Introduction to Fundamental Analysis
Qualitative analysis for a company and industry.
Through this series, we will learn how to analyse companies, just as Warren Buffet does.
As mentioned in the last article Introduction to Fundamental Analysis, there are 2 main frameworks to analyse an industry’s profitability and the company’s position: The SWOT analysis and Porter’s Five Forces.
The SWOT Analysis
Identifies the company’s Strengths & Weaknesses, focused on the internal ecosystem, and Opportunities & Threats, focused on the external environment. From this you can also extract information to create different strategies to better position the company — to be discussed.
A useful tip when conducting a SWOT is to compare the company to its direct competitors to make the analysis as direct as possible.
Internal Ecosystem, S & W.
What is the company good at? What is its competitive advantage and what are those factors that contribute to it? These questions will help you find its strenghts. For example: successful advertisement, brand name, a specific collaboration, clean environment, competitive price…
As for the weaknesses, look into those aspects that are keeping the company from performing at its best. But what when you know the weaknesses? Well, you will need to get creative and find out how to minimize or erradicate them, or even better: how to turn them into strengths. Some examples may include a weak product development, weak management, or innefficient joint venture.
It is important to note that these strengths and weaknesses are directly linked to those of the competitors’, meaning that they will be relative to them.
External Ecosystem, T & O.
Opportunities are those factor from the external environment that can serve you to craft an outstanding competitive advantage to better position yourself. For example, economic and technological developments, internationalization, market trends, public regulations, etc. On the contrary, threats will have a negative impact on your company. Examples are global economic recession, playing in a mature and saturated industry, etc.
But wait… how do I analyse all these things?
Well, you can go to the company’s website and read their 10K filling, which is a document that summarizes the company’s financial performance. Otherwise, you can access websiets like seekingalpha.com where, luckily, other investors will have done the analysis for you. However, it’s always better to double check and compare reports.
Remember: These analyses are always relative to the competition.
Contrary to what is taught in business, Harvard Business Review recommends to flip the steps and start with the external factor. This, will allow us to use the follwoing framworkd: “Given the condition of [external factor], our ability to [internal factor] leads to our recommendation that we [recommendation].”
Porter’s 5 Forces.
The SWOT is a useful strategic plan but in order to do this you need to carefully analyse your competition. This framework helps to map the company’s industry and better understand the context.
It analyses 5 competitive forces that define every industry to determine its SWOT:
- Bargaining power of suppliers: depend on the differentiation of the inputs, switching costs, presence of substitutes, supplier concentration, relative costs to total costs, importance of volume to supplier, and threat of forward integration. In a nutshell, how dependent are you on the supplier and vs?
- Threat of substitute products or services: dependent on the price performance and quality of the substitutes, switching costs, regulation and availability of substitutes. Regulation can play a big role in this regard, such as in the drug industry.
- Bargaining power of buyers: How much does the company depend on its buyers? We can look at buyer concentration, buyer dependence, buyer’s switching costs, buyer information, price sensitivity, brand identity… If you only had one buyer, then you’d most likely lower your prices so that it does not switch to another one.
- Threat on new entrants: when it comes to this threat, we need to look at how much barriers do companies have to enter the industry: economies of scale, brand identity, switching costs, capital requirements, government policies, access to distribution and inputs, proprietary product differences, etc.
However, what about the industry rivalry?
This is dependent on:
- Industry growth: the slower, the higher rivalry.
- Product differences: the lower, the higher rivalry.
- Brand identity: the lower, the more rivalry.
- Switching costs: the lower, the more rivals.
- Exit barriers: the easier it is to exit, the more chances of rivalry.
- Concentration: _________ can you guess?
Listen to Michael Porter’s talk on the 5 forces:
As said, this series will be somewhat based on Buffet’s recommendations, and today’s lesson is to invest just in business models you understand. Don’t join the Bitcoin hype if you do not know what it is about, don’t invest in bonds if you don’t know how thew work. However, there is something that even the best investor is vulnerable about: the management’s performance.
This is defined as corporate governance, and will come in the next part of fundamental analysis.
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Bibliography:
Hendriks, P., Heeringa, M., Koenraadt, J., Rikken, I., Paganini, A., Grigolini, A., Vlaming, E., Dijkstra, S., Piech, S., Kalinin, P., Quint, S., Faddegon, A. (2020) B&R Investment Guide. Second Edition August 2020. B&R Beurs, 25–27.
