8
SECURITY ANALYSIS
Now that we’ve covered the top-down method, let’s pick some stocks. This chapter walks you through analyzing individual Materials firms using the top-down method presented in Chapter 7. Specifically, we’ll demonstrate a five-step process for analyzing firms relative to peers.
Every firm and every stock is different, and viewing them through the right lens is vital. Investors need a functional, consistent, and reusable framework for analyzing securities across the sector. While by no means comprehensive, the framework provided and the questions at this chapter’s end should serve as good starting points to help identify strategic attributes and company-specific risks.
While volumes have been written about individual security analysis, a top-down investment approach de-emphasizes the importance of stock selection in a portfolio. As such, we’ll talk about the basics of stock analysis for the beginner-to-intermediate investor. For a more thorough understanding of financial statement analysis, valuations, modeling, and other tools of security analysis, additional reading is suggested.
Top-Down Recap
As covered in Chapter 7, you can use the top-down method to make your biggest, most important portfolio decisions first. However, the same process applies when picking stocks, and those high-level portfolio decisions ultimately filter down to individual securities.
Step one is analyzing the broader global economy and identifying various macro “drivers” affecting entire sectors or industries. Using the drivers, you can make general allocation decisions for countries, sectors, industries, and sub-industries versus the given benchmark. Step two is applying quantitative screening criteria to narrow the choice set of stocks. It’s not until all those decisions are made that we get to analyze individual stocks. Security analysis is the third and final step.
For the rest of the chapter, we assume you have already established a benchmark, solidified portfolio themes, made sub-industry overweight and underweight decisions, and are ready to analyze firms within a peer group. (A peer group is a group of stocks you’d generally expect to perform similarly because they operate in the same industry, possibly share the same geography, and have similar quantitative attributes.)
MAKE YOUR SELECTION
Security analysis is nowhere near as complicated as it may seem—but that doesn’t mean it’s easy. Similar to your goal in choosing industry and sector weights, you’ve got one basic task: spot opportunities not currently discounted into prices. Or, put differently, know something others don’t. Investors should analyze firms by taking consensus expectations for a company’s estimated financial results and then assessing whether it will perform below, in line with, or above those baseline expectations. Profit opportunities arise when your expectations are different and more accurate than consensus expectations. Trading on widely known information or consensus expectations adds no value to the stock selection process. Doing so is really no different than trading on a coin flip.
The top-down method offers two ways to spot such opportunities. First, accurately predict high-level, macro themes affecting an industry or group of companies—these are your portfolio drivers. Second, find firms that will benefit most if those high-level themes and drivers play out. This is done by finding firms with competitive advantages (we’ll explain this concept more in a bit).
Since the majority of excess return is added in higher-level decisions in the top-down process, it’s not vital to pick the “best” stocks in the universe. Rather, you want to pick stocks with a good probability of outperforming their peers. Doing so can enhance returns without jeopardizing good top -down decisions by picking risky, go-big-or-go-home stocks. Being right more often than not should create outperformance relative to the benchmark over time.
A FIVE-STEP PROCESS
Analyzing a stock against its peer group can be summarized as a five-step process:
1. Understand business and earnings drivers.
2. Identify strategic attributes.
3. Analyze fundamental and stock price performance.
4. Identify risks.
5. Analyze valuations and consensus expectations.
These five steps provide a consistent framework for analyzing firms in their peer groups. While these steps are far from a full stock analysis, they provide the basics necessary to begin making better stock selections.
Step 1: Understand Business and Earnings Drivers
The first step is to understand what the business does, how it generates its earnings, and what drives those earnings. Here are a few tips to help in the process.
• Industry overview: Begin any analysis with a basic understanding of the firm’s industry, including its drivers and risks. You should be familiar with how current economic trends affect the industry.
