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Chapter 7: Company Analysis – Business And Governance

Chapter 7: Company Analysis – Business And Governance – NISM-Series-XV Research Analyst Exam Study Notes Download PDF Book 

Role of Company Analysis in Fundamental Research

Company analysis in fundamental research refers to the in-depth and careful examination of a company’s business within the context of its industry and the overall economy. It involves assessing how external macro-economic and industry-specific factors affect the company, as well as analysing company-specific factors to determine its potential success and risks.

Topic Pointers:

  1. Company’s Business Understanding: Initially, understand the company’s business as it defines the industry context. This includes knowing what the company does and its role within its industry.
  2. Business Model Evaluation: Assessing the company’s business model involves understanding how the company operates and generates revenue.
  3. Competitive Advantage Analysis: Investigating whether the company has any advantages over its competitors, which could be in terms of technology, market position, brand, etc.
  4. Opportunity and Threat Handling: Evaluating the company’s ability to capitalise on opportunities and withstand potential threats in the market.
  5. Management Competency Assessment: Analysing the competence of the company’s management in identifying and executing effective strategies.
  6. Vision and Performance Visibility: Reviewing the management’s vision for the company’s future and their ability to provide insights into short-term performance and long-term goals.
  7. Governance Structure Review: Examining whether the company has a governance structure that ensures the board and management act in the best interests of the company and its shareholders.
  8. Governance Execution: Assessing the effectiveness of the implementation and execution of governance structures.
  9. In-depth Analysis: Going beyond superficial answers to understand the company in detail, including asking follow-up questions and seeking data to substantiate findings.
  10. Qualitative and Quantitative Data: Balancing qualitative analysis with the acquisition of relevant quantitative data to support conclusions.

Understanding Business and Business Models in Equity Investing

In equity investing, understanding a business or its model is crucial for successful investment. This involves comprehensively researching the company’s operations, customer base, and service delivery methods to determine its potential for success and investment suitability.

Topic Pointers:

  1. Essence of Equity Investing: Equity investing is equated with part ownership in a business, emphasising the importance of understanding the business one is investing in.
  2. Qualitative Research Starting Point: Initial research should focus on:
    • Understanding what the company does and how it operates.
    • Identifying who the company’s customers are and their reasons for choosing its products or services.
    • Assessing how the company serves its customers.
  3. Investment Philosophy: Emphasising investment in businesses that are well-understood by the investor. This approach is supported by prominent fund managers and echoed in Warren Buffet’s advice on avoiding wide diversification when lacking understanding.
  4. Sector-Specific Parameters: Recognizing that each sector has unique evaluation metrics, such as footfalls and same store sales (SSS) in retail, Net Interest Income (NII)/Net Interest Margin (NIM) in banking, Average Revenue Per User (ARPU) in telecom, and average room tariffs in hotels.
  5. In-Depth Sector Knowledge: The necessity for analysts to have in-depth knowledge of the sectors they research.
  6. Unique Business Operations: Acknowledging that every company has a unique way of conducting business, which affects the efficiency of product and service delivery and, consequently, its earnings.
  7. Importance of Business Model Analysis: The need for analysts to understand the complete business model of a company, as competition is often between business models rather than just products or services, as per Dr. Garry Hamel.

Pricing Power and Sustainability in Business

Pricing power refers to a company’s ability to independently set and control the prices of its products or services. It is crucial for maintaining and growing a company’s profit margin.

Topic Pointers:

  1. Importance of Pricing Power:
    • Essential for profit margin maintenance and growth.
    • Enables companies to manage input cost fluctuations and demand variations.
  2. Drivers of Pricing Power:
    • Industry Factors: Competition intensity, product price elasticity, and commoditization level.
    • Company-Specific Factors:
      • Natural leadership position in the industry.
      • Brand affinity and loyalty among customers.
      • Cost base compared to competitors.
  3. Impact of Pricing Power:
    • Companies with strong pricing power can pass increased input costs to customers.
    • Allows flexibility in pricing strategy, especially during high demand, enhancing profit margins.
  4. Examples of Industry Influence:
    • Petrochemical products: Smaller companies often base their pricing on the prices set by industry leaders like Reliance Industries Limited (RIL), demonstrating RIL’s pricing power.
  5. Brand and Cost Base Influence:
    • Strong brand perception/loyalty enables independent pricing.
    • Low cost base allows pricing flexibility without fear of competitive undercutting.
  6. Relevance in Industry Analysis:
    • Understanding pricing power is vital for predicting industry performance and identifying outperforming companies.

Example: Reliance Industries Limited (RIL) in Petrochemicals: RIL, as an industry leader, independently sets product prices, influencing smaller players in the industry. This is an example of how a company’s leadership position and market influence contribute to its pricing power.

Competitive Advantages and Points of Differentiation over Competitors

Competitive advantages refer to the unique factors that allow a company to outperform its competitors in the industry. These factors include product differentiation, competitive pricing, and superior execution.

