Chapter 2: It’s Your Business!
The first step in fundamental analysis is understanding the company’s business in which you want to invest. Business is a very broad term. In this chapter, we will understand how to research a company from an investor’s perspective. What aspects does an investor need to look for in a company’s business to make sense of its financial statements? Let’s understand…
The very beginning of fundamental analysis is knowing the business you are getting into. If you are looking to invest in a company (i.e., buy shares of that company), it is all about your business to know how the company makes money.
What exactly is “business” in the first place?
Richard Branson, co-founder of Virgin Group, said,
"A business is simply an idea to make other people’s lives better"
Making money in the process isn’t a bad thing, either. The business idea involves finding a need or a want in the market and testing whether people are willing to pay to fulfill this want or need.
Why should you understand a business?
As discussed in the previous chapter, a fundamental investor needs to think of a stock as their own company and understand what’s best for its growth.
When you know what the business does and how it makes money, you can make sense of the financial figures such as revenue and profits. You can build your understanding of the company’s potential to grow and sustain in a dynamic business environment.
To understand the business of a company you want to invest in, you need to understand:
- The business model
- The business growth cycle
- The business environment a company operates in
- Macroeconomic aspects that affect participants in the economy
The business model
A business model is a detailed plan of how the company intends to profit from the business idea. Some of the craziest business ideas that nobody thought would ever succeed include selling packaged drinking water (Bisleri) when it was freely available at public water coolers, creating a movie ticket booking app when one could easily book a ticket (Bookmyshow) at the counter, and using a prepaid wallet (PhonePe) when one could pay in cash or through net banking. However, their business models converted these ideas into profitable business ventures, and in a great way indeed. A business model tells you about:
The offering: The business model describes the product or service that the company offers, what need/want the offering aims to fulfill, how the offering is priced, packaged, and sold (marketing), who the target customer is and other details.
The business structure: The business model describes how the company plans to manufacture or source the materials, distribute and market the product or service, the cost incurred, how much investment the company needs, and where it will use it.
The growth potential: The business model also outlines the road to growth and expansion, stating how it plans to scale its operations.
There are various types of business models. The most common is a manufacturing model, where businesses produce and sell an item to the customer. Automotive companies, fast-moving consumer goods companies, and even mobile phone companies follow this traditional business model. Here’s a summary of the most common types of models:
The company’s management can start with one business model and keep adding, innovating, and evolving its model with time, depending on its target audience’s changing needs and wants.
To give you a practical example of a successful business model that evolved with time and remained relevant, let’s talk about Apple.
Apple started out with the traditional manufacturing model, developing the brand and product (iPhone, Mac, Apple watch) and selling them to anyone looking for a secure computing experience and aesthetic value. Its business structure was to outsource its manufacturing and assembly to China to reduce production costs. There was a huge market to tap through geographic expansion, technology upgrades, and new product launches. This model helped Apple become the first stock to reach a $1 trillion market capitalization.
Market capitalization
A company’s share price is multiplied by the number of shares trading on the stock exchange. So if X Co. has 100 shares trading on the stock exchange at Rs. 5 per share, its market cap is Rs. 500. The total market value of all outstanding shares is Rs 500. The market cap determines a company’s size (large-cap, mid-cap, small-cap) and compares its performance with other companies of different sizes.
Where to find a company’s business model?
No set format or document exists where a company details its business model. It is at the company’s discretion how much it wants to reveal. However, a company’s Annual Report is the best place to begin. Apart from that, you can do your research by reading newsletters, analysts’ reports, CEO interviews, and detailed videos and podcasts to build your understanding of the company’s business model.
Fundamental research requires using multiple reference materials, annual reports, trustworthy news sources, and past news stories in business newspapers/magazines to build your understanding of the business.
The key skill of a fundamental investor is having their thought process and opinions formed on the foundation of the data and information they collect. They do their research rather than getting influenced by rumors.
How to analyze a business model?
Two companies can have the same business model and yet deliver different outcomes. This is because a business’s success or failure depends on how its management executes the business idea through the business model. For multiple reasons, one company could perform better than another with the same business model.
This is where the second step of understanding the business life cycle emerges.
Life-cycle of business
Imagine Amar and Ajay driving the same car, but Amar driving at 60km per hour and Ajay at 120 km per hour. Their performance (risk and reward) will differ in the short and long term. The same goes for a business cycle. Understanding the speed at which revenue and profit are growing can help you determine which phase of the business lifecycle the company is in.
A business’s lifecycle defines its progression in stages. Typically, there are five stages of a business lifecycle.
1. Launch stage
This is where the company is a startup trying and testing its business model. Its main objective is to attract customers through a value proposition and deliver the product/service. A company in this stage has low sales and high advertising and market expenses. It may also have low to no debt, as banks are skeptical of giving loans to startups whose business models have not yet proven to generate results.
