10 Questions to Ask When Analysing a Company
This week, I thought I would take a break from the noise of markets and write a more educational article, describing 10 questions you should ask yourself before investing in any company. I hope you enjoy it, and any feedback or questions are welcome at:
1. Liquidity is Everything
The most important aspect of any business is liquidity. Therefore, the first question you should ask is; Does this business have sufficient liquid assets to meet any short-term liabilities? In simple terms, does this company have enough cash to pay off debts coming due soon? If not, it’s never a good outcome for shareholders. Insufficient cash will lead to either bankruptcy (losing your entire investment), or dilution (issuance of debt or stock to cover debt repayments), meaning your equity stake is worth less. One simple way to evaluate a company’s liquidity is through the Current ratio. The Current ratio measures current assets vs current liabilities (debt coming due within one year). If this ratio is greater than 1, then the company has sufficient short-term assets to meet its short-term commitments. An even more conservative measure is the Quick ratio. This compares current assets minus inventory vs current liabilities. Inventory can be hard to sell in tough times (such as a recession) so excluding this can be a more accurate way to find out how strong a business’ liquidity is. For banks, the Tier One Capital and Liquidity Coverage Ratios are the best way to assess liquidity.
Another question you could ask surrounding debt is; how much debt does the company have? A highly geared company may spend all its profit and free cash flow paying down debt, and therefore will never have the opportunity to fund future growth. Sector-specific nuances come into play here, as sectors like Energy require large debt levels to fund E&P and daily operations, but using your own judgement in this regard is key. If the debt level is high, a question to ask yourself would be; is this debt productive (i.e. being used to generate returns on investment)? If the answer is no, and it is primarily being used to cover fixed costs involved in the business's daily operations, then the stock may be one to avoid.
2. The Magic Quadrant
Once you’ve analysed the business liquidity, then you must understand which environment it’s likely to thrive. You can pick the best businesses in the world, but they will still underperform if the macro environment is not favourable. An example of this is Amazon (AMZN), which is down 35% this year, even though it’s a great business with huge profits. For a more in-depth look at the sectors and assets that perform in each environment, please read my article on macro direction.
Therefore, you should ask yourself – How will this investment perform in the current macro environment? If the economy is in a recession, it’s probably wise to avoid clothing brands as the population is unlikely to spend on clothes if their income is squeezed. On top of this, you should ask - is it a risk-on or risk-off investment, and which sector is it in? This will help you grasp what stage of the business/economic cycle we are in, and therefore when it is likely to perform. For example, we were in an inflationary boom throughout 2021, so energy stocks performed better than growth stocks. If you had bought high-growth companies in the renewable energy or cannabis space during 2021, you would have been killed regardless of the long-term fundamentals.
The macro quadrant, Source: Ray Daliio
3. Don’t overpay
Next comes one of the most important aspects of investing, the price you pay. As great investor Warren Buffett says, “Price is what you pay, Value is what you get”. Overpaying for any investment can mean the company either grows into its valuation (share price trades side-ways for a long time) or the share price collapses back to an attractive/reasonable valuation. Therefore, ask yourself honestly - Is this company cheap or expensive relative to the market and its competitors? You should compare things like revenue growth, Return on Invested Capital (ROIC), and gross margins, to decipher whether a business should be valued on a higher or lower multiple. A software company that has a moat around its business and recurring revenue would demand a higher valuation than a highly indebted oil miner in Alaska. Ratios such as Price-to-Earnings (P/E) and Enterprise Value/EBITDA are good for judging this.
Once you have uncovered the relative valuation of the company compared to the growth rates of its peers, you should then ask if the premium or discount is justified and at what price you are willing to pay/do you think is fair? This is where an in-depth analysis of the company comes into play, and it is largely subjective. You must decide whether the stock is beaten down for an unjustified reason, or whether the premium is worth paying as the business is so good. For example, investors have been willing to pay a higher and higher multiple for Diageo (DGE), as its alcohol is becoming a stalwart in the alcohol industry, with drinks like Guinness and Captain Morgan’s being staples in any bar or restaurant.
Investor’s are willing to pay an ever-higher multiple to hold Diageo stock, Source: Tikr Terminal
4. Management
So, the stock has the cash to survive and grow, is in the correct macro environment, and is at an attractive price, what next? Can management deliver on its promises? An astute management team should have a clean balance sheet. They should also be providing a good return for shareholders in the form of dividends, revenue/profit growth, or share buybacks – or a combination of these. Signs of strong management are a high ROIC (more than 10%), strong and growing margins and focus on delivering a long-term vision with shareholders in mind. Meta Platforms (see below) have increased Return on Capital from 3% to 33% from 2012 to today, and the share price has reflected that. Another nice addition is insider buying. Generally speaking, the management team of any public company is expected to hold some equity in the business. However, huge insider buying can confirm the commitment of the team to the long-term growth of the business, and support for its shareholders. Red flags include dilution through excessive share issuance and unjustifiably high stock-based compensation (subjective but one metric to watch).
