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Stock research is incomplete without this... - Views on News from Equitymaster
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  • Jan 13, 2012

    Stock research is incomplete without this...

    Companies from a particular sector operate in a similar business and regulatory environment. The dynamics of the business are the same and so is the demand supply scenario. So what is it that makes one stock better than others? A relative study of all companies in the sector answers this. Thus, while investing it is important to not just study the company in detail but also analyze it relative to others in the same field. In this article, we will discuss what qualitative factors we need to watch out for while studying the peer companies.

    Criterions for peer analysis

    First of all, we need to know which companies are comparable to the one we want to analyze. To be comparable, companies should be similar, for example, these could belong to the same sector. Also, at times being in the same sector may not be sufficient if the companies have different business models. What we mean is that it is actually not useful to compare Pantaloon vis-a-vis Titan even though they are in the same sector. Similarly, an Indian generic pharmaceutical company should ideally be compared with an Indian peer operating in the generics space rather than an innovator multi-national (MNC). For comparable companies in the same sector, the following comparisons may be made:

    Market share: Number of players in the business or sector defines the level of competition. More the number of players, more intense is the competition in the industry. In an intensely competitive business, the market share enjoyed by industry players tends to be lower and reduces with addition of competition. The profit margins also take a hit because buyers/ customers have more options available to them and thus more bargaining power. This would induce the companies to reduce their prices to be able to sell more than the others thereby impacting their margins adversely.

    Barriers to entry: Barriers to entry are obstacles that make it difficult to enter a given market. These may be in the form of higher capital requirement, use of superior technology or need for constant research and development. A company that is into any such business has a distinct advantage over others. For example a company that has the first mover advantage in using an advanced technology to produce its goods tends to benefit till the time others catch up with it. Thus, it may prove to be a better bet.

    Raw material sourcing: It is crucial for companies to procure their raw material from the right places and at the right prices. A company that has a proper arrangement in place for sourcing of such raw material is likely to do better in sustaining profits. Companies sometimes get into long term contracts at pre determined prices to buy their inputs from suppliers. They are thus saved from the risks in price fluctuations. For companies that have exposure to exchange rate fluctuations, it is better to invest in one that is sufficiently hedged against the forex risks that may arise.

    Forward/ backward integration: To maintain steady supply of raw materials, firms may decide to manufacture these on their own or have captive capacities. Private labels being introduced by retailers in their stores is one such example of backward integration. Retailing companies are in direct contact with the consumers and know their tastes and preferences the best. To capitalize on this, they may decide to manufacture goods on their own instead of buying from other manufacturers. Although it has its own share of associated risks, but such retailers are expected to generate more profit. Forward integration is when a company decides to make finished products and reach out to customers through its own retail stores .

    Brand image: With people getting more aware about brands, brand plays a decisive role in the buying decisions of consumers. A good brand is associated with better quality and greater satisfaction. For companies that operate in consumer oriented sectors, it is particular beneficial to have a known brand or label of products. A brand that has existed for years tends to attract loyalty of customers and thereby help the company in generating more revenues. Owning a well known brand may also give the pricing power to the companies. They may be able to charge a premium for their products thereby increasing profit margins.

    Financial numbers: Last but definitely not the least, it is important to compare companies on the basis of their financial numbers. A relative financial analysis of profit margins, average sales growth over several years and debt-equity ratio helps in deciding which company one should invest into. Creditor days speak about the credibility of the company while inventory turnover reflects the efficiency in operations.

    A thorough analysis of the above mentioned factors and subsequent relative valuation of all comparable companies can help investors decide the best stocks to invest in. We should remember that a company does not work in isolation. It operates in a business environment that is competitive. Similarly, we cannot analyse a company in isolation, it must be analyzed in relation to peers in the same industry, if any.



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