As we all know, a fundamental analyst is one who focuses more on value and less on charts and technicals. The primary goal of the fundamental analyst is to look for value in a stock. This has two perspectives. Firstly, whether the company is going to show consistent improvement in profits and cash flow generation in the coming quarters and coming years? Secondly, does the company bring some unique edge to the table that cannot be easily replicated? While the former is more quantitative, the latter is more qualitative. It is by combining both these aspects that the fundamental analyst takes a view on a company.
Long term investing is essentially based on fundamental analysis. What fundamental analysis does is to project the cash flows of a business and then discounts these cash flows backwards to arrive at a valuation.
Remember, this Discounted Cash Flow (DCF) method has been adequately spoken about and hence we shall not dwell too long on that. Having assumed that the DCF is done and dusted, our focus shall be more on the value addition that the fundamental analyst brings to the table.! Here are 6 questions that every fundamental analyst asks about the company..
1. What are the prospects of the company’s business and what are the risks in its model?
There is a popular joke in fundamental analysis that if the past is all that matters then librarians and archaeologists will be the richest investors in this world. Obviously, that is not the case. When you buy a company you are more interested in the prospects of the company rather than what it has done in the past. The first question pertains to growth. Does the company operate in a high growth business? After all, stable businesses are too dour and boring. Does the company make products that have cyclical demand or round-the-year demand? You pay a premium for Britannia and Hindustan Unilever because there is hardly any cyclicality in their business model.
Prospects will be of little use if the company is not equipped to take on competition. There is product competition that can arise from better and cheaper products in the market. For example, Reliance Jio threatened the telecom business models with their superior offering. Alternatively, it could also be disruptive products. Hero Honda (the old name of Hero Moto) disrupted the two-wheeler industry with a focus on motorbikes and fuel efficiency. As an investor, keep an eye for such risks in stocks.
2. Eyeballs and footfalls are fine; but show me the profits and the hard cash
Growth is not very meaningful if it is coming at a huge cost. Take the case of what the likes of Myntra and Flipkart are doing. They buy market share by giving huge discounts which are being funded by global investors. That is hardly a sustainable business model. That is what will determine the future value of the company. Gestation is understandable but visibility is important. We are talking about visibility of profits. There is only so much you can afford to spend and only so long you can afford to wait. Again, profits are not reflective of the actual cash flows of the company. You also need to check the cash flow statements of the company to reassure that the positive cash flows from operations can finance investments.
3. A lot of the brand value comes from the quality of management
This is slightly qualitative in nature but if the company has been around for a long time then the quality of the management is out there. Why do groups like Hindustan Unilever, Britannia get a premium in the market. It is not just their non-cyclical products but also the management image that they have cultivated. Business groups like Tatas, Birlas and Mahindras enjoy a premium image in the market because they have taken pains to ensure that they maintain highest standards of disclosure, transparency and corporate governance. Given a choice, you must always rely on a company that can add that reputational advantage.
4. It is all about corporate governance, corporate governance and corporate governance
This is partially covered in the previous point but this also pertains to the actual executive management of the company. What are the instances that made you uncomfortable as an investor. You surely cringed when PC Jewellers suddenly cancelled their buyback offer. You must have also been uncomfortable when the auditors of Manpasand Beverages suddenly resigned without offering any explanation. In the past, companies like Satyam, Deccan Chronicle, Kingfisher Airlines, Amtek Auto and Bhushan Steel actually kept the shareholders in the dark about their real performance. Enron and Lehman did that on a much bigger scale in the US resulting in their bankruptcy. You do not want to invest in a company that is likely to throw up negative surprises in the future.
5. Does the company have a moat and is there margin of safety?
Moat is a sustainable advantage. It can come in a variety of forms. It can be in the form of high margins, unique patents or even in the form of market leadership or even a unique positioning. Moats are critical because they ensure that the company is able to hold on to its growth and its operating margins even in tough market conditions and in economic down cycles. Generally, companies with a moat get a more attractive valuation in the market. That partly explains the valuations of companies like Maruti, Britannia etc.
6. Is the company going to guzzle too much of capital?
This is especially true for companies that have massive plans for expansion or diversification in the future. Markets are uncomfortable with capital guzzlers. You can see examples all around you. The question is on funding these costs? If the funding is through equity then you need to be prepared for dilution of earnings. If the funding is through long term debt, then you are looking at financial risk. Remember, expansion and diversification is integral to growth. What you need to ensure is that it can generate cash flows to justify these decisions. That is the tricky assessment.
This 6 factor model can go a long way in paving a clear path to look at a company fundamentally. At the end of the day, the qualitative assessment will trump the quantitative assessments.