Meta Platforms has had a booming ROC which is reflected in the share price performance, Source: TIKR Terminal
5. Look in the Mirror
Finally comes the trickiest part, beating yourself. What Biases do I have? As humans, we are driven by emotion. This is evident in the market sell-off today, as fear and greed play a huge role in asset prices over the short-medium term. As an investor, you must understand your biases and remove them from your investment decisions. Remember: The stock does not know you own it. It will move where it wants to regardless of how much capital you invested, or how much you believe in the business, so you better know what you own and check yourself regularly on why you own each investment. It helps to write this down so you can revise your reasoning if the share price falls or you think you’ve found a better opportunity. Finally, ask yourself what could go wrong with this investment? How might your thesis be wrong or what risks could affect the profitability of this investment? After all, it is your money you’re playing with, so know why you could be wrong and when to get out of a position. When the fundamentals change you must change your mind, regardless of whether you’re making a profit or a loss. Taking a dose of ‘hopium’ and praying the stock comes back into profit is the worst thing you could do (see below). Regardless, you don’t need to be right all the time to make money. It’s only matters how much you make when your right and how much you lose when you’re wrong. Some of the greatest investors in the world have a win rate of less than 50%.
Investor psychology in a nutshell
Current Outlook
As witnessed by the CPI number this week, price pressures are broadening into services and shelter (rent). With credit card debt increasing, consumers seem to be backstopping their larger costs with higher debt levels. Although markets are tanking, they are still somewhat anchored on the belief that inflation will come down rapidly. The Bank of England’s Monetary Policy Committee (MPC) has been continually incorrect about the path of inflation upward but believes that the path lower for inflation will be sharp (see below). Neither the markets nor the central banks are pricing in a significant chance of heightened inflation for longer. With China potentially entering a permanent zero-covid policy regime, supply chains fractured, energy costs continuing to rise, and war damaging the two previous points further, I cannot see this rapid path downward coming to fruition unless the tightening by central banks causes a recession.
Although the companies The Spark’s portfolio hold are attractive on many measures, they will not fair well as earnings estimates are downgraded and the consumer begins to cut back on spending. Therefore I am selling Micron Technologies (MU) and WarnerBros Discovery (WBD). Micron is worrying as the US continues to confirm its defence of Taiwan (which it previously didn’t do), and any invasion by China would affect about 25% of Micron’s revenue. Also, 90% of semiconductor production comes from Taiwan, making this area extremely important to the global supply of chips. China continues to enter Taiwan's airspace, even flying nuclear bombers over the region while US President Joe Biden visited recently. This worries me, and regardless of whether this issue escalates any further, MU is a growth stock that will continue to underperform while financial conditions remain as they are (more below). WarnerBros Discovery is still an attractive company long-term, but with analyst downgrades for Netflix, and the consumer likely to cut back on discretionary spending, WBD streaming is likely to perform poorly. I will not hesitate to revisit WBD if the central bank’s dreamy soft landing for the economy comes to fruition, but I do not believe that to be the case.
For this reason, I am allocating 8% of capital to iShares TIPS 0-5yr USD (TIP5). Treasury Inflation-Protected Securities (TIPS) are bonds with repayments linked to the inflation rate. This means you get some form of protection of your capital against a rise in prices. 0-5yr TIPS are essentially a cash equivalent (short-dated bonds are akin to cash for large institutions) as they are highly liquid and secure (issued by the US Government). This makes them a defensive asset in times of uncertainty and gives the portfolio more exposure to the US Dollar, the world reserve currency, and a global safe-haven asset for tough times. A risk-off environment like this is a time to protect the downside and worry less about capital appreciation.
Action:
- Buying 8% of iShares 0-5 TIPS (TIP5) at £5.25
- Selling 100% of WarnerBros Discovery at a 33% loss (£232.62)
- Selling 100% of Micron Technology at a 3% loss (£12.40)
Portfolio Return Year-to-date: -1% vs S&P500: -19%
Total Return since inception (20/09/2021): 5% vs S&P500: -11%
Never fall in love with any stock.
See you next time,
Peter
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.