• Company description: Obtain a business description of the company, including an understanding of the products and services within each business segment. It’s always best to go directly to a company’s financial statements for this. (Almost every public firm makes their financial statements readily accessible online these days.) Browse the firm’s website and financial statements/ reports to gain an overview of the company and how it presents itself.
• Corporate history: Read the firm’s history since its inception and over the last several years. An understanding of firm history may reveal its growth strategy or consistency with success and failure. It also will provide clues on what its true core competencies are. Ask questions like: Has it been an industry leader for decades, or is it a relative newcomer? Has it switched strategies or businesses often in the past?
• Business segments: Break down company revenues and earnings by business segment and geography to determine how and where it makes its money. Find out what drives results in each business and geographic segment. Begin thinking about how each of these business segments fits into your high-level themes.
• Recent news/press releases: Read all recently released news about the stock, including press releases. Do a Google search and see what comes up. Look for any significant announcements regarding company operations. What is the media’s opinion of the firm? Is it a bellwether to the industry or a minor player?
• Markets and customers: Identify main customers and the markets it operates in. Determine whether the firm has any particularly large single customer or a concentrated customer base.
• Competition: Find the main competitors and how market share compares with other industry players. Is the industry highly segmented? Assess the industry’s competitive landscape. Keep in mind the biggest competitors can sometimes lurk in different industries—sometimes even in different sectors! Get a feel for how the firm stacks up—is it an industry leader or a minor player? Does market share matter in that industry?
Step 2: Identify Strategic Attributes
After gaining a firm grasp of firm operations, the next step is identifying strategic attributes consistent with higher-level portfolio themes. Also known as competitive or comparative advantages, strategic attributes are unique features allowing firms to outperform their industry or sector. Since industry peers are generally affected by the same high-level drivers, strong strategic attributes are the edge in creating superior performance. Examples of strategic attributes include:
• High relative market share
• Low-cost production
• Superior sales relationships/distribution
• Economic sensitivity
• Vertical integration
• Strong management/business strategy
• Geographic diversity or advantage
• Consolidator
• Strong balance sheet
• Niche market exposure
• Pure play
• Potential takeover target
• Proprietary technologies
• Strong brand name
• First mover advantage
Strategic Attributes: Making Lemonade
How do strategic attributes help you analyze individual stocks? Consider a simple example: There are five lemonade stands of similar size, product, and quality within a city block. A scorching heat wave envelops the city, sending a rush of customers in search of lemonade. Which stand benefits most from the industry-wide surge in business? This likely depends on each stand’s strategic attributes. Maybe one is a cost leader and has cheapest access to homegrown lemons. Maybe one has a geographic advantage and is located next to a basketball court full of thirsty players. Or maybe one has a superior business strategy with a “buy two, get one free” initiative that drives higher sales volume and a bigger customer base. Any of these are core strategic advantages.
Portfolio drivers help determine which kind of strategic attributes are likely to face head or tailwinds. After all, not all strategic attributes will benefit a firm in all environments. For example, while higher operating leverage might help a firm boost earnings when an industry is booming, it would have the opposite effect in a down cycle. A pertinent Materials example is access to iron ore reserves for a steel producer—an important strategic attribute from 2003-2007 due to the rising cost of raw materials. When iron ore prices decline, however, iron ore operations will create a drag on company earnings growth relative to other producers. Thus, it’s essential to pick strategic attributes consistent with higher-level portfolio themes.
A strategic attribute is also only effective to the extent management recognizes and takes advantage of it. Execution is key. For example, if a firm’s strategic attribute is technological expertise, it should focus its efforts on research and development to maintain that edge. If its strategic attribute is low-cost production relative to its peer group, it should capitalize by potentially lowering prices or expanding production (assuming the new production is also low cost) to gain market share.
Identifying strategic attributes may require thorough research of the firm’s financial statements, website, news stories, history, and discussions with customers, suppliers, competitors, or management. Don’t skimp on this step—be diligent and thorough in finding strategic attributes. It may feel an arduous task at times, but it’s also among the most important in security selection.
