on the company.
#2.1 Utility of the questions…
First, these questions works as a “self appraisal” for the investor. How?
If one can answer all at one go, it means the company is within the circle of competence.
If one cannot answer these questions, then these are the information that must be sought before investing.
Moreover, while answering these questions, a general feeling will also develop about the company and its quality.
Answering these questions is not easy.
One will need information’s to fill up this form.
A person may not have these information off-hand.
So what what one can do is, to look for the right answers……
Be prepared, it will take few of days to collect the data. Do not get distracted during the data-fetching phase.
The results will be worth the effort.
#2.2 Where to get the information?
The best source of such information will be the following:
- The latest annual report of the company.
- News feeds on the company.
Annual report can be downloaded from the company’s website.
One can subscribe to the news feeds using “Google Alters”.
Regular reading of the news feeds helps to gain a deep insight about the company’s underlying business.
Is this a easy habit to practice? It is not.
Probably this is why value investing is not as popular.
But people who practice it, will swear about its success.
Gathering information about a company can be painful for some. Why?
Because they want ready made answers.
Unfortunately in stock investing, read-made-answers are often delayed.
By the time it reaches us, its effectiveness is already gone.
Hence it is better to fetch information by self. This is a sure way of success in investments.
#3. How experts fetch information about a company?
Expert investors gather information a bit differently.
One such approach is stated here:
- Talk to people who know the company.
- Talking to the customers gives the best feel.
- Talk to the employees. This gives the best inside-story.
- Talking to the suppliers gives a different perspective.
This is a great way to build a competence about a company.
It helps one to source some facts which even newspapers did publish.
But it is true that only professional investors can give so much time for information gathering like this.
For other, the best way is by reading annual reports and news feeds.
#4. Companies worth investing our time on…
So it is clear that “building a circle of competence” is essential in stock investing.
But the problem, it is a very time taking activity.
How to pick our stock in which it will worth an effort?
Good companies keep giving hints to its potential investors.
A good company has a strong brand loyalty.
Take example of Indian companies like:
- Royal Enfield.
- Cafe Coffee Day.
- Lakme etc.
These are such brands which compliments the brand India.
There are global brands Google, Amazon, Apple, Facebook, Samsung, Nike, Adidas, Ferrari, BMW, Mercedes, etc.
These are also brands which compliments the brand name of their respective countries.
How one can identify such companies?
People love their products. They even stand in lines (wait) to buy them.
Example: I-Phone, fast-cars, premium-homes, consumables like food, public transport, etc.
Remember names of companies who manufacture them.
Keep these companies in your “watch-list”.
Read their annual reports and news feeds regularly.
#4.1 Characteristics of great companies
One of key indicator which speaks the most about its company is “EPS history”.
Please note, we are not talking about EPS, but EPS history.
What one should look in EPS history?
- Reported EPS over last 10 years.
- EPS was positive or negative in these years.
- How EPS grew year-on-year.
- EPS growth in 3year, 5 year, 7 year & 10 year time horizon.
Good companies, show consistent EPS growth each year.
Moreover, over longer time horizons like 7/10 years, EPS growth beats inflation.
These companies also pay a fraction of EPS as dividends to its shareholders.
The advantage of investing in such companies is two-fold:
- They yield short term income in form of dividends.
- Over longer time horizons, the render faster capital appreciation rates.
Why these companies display such excellent EPS growth?
Because of their competitive advantage.
How to if the company is enjoying the competitive advantage or not?
Remember to answer the above listed 15 question.
As we have already seen, these are only qualitative questions.
An investor must also answer few quantitative questions about the company.
The answer to these quantitative questions, are hidden in the following financial reports:
- Balance sheet,
- Profit and loss account, and
- Cash flow statement.
These are three reports that helps investors to estimate the true value of a company.
This is called financial analysis of the company/stocks.
We will see this in our next chapter (Value Investing & Financial Analysis).
#4.2 Who are the Top Managers?
Who is the Chairman, CEO, Board?
In addition to the 15 qualitative checks, it is also important to check the Top Managers of the company.
An investor must know who is Managing the company.
A good manager will eventually manage the company for the benefits of all stakeholders.
The positive impact of a good manager on the business is huge.
Ratan Tata took Tata’s from a few million-dollar-company to a 100-million-dollar company in 15-20 years.
Bill Gates: Imagine Microsoft being what it is today without him.
Steve Jobs: Try to guess Apple’s present without the persistence of him.
People like Jeff Bezos, Warren Buffett has more influence on their companies growth than anything else.
Value investing is about buying stocks of GOOD companies, run by GREAT managers.
Even best of business gets destroyed if it is not run by good managers.
Once you have all the qualitative information about the company, you are ready for the next step.
What is that?
Checking the valuation of the company.
This is the part of the quantitative check (financial analysis of the company).