Companies at this stage need more historical data to help analyze the company. Here, you have to rely more on qualitative analysis that focuses on the company’s owner(s), who are the whole and soul of the company. Startups generally get seed funding from relatives, friends, angel investors, and their own money.
2. Growth stage
Once the company has secured its existence and built a decent customer base and revenue stream, the owner focuses on survival. This is the stage where you know the business model is working, and now it has to survive in the business community. Hence, the focus extends to recovering costs and breaking even while growing revenue. The growth phase is the longest and most lucrative time for both the company and its investors.
Think of it like your school and college days. Just like you learned multiple subjects, developed hobbies, identified your strengths and weaknesses, and polished your skills, a business does the same in the growth stage.
This could be a crucial stage as many unforeseen events, ineffective management, new product failures, or risky decisions could strike and pull the company back into the survival stage. Many examples of growing companies were pulled back while they were at the peak of their growth.
Consider Yes Bank, a fundamentally strong bank run by the balanced combination of Rana Kapoor (the aggressive) and his brother-in-law Ashok Kapur (the conservative). After Ashok Kapur’s demise in 2008, the scales tilted heavily towards risky decisions as the bank started lending to companies under financial stress, including the Anil Ambani Group, Dewan Housing Finance Corporation, and the Zee Group. While these decisions resulted in significant growth in the short term, they also increased the risk of Yes Bank.
A 2015 UBS report found that such loans exceeded Yes Bank’s net worth. While the bank was growing aggressively, the business risk increased significantly, and it was only a matter of time before these stressed loans hit the fundamentals. Since RBI closely regulates banks, the regulator intervened in August 2018 and refused to extend Rana Kapoor’s tenure as the CEO, which was coming to an end in January 2019. A new CEO was instituted. From there began a series of unfortunate events that led to depositors withdrawing cash and a falling stock price, among other things.
3. Shake-out stage
This is the stage where a company moves towards its peak. It is growing revenue but at a slower rate. The company begins to see market saturation or new competitors taking over market share. This is where the cash flows grow faster than profits. Since many companies see money in the business, competition intensifies as too many players spring up to grab a slice of the profit pie.
Not many companies have reached this stage. Sometimes it is the nature of the business/industry and sometimes it is the constant fire-fighting within the company. But a business that reaches the shake-out stage has relatively lower business risk than those in the growth stage.
4. Maturity stage
This is the stage where a company has reached its peak. It is a market leader, and competition no longer affects it. IT giants like Infosys, TCS, and Wipro have achieved this stage. They have a strong history and high cash flows. However, sales stagnate and decline gradually at this stage unless a new category is entered.
The company has already implemented the growth plans mentioned in the business model. The challenge is to find the next growth factor. They are resourceful, have plenty of cash, a brand name, a loyal customer base, and the skill and talent to pursue the next growth expedition. Active management may revisit, review, and redesign the business model to adapt to change and find a new value proposition to extend its lifecycle.
5. Decline stage
Many companies, like Apple, stay in the maturity stage for a long time. However, some need help keeping up with the changing business environment and technological advancements, which pushes them into the decline stage. The company’s sales, profits, and cash flows fall faster as it loses its competitive edge. Then comes the point where the company exits the market.
However, a complete restructuring can turn a business from near bankruptcy to profitability. A turnaround can be made through a management reshuffle, a new business model, and a new beginning from the survival phase because a declining stock is as risky as a startup.
No guidebook can tell you which company is at which business lifecycle stage. You have to observe the qualitative (growth strategy, offerings) and quantitative (revenue and profit growth rate) fundamentals to identify the phase in which the business is operating.
Going back to our earlier example of Apple…
Apple rose to glory in 2007 on the back of its flagship iPhone. After 9 years of capturing the market, it reported its first decline in iPhone sales in August 2016 as the mobile phone market had reached a saturation point. People needed more time to be ready for a $1,000 price tag for a mobile phone. Moreover, the company needed to catch up on technology, making adding new features to the phone difficult.
Apple was at the maturity stage. It went back to the drawing board and adopted a service-based model. It used its existing iOS ecosystem to sell various subscriptions and services, such as Apple TV, iTunes, etc. and extended its lifecycle. This boosted its sales and revenue, bringing the stock to the $1 trillion market valuation.
In the meantime, it kept innovating new products. Apple Watch and Airpod extended its lifecycle and found the next $1 trillion valuation in August 2020. With the market fast saturating, Apple is continuously developing new products to find its next growth cycle. The company has a loyal customer base despite competition.
Understanding the business environmen
So far, we have focused on what goes on inside the business. However, a company operates in an economy where several players are present. The business interacts with these players directly or indirectly and maintains its momentum. While understanding the business, you also need to understand the industry the company operates in and how macroeconomic factors impact its growth and sustainability.