Step 3: Analyze Fundamentals and Stock Price Performance
Once you’ve gained a thorough understanding of the business, earnings drivers, and strategic attributes, the next step is analyzing firm performance both fundamentally and in the stock market.
Using the latest earnings releases and annual report, analyze company performance in recent quarters. Ask:
• What are recent revenue trends? Earnings? Margins? Which business segments are seeing rising or falling sales?
• Is the firm growing its business organically, because of acquisitions, or some other reason?
• How sustainable is their strategy?
• Are earnings growing because of strong demand or because of cost cutting?
• Are they using tax loopholes and one-time items?
• What is management’s strategy to grow the business for the future?
• What is the financial health of the company?
Not all earnings results are created equal. Understanding what drives results gives clues to what will drive future performance.
Check the company’s stock chart for the last few years and try to determine what has driven performance. Explain any big up or down moves and identify any significant news events. If the stock price has trended steadily downward despite consistently beating earnings estimates, there may be a force driving the whole industry downward, like expectations for lower metal prices. Likewise, if the company’s stock soared despite reporting tepid earnings growth or prospects, there may be some force driving the industry higher, like takeover speculation. Or stocks can simply move in sympathy with the broader market. Whatever it is, make sure you know.
After reading the earnings calls of a firm and its peers (these are typically posted on the investor relations section of a firm’s website every quarter and transcripts can also be found at http://seekingalpha.com/tag/transcripts), you’ ll begin to notice similar trends and events affecting the industry. Take note of these so you can distinguish between issues that are company-specific or industrywide. For example, economic growth or labor scarcity often affect entire Materials industries, but hedging policies or a government’s tax policies may only affect specific producers.
Step 4: Identify Risks
There are two main types of risks in security analysis: stock-specific risk and systematic risk (also known as non-stock specific risk). Both can be equally important to performance.
Stock-specific risks, as the name suggests, are issues affecting the company in isolation. These are mainly risks affecting a firm’s business operations or future operations. Some company-specific risks are discussed in detail in the annual reports, 10-Ks for US firms and the 20-Fs for foreign filers (found at www.sec.gov). But one can’t rely solely on firms’ self-identifying risk factors. You must see what analysts are saying about them and identify all risks for yourself. Some examples include:
• Stock ownership concentration (insider or institutional)
• Customer concentration
• Sole suppliers
• Excessive leverage or lack of access to financing
• Obsolete products
• Poor operational track record
• High cost of products versus competitors
• Late Securities and Exchange Commission (SEC) filings
• Qualified audit opinions
• Hedging activities
• Pension or benefit underfunding risk
• Regulatory or legal (pending litigation)
• Pending corporate actions
• Executive departures
• Regional, political/governmental risk
Systematic risks include macroeconomic or geopolitical events out of a company’s control. While the risks may affect a broad set of firms, they will have varying effects on each. Some examples include:
• Commodity prices
• Industry cost inflation
• Economic activity
• Labor scarcity
• Strained supply chain
• Legislation affecting taxes, royalties, or subsidies
• Geopolitical risks
• Capital expenditures
• Interest rates
• Currency
• Weather
Identifying stock-specific risks helps an investor evaluate the relative risk and reward potential of firms within a peer group. Identifying systematic risks helps you make informed decisions about which sub-industries and countries to overweight or underweight.
If you don’t feel strongly about any company in a peer group within a sub-industry you wish to overweight, you could pick the company with the least stock-specific risk. This would help to achieve the goal of picking firms with the greatest probability of outperforming its peer group and still perform in line with your higher-level themes and drivers.
Step 5: Analyze Valuations and Consensus Expectations
Valuations can be tricky. They are tools used to evaluate market sentiment and expectations for firms. They are not a foolproof way to see if a stock is “cheap” or “expensive.” Valuations are primarily used to compare firms against their peer group (or peer average) or a company’s valuation relative to its own history. As mentioned earlier, stocks move not on the expected, but the unexpected. We aim to try and gauge what the consensus expects for a company’s future performance and then assess whether that company will perform below, in line, or above expectations.
