Stock Analysis: The Most Important Things (Plus, A Case Study)

I recently came across a video* of Warren Buffett talking to a few B-School students on his trip to India in 2011.

The host asked him this question – What exactly goes through your mind when you’re actually making an investment?

Buffett’s reply to this question was brilliant for it contained the crux of everything he has said over the years about how to evaluate a certain business and it’s future economic potential (text in bold and brackets are mine) –

Well, if I drive by a McDonald’s stand or a Kentucky Fried Chicken stand I will automatically think to myself “What is this business worth?”

You know, how many customers can walk in the door (demand, scalability, growth potential)? What kind of gross margins (profitability, pricing power) can they have? How many people do they need (scalability)? How likely is it that another chicken stand opens across the street (competition, entry barriers, moat)?

I mean, all of those things. And that’s true of the chicken stand and it’s true of Google or you name the business. I mean, it’s all about evaluating the economic potential, the economic future of a given business. And most of them you don’t know the answer on (say no to most businesses, because you really don’t understand them).

But every now and then you run into one where you know the answer (simple businesses). But that’s all business is.

It’s what Aesop said a long time ago: “A bird in the hand is worth two in the bush.” (well, that’s the definition of discounted cash flow) You know, that was said in 600 BC and that’s now what’s called discounted cash flow and all that sort of thing. But he saw that and figured it out, you know, twenty-six hundred years ago. And all I’m trying to figure out is if I could take that dollar in my hand: When do I get the two dollars out of the bush (timing of future cash flows)? How sure am I of getting it out of the bush (certainty of future cash flows)? Is there some other bush where I can get three dollars out of it instead (opportunity costs, better alternatives)?

I mean, it’s very basic stuff (investing is simple, you see, but only if you keep it simple). And a lot of times you look at it and you say “I don’t know how many birds there will be in the bush.” (complex businesses, or those that undergo a lot of changes due to nature of industry, competition, etc.) So you go in to the next one until you find the answer (you just need a few good ideas in a lifetime).

Buffett, once more, makes it clear that rather than obsessing with the bewildering fusion of news and noise, you should concentrate on a few key elements in stock selection.

If I were to list down the most important questions on business/stock analysis based on what Buffett mentioned above and a simple checklist I maintain, they would be –

1. Is the business simple to understand and run? (Complex businesses often face complexities difficult for its managers to get over)
2. Has the company grown its sales and EPS consistently over the past 5-10 years? (Consistency is more important than speed of growth)
3. How much are the company’s products in demand? Is there a long runway of growth for these products over the next 10 years? Could they be disrupted badly? (Past may have been good, but how good, sustainable the business could be in the future is of paramount importance; look at simple products/services that have low probability of getting disrupted)
4. Has the company been able to scale up its business in the past? Can it scale up well in the future? (Check if a business is too capital and/or labour intensive, for that may cause difficulties in scaling up without big side effects of doing so; historical track record of the management is a nice indicator of its future capabilities, but again if you expect the nature of the industry to not change much)
5. Will the company be around and profitably better in 10 years? (Suggests continuity in demand for and profitability of the company’s products/services)
6. How competitive is the industry in which the company operates? How has it done against its key competitors? Does the company have a sustainable competitive moat? (Pricing power, profit margins, lead over competitors, entry barriers for new players)
7. How good is the management given the hand it has been dealt? (Capital allocation, return on equity, corporate governance, performance against competition over 8-10 years)
8. Does the company require consistent capex and working capital expenditure to grow its business? (Companies that have to spend continuously on such areas are like running on treadmills, which is not a good situation to have; they may have or are likely to have stretched balance sheets that are detrimental to equity shareholders’ value creation)
9. Does the company generate more cash than it consumes? (Cash generators have a higher probability of surviving and prospering during bad economic situations)
10. Have the cash flows shown some stability in the past? (Good indicator of future certainty and timing of cash flows, which is a necessary aspect, not just to assess the continuity of a business but also to assess its valuations with some reasonable degree of success)
11. What are the opportunity costs of investing in this business? What would I compromise on if I invest in this business? (Check the next best alternative. Maybe that alternative is better than this business, so check for it)

Information, you see, generally follows the well-known 80/20 rule: the first 80% of the available information is gathered in the first 20% of the time spent. These above questions should help you in this aspect i.e., getting you 80% understanding about the business you are analyzing without spending a lot of time on that.

Anyways, especially on the point about competitive analysis, I have done some number crunching for the three Indian 2-wheeler majors – Hero Motorcorp, Bajaj Auto and TVS Motor (based on numbers from Screener.in) – to give you some ideas on how you can do it for the company you are analyzing and its competitors (remember opportunity costs?).

The analysis, along with my observations, lie in this financial analysis excel document of Hero Motocorp in the sheet “Competitive Analysis.” Also, download the respective excels for Bajaj Auto and TVS Motor if you wish to extend your analysis using more numbers.

Keep It Simple, Please!
In stock investing, often we focus so much on trying too hard that either we never start working on the process of picking up great businesses (seeing the enormity of the task), or we start believing that our immense hard work and knowledge gives us great control over the future of stocks we own.

The reality is that, no matter how hard we try to analyze the intricacies of business, we may not be as important to the results as we’d like to think we are.

Like Seth Klarman wrote in Margin of Safety –

Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty.

The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.

And like Buffett explains to B-School students, please keep it simple!

* Watch 57:04 minutes onwards in this video for this particular discussion

Statutory Warning: Nothing I’ve written above must be construed as investment advice to buy or sell shares. Please make your own decision, as blindly acting on anyone else’s research and opinions can be injurious to your wealth. My analysis may be biased, and wrong. I have been wrong many times in the past. I am a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014 (Registration No. INH000000578).