One of the most commonly used analysis frameworks is Porter’s 5 Forces. Michael Porter introduced this strategic analysis model in a 1979 article published in the Harvard Business Review. It is used to understand an industry’s competitive landscape.
Let’s look at each one.
1. Competitive rivalry: Here, you look at the intensity of the competition and where your company stands in comparison. Is it a market player or a new entrant? How many strong contenders are there for the market share?
Intense competition caused by price wars affects a company’s ability to charge a premium, increasing marketing costs to poach each other’s customers. Some good examples are Coca-Cola vs. Pepsi, McDonald’s vs. Burger King, and Airtel vs. Jio. Mild competition gives the company an edge to charge a premium and reduces customer retention stress. The focus shifts to supply and operations.
2. Potential for new entrants: Here, you look at how difficult it is to enter this business. Are there any barriers to entry, such as initial capital requirements and regulatory approvals? For instance, banks and hospitals are highly regulated, whereas telecom and airlines need huge initial capital, creating a barrier for new entrants. On the other hand, the restaurant industry has low entry barriers, making it highly competitive.
3. Threat of substitutes: A substitute, though not a directly competitive product, could reduce the overall demand for the product/service. For instance, mobile phones substituted landline phones, OTT platforms substituted Cable TV, and digital cameras substituted reel cameras. A substitute shifts the demand and reduces the overall market for the business. Sometimes, it can also cause an existential crisis for an industry. If the threat of substitution is high, you should examine the company’s strategy to innovate and grow with the trend. Kodak’s management’s inability to incorporate digital photography into its business model led to its downfall.
4. Bargaining power of supplier: The power to bargain comes when supply is abundant. If the supplier offers a niche product that is highly technical or has limited availability, the company could face higher inventory costs or a disruption in its operations due to a lack of supply.
Pratt & Whitney supplies jet engines to airlines worldwide and has strong bargaining power. A technical issue in its engines grounded several aircraft, costing airlines massive losses as they could not fly those planes despite high demand. Go First Airlines even filed for bankruptcy because of the engine issue. On the other hand, when supply is abundant, suppliers tend to lose, and the company benefits as they can buy at a huge discount.
5. Bargaining power of customer: A customer’s bargaining power defines how competitive the market is and how easy it is to switch. When customers have high bargaining power, as in the case of mobile phone services (Jio, Airtel, Vodafone Idea), there are price wars that affect companies’ profits. On the other hand, when customers have low bargaining power, such as petrol and electricity, the company’s profits are stable.
Tip
Studying a company is like preparing a presentation. The above three concepts—business model, business lifecycle, and business environment—can help you create a framework for your research. It tells you how to analyze the company’s business. As Charlie Munger beautifully puts it, “Understanding how to be a good investor makes you a better business manager and vice versa.” The initial understanding of the company will help you build a strong foundation for your analysis. It’s essential to stay updated on the current happenings in the business world. You can subscribe to business newspapers, set news alerts, and spend 30 minutes daily reading the news.
How a fundamental investor studies a business?
To be a fundamental investor, you need to think like the captain of a cricket team. First you need to observe and analyse all the players, their strengths and weaknesses, before selecting your final team (business model). But having selected the best possible team isn’t enough. What kind of a pitch are you playing on, are the weather conditions in your favour, is the outfield slow or fast – every last detail matters (business environment) as it affects your overall game.
Similarly, just zeroing in on a stock or company with a successful business model isn’t enough. You need to be aware and updated on the macroeconomic environment (consumer spending, government policies), competitors and business environment, and the core strengths of your company. Only when you have the complete picture can you design a game-winning strategy.
And even a sound, solid strategy can only help you make a good start. Once the game begins, its all about the score. As a batsman, you will have to face a volley of googlies, short balls and bouncers. You need to be sharp in analysing the bowler’s stride and length to tackle the ball coming your way – and you need to do all this as you stand at the crease (Business lifecycle).
Fortunately, for investors, there is a way of accessing and analysing a company’s scores before and after investing in a stock.
With the help of financial statements, which we will cover in the next chapter.
Summary
- A business is an idea to fulfill a demand/need and make money in the process. A fundamental investor should know the business of the company they are investing in to make sense of the financial figures.
- To understand a business, you need to do research about the company’s business model, business lifecycle and the business environment the company operates in.
- To study a business model, look at the company’s product/service offerings, business structure, and growth plans. This information can be found in annual reports, business newspapers etc.
- Any business has 5 stages – launch, growth, shake out, maturity, and decline. You can identify which stage the company is in by observing its sales, net profit and cash flow. The business stage can help determine the company’s business risk.
- To study the business environment, you can start with Porter’s 5 forces: Competitive rivalry, Threat of new entrants, Threat of substitutes, Bargaining power of supplier, Bargaining power of customer.
- A fundamental investor is like a team captain who studies the business model of the company to know its strengths, understands the business enviornment, and prepares his game plan. This preparation helps him invest with confidence across all stages of the business.