Valuations provide little information by themselves in predicting future stock performance. Just because one company’s P/E is 20 while another’s is 10 doesn’t mean you should buy the one at 10 because it’s “cheaper.” There’s likely a reason why one company has a different valuation than another, including such things as strategic attributes, earnings expectations, sentiment, stock-specific risks, and management’s reputation. The main usefulness of valuations is explaining why a company’s valuation differs from its peers and determining if it’s justified.
There are many different valuation metrics investors use in security analysis. Some of the most popular include:
• P/E—price-to-earnings
• P/FE—price-to-forward earnings
• P/B—price-to-book
• P/S—price-to-sales
• P/CF—price-to-cash-flow
• DY—dividend yield
• EV/EBITDA—enterprise value to earnings before interest, taxes, depreciation, and amortization
Once you’ve compiled the valuations for a peer group, try to estimate why there are relative differences and if they’ re justified. Is a company’s relatively low valuation due to stock-specific risk or low confidence from investors? Is the company’s forward P/E relatively high because consensus is wildly optimistic about the stock? A firm’s higher valuation may be entirely justified, for example, if it has a growth rate greater than its peers. A lower valuation may be warranted for a company facing a challenging operating environment in which it is losing market share. Seeing valuations in this way will help to differentiate firms and spot potential opportunities or risks.
Valuations should be used in combination with previous analysis of a company’s fundamentals, strategic attributes, and risks. For example, the following grid shows how an investor could combine an analysis of strategic attributions and valuations to help pick firms.
Stocks with relatively low valuations but attractive strategic attributes may be underappreciated by the market. Stocks with relatively high valuations but no discernible strategic attributes may be overvalued by the market. Either way, use valuations appropriately and in the context of a larger investment opinion about a stock, not as a panacea for true value.
IMPORTANT QUESTIONS TO ASK
While this chapter’s framework can be used to analyze any firm, there are additional factors specific to the Materials sector that must be considered. The following section provides some of the most important factors and questions to consider when researching firms in the sector. Answers to these questions should help distinguish between firms within a peer group and help identify strategic attributes and stock-specific risks. While there are countless other questions and factors that could and should be asked when researching Materials firms, these should serve as a good starting point.
Supply/Demand Environment: For globally priced goods, what is the product’s supply/demand environment around the world? And for regionally priced goods, what is it within the firm’s countries of operation? Have prices recently been affected by changes or expectations of changes in the supply/demand equation? Both supply and demand side factors will have a great influence on prices, which can be volatile.
Revenues and Earnings Breakdown: Most firms produce more than a single product. The more diversified the revenue, the less exposed the firm is to fluctuations in a single product or end market. Its product mix will also determine what has the greatest effect on the firm’s future earnings and performance. How are the firm’s revenues and earnings divided between products? How does this compare to competitors? Is it more concentrated or diversified?
Production Growth: What is the firm’s production growth history? Is the firm consistently growing production or is it experiencing declines? What is its production growth relative to peers? What is its strategy for increasing production? Is it organic or through acquisitions?
Organic growth carries operational risk and could potentially yield limited success due to unexpected obstacles and higher costs, difficult governmental royalties, or regulatory negotiations. Growth through acquisitions, however, could increase integration risks and raises the possibility of paying too much for a firm or asset.
Of course, production growth for the sake of production growth is not always a good thing. If done on a large enough scale, it may depress prices and actually reduce total earnings. Instead, firms may find share buybacks or dividends as better means of increasing shareholder value.
Reserve Replacement: This is most applicable to industries where production is limited by available resources. This includes producers in metals and mining, construction materials, lumber, and some segments of chemicals such as mined fertilizers. What is the firm’s history of reserve replacement? Does it have a strategy in place to grow reserves? How many years can it sustain production with current reserves? Firms with relatively long life reserves may not need to take major risks to grow production in the future. This could be a distinct competitive advantage.
