How did you know that analysis was for you? What do you do on a daily basis? How do you go about analysing a company? How do you value it? How can you reduce risk in an investment process?…These are just some of the most common questions posed to “value” analysts by young people who are studying and want to understand what we do, or are simply mulling over their future. In this article we aim to provide them with some answers which will be useful for investors in general.
An essential precondition of analysis is that it should awaken a desire to learn. In other words, a desire to understand the dynamics of a sector, a company’s strategy, deciphering how the market sees things and where it might be mistaken, finding out whether there are other methods or ways to understand and/or price businesses which can add value, etc. Ultimately, it is about have a passion for researching, analysing and understanding investment opportunities.
As with other activities, you often discover this once you are immersed in the process. Our daily life requires effort and perseverance, backed up by many hours of preparation and a capacity for continual learning. And underpinned by some degree of financial framework.
WHAT DO ANALYSTS DO ON A DAILY BASIS?
Our overarching goal is to uncover “small gems”. Undervalued companies which offer us a sufficient margin of safety, since the latter reduces the risk of a permanent loss of capital and therefore increases the probability of a reasonable return. We seek opportunities which provide asymmetric risk-reward.
HOW DO WE GO ABOUT ANALYSING COMPANIES?
We are confronted with an overdose of information on a daily basis. Our goal is to simplify it, discarding redundant information so that crucial information can “speak to us”. We try to pinpoint the three critical variables that can determine 70-80% of a company’s value creation and we delve into them with the goal of building a sound and simple investment hypothesis.
Firstly, we look for clues in the facts to create a reference framework: analysing recent results performance and the company’s financial structure over a cycle; understanding that a business’ value depends on who is managing it and the strategy they develop.
At times, understanding a company’s corporate governance helps us to get a hold on some of the things that are happening. We seek to gauge management quality, the management team’s track record of results. In this regard, if we look at the returns posted by the Spanish market over the last 20 years for example, we can highlight companies such as Elecnor (17% annualised return) or CAF and CIE with 15% returns. These companies have conservative management teams, who know their business back-to-front, focus on their circle of competence, are cost efficient, invest in research and development and have family/employees in their shareholding structure whose long-term interests align with minority investors. CIE is also noteworthy for its capacity to buy and integrate effectively.
Analysing more recent periods, such as the last 10 years, we can also identify companies that have become pioneers and global leaders in their sector. Examples include Inditex (+17% annualised return) or Grifols and Viscofan with 15% annualised returns. All three companies operate in growth sectors.
Inditex combines exceptional execution of a business model based on a system of flexible production and high “pull” capacity response (they know their customers, whose real-time demand drives production) with oversight from an integrated information and centralised logistics systems (as illustrated by the success of their online platform). This enables them to be cost efficient, offering a value for money fashion product.
Grifols stands out for a combination of corporate management with a clear long-term vision (they work over 10-year horizons) and a particular focus on the security of their products. Alongside this, they are judicious with capital allocation (e.g. transformative acquisition of Talecris), which makes them one of the leading global companies in the blood-derived products sector. It is worth noting that both companies are backed by a family as controlling shareholder. Viscofan is another good example of management, efficiency and reliability in the production process.
All of these touchpoints, help us to take the measure of a company. But it is crucial to understand the business model, what the company does, its strategy, how they earn money, where their competitive advantage lies, and above all, whether it is sustainable.
To do so we have to understand whether there are barriers to entry and how rigid they are. We try to understand whether the company has an advantage in terms of costs, process or brand differentiation (for example, Coca-Cola which stands out for its consistency and commercial success), there are also some premium brands among car manufacturers or other luxury brands in other sectors. We also need to understand whether there is a network effect (an example are the internet titans) or switching costs. For example, users of Microsoft Office learn to use a series of standardised tools which improve productivity and are also exchanged among colleagues, suppliers, clients, etc.
Companies can also have unique assets. Take an electricity distribution network or a generation plant, which is able to produce green energy at a low marginal cost. Or, for example, Ferrovial, which has a unique asset in the world of infrastructures in the form of the 407 Express Toll Route in Canada, where they recovered their initial investment in ten years and now have an asset retaining a useful life of over 80 years. Furthermore, Ferrovial’s interests are clearly aligned with the minority investor, as indicated by shareholder dividend remuneration and share buybacks carried out in recent years. We have to bear in mind that, in general, regulated assets need to be weighted according to their underlying regulatory framework.
For us it is essential to understand the sector in which the company is operating and how it is structured: the degree of sectoral concentration and the profile of demand (who are the clients, what do they want, how much are they willing to pay). But we also need to understand the sector’s product range (its value proposition): by following competitors and their strategies, understanding the situation in terms of supply-demand.
It is worth considering whether there is potential for technological change of disruptive products. An example is the emergence of Amazon in commercial distribution, creating a leader with scale and brand recognition, which is hard to replicate. We also need to be wary of potential regulatory changes or shifts in consumer habits that can modify the status quo. If we are looking at a company in a cyclical sector, for example, in the commodities sector, such as Acerinox – one of the most competitive companies in the world in stainless steel – it is worth understanding the current phase of the cycle and considering whether structural changes could arise.
HOW WE DO ALL OF THIS?
By reading expert reports, meeting the management team, speaking with competitors, providers, former employees and constantly focusing on the dynamics driving the sector and the company. In other words, considering the risks and opportunities facing the company.
Once we have completed this phase, we need to ask ourselves whether we have been able to understand the sector dynamics, the company’s strategy and how it makes money. If we are not certain, we need to think whether it makes sense to continue the process, either because we do not know, or it is not possible to reach a conclusion or because there are variables outside our control.
HOW DO WE VALUE A COMPANY?
All of the above will serve as a basis for forming an opinion about the company and building a simple model to determine normalised earnings. Once we have done the prior work, the next task is determining how much the company is worth – its intrinsic value. Our approach should be based on applying a simple and coherent approach.
We believe that there are at least three key factors which determine value creation in a company: growth, margins (especially in companies with little capital invested) or the return on capital invested (for companies with capital employed), risk, and the sustainability of these variables over time. Therefore, it is important to know where they come from and, above all, how they could develop in the future (growth trends). This should provide a basis for a sound valuation.
There are a wide variety of valuation methods and associated metrics. In our opinion, the valuation itself is not as important as what the company generates (its cash flow). Everything that we can’t explain in a simple cash flow is not worth convoluting in a valuation approach (cost of capital, beta, etc.) or with a complicated model.
Despite having done all the above, investment ideas will sometimes work and other times won’t. Sometimes they work for the right reasons and other times for the wrong reasons. The crucial thing is understanding why something happened, reviewing our process and extracting the appropriate conclusions.
HOW CAN WE REDUCE RISK IN OUR DECISION MAKING PROCESS?
We should concentrate our efforts within our circle of competence, avoiding daily distractions and focusing on the key parameters which determine a company’s long-term value. Likewise, we should understand the company and the sector as well as possible, buying as cheaply as we can, understanding and quantifying risks in adverse scenarios, being rigorous in the application of our approach and consistent in our philosophy. All of this will help us to be well prepared.
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