Topic Pointers:

  1. Product Differentiation:
    • Key Aspect: Incorporating superior product features to appeal to target customers.
    • Importance: Creates a value proposition, attracting more customers.
    • Requirements: Strong R&D and a culture of innovation.
    • Industry Dynamics: Leadership positions may shift among players; those with stronger innovation typically outperform.
    • Analytical Approach: Compare company products with competitors, focusing on substantive advantages, not just marketing claims.
  2. Competitive Pricing:
    • Strategy: Offering products at lower prices to attract customers, especially in markets with similar products.
    • Sustainability: Viable only if the company has a lower cost base than competitors.
    • Industry Variance: More evident in commoditized industries; complex in industries with product differentiation (e.g., cars).
    • Analysis Method: Assessing value for money through primary research or past performance analysis.
  3. Execution:
    • Critical Factor: Ability to outperform competitors in communication and sales strategies.
    • Measurement: Evaluate past performance and management capabilities.

SWOT (Strengths, Weaknesses, Opportunities, and Threats) Analysis

SWOT Analysis is a framework used to evaluate a company’s internal strengths and weaknesses, and external opportunities and threats. It helps in assessing a company’s growth potential and risk tolerance.

Topic Pointers:

  1. Context of SWOT Analysis:
    • Importance: Assists in understanding how external changes impact companies differently.
    • Application: Useful in evaluating company fundamentals in changing environments.
  2. Components of SWOT:
    • Strengths and Weaknesses: Internal factors within a company’s control.
    • Opportunities and Threats: External factors arising from environmental changes.
  3. Application in Different Scenarios:
    • For Companies: Identifying strengths and weaknesses first, followed by opportunities and threats, is suitable for strategy formulation.
    • For External Analysts: More effective to analyse external opportunities and threats first, then assess company strengths and weaknesses.
  4. Methodology:
    • Internal Analysis: Assessing a company’s inherent capabilities and limitations.
    • External Analysis: Evaluating the external environment for potential benefits and risks.
  5. Impact of External Events:
    • Example: The COVID-19 pandemic’s impact varied based on companies’ financial robustness.
    • Companies with strong financial positions could better withstand lockdowns.
  6. Analyst’s Approach in SWOT:
    • Equity Analysts: Preferably start with external conditions (E-I-C framework) and then examine company-specific factors.
    • Strategic Decision Making: Focus on internal factors first, aligning with company strategies.

Example:

  • COVID-19 Pandemic:
    • Threat: Business lockdowns.
    • Impact: Companies with weak finances were more vulnerable, whereas those with strong finances could survive.

Strengths in a Company

Strengths are internal capabilities of a company that enable it to leverage external opportunities and withstand threats.

Topic Pointers:

  1. Strong Financial Position:
    • Importance: Provides resilience against market downturns and flexibility in strategic decisions.
    • Benefits: Facilitates investment in growth opportunities and buffers against financial crises.
  2. Highly Valuable Intellectual Properties:
    • Role: Acts as a competitive edge, offering unique products or services.
    • Advantage: Protects market share and can generate revenue through licensing.
  3. Low Customer Concentration:
    • Impact: Reduces dependency on a small number of customers.
    • Benefit: Enhances stability and mitigates risk of revenue loss from losing individual clients.
  4. Low Cost or High Margins:
    • Relevance: Enables competitive pricing strategies and higher profitability.
    • Outcome: Provides a cushion against cost increases and price competition.
  5. Support from Parent Company or Government:
    • Effect: Offers financial, logistical, or infrastructural advantages.
    • Consequence: Can result in easier access to resources, markets, or regulatory support.
  6. Strong Execution Capability and Track Record:
    • Significance: Reflects operational excellence and reliability.
    • Result: Builds trust and reputation, leading to sustained customer relationships and market leadership.

Weaknesses in a Company

Weaknesses are internal issues in a company that make it vulnerable to external events or hinder its ability to capitalise on opportunities.

Topic Pointers:

  1. Weak Financial Position:
    • Implication: Limits the ability to invest in new opportunities or withstand economic downturns.
  2. High Fixed Costs:
    • Concern: Makes it difficult to maintain profitability during revenue fluctuations.
  3. Low Margins:
    • Risk: Minor downturns can quickly turn profits into losses.
  4. Higher Customer Concentration:
    • Vulnerability: Dependence on a few customers increases risk of significant revenue loss if these relationships falter.
  5. Significant Legal Cases:
    • Distraction and Risk: Can divert focus and resources, with potential for substantial losses.
  6. Lack of Experience:
    • In Specific Strategies or Environments: Hinders the ability to adapt to new opportunities or changes in the market.
  7. Contextual Relevance:
    • Importance: Analysts should focus on weaknesses that directly impact opportunities and threats.
    • Example: Lack of experience in self-driving cars is a relevant weakness for an Indian automobile company if the industry is moving towards such technologies.
  8. Limitations of SWOT Analysis:
    • Outsider Perspective: Analysts may not identify all weaknesses, such as undisclosed government influence or hidden financial issues.
    • Example of Unidentified Weakness: Creative accounting practices may not be evident from an external analysis.

Opportunities in Business

Opportunities are prospects for growth or advancement that arise from external environmental changes.