Hedging: To what degree does the firm use hedging in its operations? How exposed are the firm’s operations to changes in prices of input costs and its end product? Materials firms’ hedging strategies show which ones have the most upside and downside relative to rising or falling prices and raw material input costs.
Geographic Breakdown & Geopolitical Risk: Regional prices and volumes demanded can vary dramatically between home and export markets. Thus, regional diversification can mitigate risks of big changes in any one market. For globally priced goods, a breakdown of regional production will help identify political and social risks to production, while a breakdown of regional consumption will identify the primary drivers.
Where are most of the firm’s current and future planned production sites? Are they in politically stable or unstable countries? What percentage of production comes from politically unstable regions? Do they have a solid history of operating in foreign territories? Has the company historically had good or troubled relations with governments in the region? Are labor unions historically strong or weak in those regions? Do tariffs, subsidies, or price caps exist? Is the firm beholden to trade problems with other regions? For regionally priced goods, how quickly is the product’s end market growing in its regions of operation?
While a firm with relatively high exposure to a geopolitically unstable region may face higher risks of government intervention or production disruption, the potential additions to production growth may warrant these risks and are not always inherent negatives.
Production Costs: Even firms in the same industry can have highly different cost profiles. What factors are driving its production costs? What are the firm’s production costs relative to its peers? What is the firm’s strategy to mitigate industry cost inflation? Does its plan differ from competitors? If it’s a low-cost producer compared to peers, does it have a strategy to take advantage of that? If it’s a high-cost producer, does it have a strategy to change that?
Vertical Integration: Does the firm benefit from some degree of vertical integration? (That is, does it have the ability to handle multiple stages of the production process by itself?) To what degree is it reliant on other firms in its operations? Firms with more vertical integration may be able to mitigate cost increases in times of industry cost inflation.
Transportation: Transportation costs are particularly important for bulk goods (with lower value-to-weight ratios) where transportation makes up a greater percentage of overall costs. How does it deliver its product to consumers? How far away are its consumers? What impact will rising or falling transportation costs have on it compared to competitors? (Ocean freight rates can be found through the Baltic Dry Index—covered in Chapter 5.) Are there any transportation bottlenecks, and if so, does it have a plan to address them? How has the firm responded to such bottlenecks in the past?
Government Control: Are the firm’s shares owned or controlled by a government, and if so, to what degree? Does the government play an active role in firm decisions and policies, and if so, has it ever made decisions in conflict with the interests of shareholders? Does the firm secure free market pricing for its product or does the government set them? Has the company historically been given special treatment or favored over other producers for contracts, loans, or taxes? Governments in emerging markets will likely play a bigger and more volatile role in the development of their country’s natural resources than in developed ones. Government-controlled firms may be subject to unique taxes, royalties, subsidies, or price controls. Dividend policies may also be set in the best interest of balancing budgets rather than future earnings. Depending on the circumstances, government ownership can work for or against a company, but you’ ll want to know its impact.
Legislative Risks: Are there any legislative risks? These can include royalties, windfall taxes, environmental legislation, price caps, labor laws, subsidies, tariffs, and the nationalization of assets. Emission laws in particular are a popular topic of debate in the developed world.
Competition and Barriers to Entry: What is the competitive landscape of the firm’s peers? Does it compete against government-owned firms (which have historically received special treatment)? Does the firm operate in a region or industry with significant barriers to entry? Barriers to entry may include dominant market share, capital intensity, patents, proprietary technology, a concentrated industry, and difficulty in obtaining regulatory or environmental permits. High barriers to entry typically provide pricing power and reduce competition.
