Investment Checklist II - Understanding the Business - the basics

Once a company catches your attention, the first thing to do is to study the business. How does the company make money? What products/services does the company sell? If you can't describe the core business in a couple of words, it definitely deserves a place in the 'too tough' bucket. With modest effort, if you can't understand the business, you should not proceed any further.

Even if you're able to describe the business, you may have no competence in evaluating the business. For example, I might have some inkling about the oil and gas industry (because I worked in it for three years), but I am no master. So before I write my investment thesis, I must pin answer some questions -

1. Do I want to spend time studying this business? - Two things may deter you to proceed with the company at hand. You might not be interested in the business or you might discover that the learning curve is too steep. In the former case, you should definitely give up the chase. A company which bores you initially is unlikely to keep become the bedrock of investment success. (Second level thinking would also apply here - some of the best investment bets come from companies ignored by Mr. Market in the short term for being too boring!) In the latter case, you can be a good judge of the opportunity cost of your time and make a rational choice. The time taken to develop an understanding of the underlying business can be immaterial to investment success. But the depth of knowledge is not. I now try to aim for an inch wide, a mile deep sort of understanding of the companies that I'm invested in.
   
2. How would you evaluate the business if you were the CEO? - If you've always worried about your investment as a minority shareholder, you're probably not a long term investor. Wealth creation in the long term comes from alignment of interests between management and shareholders. Think like Buffett and try to evaluate a business like you'll hold it forever. This allows you to think like the CEO of the company. Not only will you pay attention to understand the business in great detail, you will also be able to evaluate management decisions in line with the company's vision.
   
3. Can I describe business operations in my own words? - You've probably done the short version of this already. But this delves into more specifics. Write down your answers to these questions and other things you think are relevant to your company. Doing this will expose grey areas in your understanding.
• What does the business manufacture/deliver?
• What are the raw materials used? How are these procured?
• Who are the customers? How is delivery done?
  
4. How does the company make money? - When I was reading Shearn's work, I thought he was being repetitive here. But the example provided by him does good justice. At the onset of the financial crisis, few financial gurus would have understood the complexity of credit default swaps. It was definitely right to say then that AIG is in the insurance business. That answered our previous question. Easy enough, but was that sufficient? NO.
   
   When the business model becomes so arcane that it's difficult to predict the effect of esoteric events on product groups, it's probably best to not bet. Personally, and given the lack of experience in my investment career, I try to stick to businesses which sell a single product/service.
   
   
5. How has the business evolved over time? - Has the company evolved into developing competitive advantage over a prolonged period of time or was it just at the right place at the right time? For cyclical industries, a bull run can see many companies rise to historic highs. With the incoming tide, everything rises. Only by delving into the past we can separate the wheat from the chaff. Good place to start is the company's website. Then onto annual reports, forums and any other media articles.
   
6. In what foreign markets does the company operate and what are the underlying risks? - Many companies have revenue streams outside their home country. In the Indian context too, a number of domestic players are entering newer geographies to diversify their customer base. This growth-oriented strategy comes with its own share of risks and opportunities.
• Similar to the overall study of the company's history, it is important to study the history of a company in foreign countries. Each operation is an economic unit unto itself and can be expected to have unique customer preferences. 
• Unless the product/service being sold needs no differentiation in foreign markets, a company will have to spend significant resources on R&D and marketing to appeal to its new customers.
• Do foreign operations have their own management teams? - Strategies in developed/mature markets are unlikely to work in developing/nascent markets.
• Is revenue growth translating into profit growth? - Be cautious if the company does not break-up its profits between geographies. The company may be masking bad performance in some countries with better performance across others. Only with a proper break-up between revenues and profits amongst the geographies can we get a good sense of multiple streams of income. Generally when a company enters a new market, it has larger costs than in mature markets. This goes beyond fixed costs to set-up plant and equipment. To gain market share, a new entrant has to fight incumbents and can be expected to have larger advertising and marketing costs.
• What are the risks to the foreign currency earnings? - Earnings are most likely denominated in currency of the foreign country where subsidiary is located. These earnings are subject to country, political and currency risks. One must be cognizant of these before extrapolating past successes onto newer geographies.
• Country risks - Protectionism and tax inefficiency are some examples. Good places to get a flavour of macroeconomic conditions are World Bank's Doing Business Report and BMI's Country Risk Reports.
• Currency risks - Currency fluctuations will have an impact on the revenue reported in the home country. Most companies use forwards to hedge their revenues. This means setting an exchange rate in the future based on current rates. This gives greater clarity in terms of expected future income. Some companies export and import from the same countries. This serves as a natural hedge to their operations. Hedging policy can be found in annual reports and management disclosures to investors.

This post helps us evaluate businesses from the management's perspective. Nothing has been said so far about the competitive landscape in which the business operates. The focus has only been on what the business does and not on how it competes with other businesses. In the next post, we will view businesses from the customer's perspective. That will do more justice to questions on industry and competition.