Technology and Innovation: In the Materials sector, this trait primarily applies to chemical producers. New technology and innovation related to new chemicals and the creation of new end markets for existing chemicals can be incredibly important in the chemical industry. Does the firm possess any proprietary technologies or patents giving it a competitive edge? Does it have a history of innovation? Is its end market dynamic, requiring the consistent release of new products, or do they specialize in more mature markets?
Brand Names: Again, within the Materials sector, this trait primarily applies to the chemical industry. Brand names provide pricing power. Does the firm have any brand names? How much higher are they able to price their product than competitors?
Regulation: How are the firm’s operations affected by regulation? Does the firm currently operate in a favorable regulatory environment? How might that change? What is the firm’s history with gaining regulatory approval for its products (primarily applicable to genetically modified seed producers) or operations by country? Firms with highly regulated assets are exposed to regulatory risks, but they may also have more stable returns.
Market Share: Dominant market share often provides greater pricing power, especially for regionally priced goods. What is the firm’s market share in each of its business segments? How fragmented are the consumers in its end market? Does the firm have pricing power for its products and services? For regionally priced products, how do their prices and raw material costs compare to competitors?
Margins: Are margins growing or shrinking? Has the company historically offset higher costs with higher prices? How does its margins compare to peers? High margins in a vacuum tell you little since some industries historically hold higher margins than others, and it’s usually well-known and taken into account in share prices.
Margins are particularly important to consider for chemical producers. Strong economic growth not only bolsters the chemical industry, but can also help prop up the price of oil and natural gas, which are its main inputs. Therefore, its ability to pass on costs through higher prices can be a key attribute in an environment of rising raw material prices. The more cyclical and commoditized its end market, the less pricing power it typically controls.
Margins are particularly important to consider for chemical producers. Strong economic growth not only bolsters the chemical industry, but can also help prop up the price of oil and natural gas, which are its main inputs. Therefore, its ability to pass on costs through higher prices can be a key attribute in an environment of rising raw material prices. The more cyclical and commoditized its end market, the less pricing power it typically controls.
Cash Flow Use: How is the firm spending its cash flow? To what degree is it buying back shares, paying dividends, spending on capital expenditures, or paying down debt? Depending on industry conditions, investors may prefer a firm rewarding shareholders with dividends and share buybacks over one taking on risky new production plans.
Balance Sheet: Many firms carry heavy debt loads due to their capital-intensive nature, so financial health can vary widely. Those with greater financial resources could be more capable of funding future growth opportunities. Does the firm have the financial ability to make large acquisitions to fuel growth? Does the firm’s balance sheet allow it to take on additional leverage?
Debt isn’t necessarily a bad thing—many firms generate an excellent return on borrowed funds. In either case, it’s vital to understand the capital structure of a firm.
Interest Rates: How sensitive is the firm’s operations to interest rates? Are rising or falling rates good or bad for the firm’s operations and share price? Firms with greater leverage tend to be more affected by interest rate movements due to changes in interest expense.
Chapter Recap
Security analysis is not nearly as complicated as it seems. In the top-down investment process, stocks are essentially tools we use to take advantage of opportunities we identify in higher-level themes. Once an attractive segment of the market is identified, we attempt to determine the firms most likely to outperform their peers by finding firms with strategic attributes. While the five-step security selection process is just one of many ways to research firms, it is an effective framework for selecting securities within the top-down process.
Do not limit yourself to the questions provided in this chapter when researching Materials firms—they are just some tools to help you distinguish between firms. The more questions you ask, the better your analysis will be.
• Stock selection, the third and final step in the top-down investment process, attempts to identify securities that will benefit from our high-level portfolio themes.
• Ultimately, stock selection attempts to spot opportunities not currently discounted into prices.
• To identify firms most likely to outperform their peer group, we must find firms that possess competitive advantages (a.k.a strategic attributes).
• A five-step security selection process can be used as a framework to research firms.
• Firms within each industry have specific characteristics and strategies separating potential winners from losers. Asking the right questions can help identify those features.
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