Topic Pointers:

  1. Events Creating Growth Inflection Points:
    • Impact: Certain events can significantly accelerate industry growth.
    • Example: Introduction of new battery technology boosting the electric vehicle segment.
  2. Technological Advancements and Regulatory Changes:
    • Result: These changes can open up new business opportunities.
    • Examples:
      • Consulting firms benefiting from the implementation of the Companies Act 2013.
      • Indian IT service providers capitalising on Y2K-related demands.
  3. Expansion of Geographical Footprint:
    • Opportunity: Changes in market or regulatory conditions can enable expansion into new territories.
    • Consideration: Previous barriers might include capital control regulations or limited market opportunities.
  4. Adverse Market Conditions Leading to Consolidation:
    • Scenario: Economic downturns or industry-specific crises can offer opportunities for stronger companies.
    • Examples:
      • Other airlines gained market share after Jet Airways suspended operations.
      • Recessionary conditions provide chances for acquisitions due to lower share prices and interest rates.

Threats in Business Environment

Threats are risks arising from external environmental factors that can negatively impact a company.

Topic Pointers:

  1. Differentiation from Internal Risks:
    • Key Understanding: Distinguish between external threats and internal weaknesses (e.g., high customer concentration is an internal risk, not a threat).
  2. Varied Sources of Threats:
    • Diversity: Threats can arise from numerous external factors and may vary widely in nature.
  3. Economic Recession:
    • Impact: Can lead to a significant decline in business fortunes across various sectors.
  4. Regulatory Changes:
    • Example: Potential bans on single-use plastics posing a threat to manufacturers of these products.
  5. Technological Disruptions:
    • Dual Impact: While offering opportunities to some industries, can be a threat to others (e.g., AI is a threat to the BPO industry focused on repetitive tasks).
  6. Industry Deregulation:
    • Effect: Removal of entry barriers increases competition.
    • Example: RBI’s decision to offer on-tap licences to new banks increased competition for existing banks.
  7. Focused Threat Analysis:
    • Approach: Concentrate on threats with a reasonable probability of occurrence.
    • Consideration: Avoiding overly extensive lists of potential threats to maintain practical usefulness.

Quality of Management and Governance Structure

The quality of management and governance structure refers to the competency and integrity of the management team and board of directors in a company, which is critical for ensuring the company’s success and alignment with shareholder interests.

Topic Pointers:

  1. Separation of Ownership and Management:
    • Structure: Shareholders own the company, while a separate management team handles daily operations.
    • Reporting: The management team, including the CEO/Managing Director, reports to the Board of Directors.
  2. Agency Risk:
    • Concept: The risk that management may not always act in the best interests of the shareholders.
    • Concerns: Potential for management to pursue personal interests or lack the capability to effectively run the organisation.
  3. Evaluating Management Competency and Integrity:
    • Challenge: Assessing management’s ability and ethical conduct is difficult.
    • Integrity Analysis: Difficult to evaluate without concrete evidence; inappropriate to speculate without reasonable evidence.
  4. Focus on Corporate Governance:
    • Strategy: Analysts should examine the corporate governance structure.
    • Objective: To ensure it has adequate controls to prevent inappropriate governance actions.

Evaluating Management Competency

Assessing the competency of a company’s top management involves analysing various aspects of their experience, qualifications, past performance, vision, and strategic alignment with the company’s goals.

Topic Pointers:

  1. Educational Qualifications:
    • Relevance: Necessary but not solely indicative of competency.
    • Consideration: Understand relevance to their current roles.
  2. Experience Years:
    • Impact: More years often equate to greater business challenge handling.
    • Significance: Experience helps in better navigating future challenges.
  3. Past Track Record in Senior Roles:
    • Analysis: Look at company performance during their tenure.
    • Limitation: Performance also depends on external factors and team dynamics.
  4. Tenure and Company Performance:
    • Evaluation: Assess performance during their time with the current company.
    • Context: Success in one company doesn’t always translate to another.
  5. Long-term Vision and Strategy:
    • Focus: Ability to articulate and pursue long-term company goals.
    • Balance: Sharing enough strategy without revealing sensitive details to competitors.
  6. Relevance to Current Strategy:
    • Requirement: Competency in executing the company’s current strategic focus.
    • Example: For a company prioritising innovation, leaders should have experience in leading research projects.
  7. Performance Guidance and Achievement:
    • Indicator: Consistency in meeting or exceeding set performance targets.
    • Implication: Suggests better control over business operations.
  8. Regulatory Compliance:
    • Measurement: Timely adherence to regulations.
    • Red Flag: Non-compliance can indicate lack of control or integrity issues.
  9. Decision-making Delegation:
    • Analysis: Extent of decision-making spread across the team.
    • Risk: Highly centralised decision-making creates key person risks.
  10. Succession Planning:
    • Importance: Ensures continuity in leadership.
    • Concern: Lack of a plan can lead to instability in management changes.

Evaluating Corporate Governance

Corporate governance encompasses the rules, processes, and procedures that guide the management and operations of a firm, aiming to ensure the well-being of all stakeholders.

Topic Pointers:

  1. Board Composition:
    • Types of Directors: Includes independent, non-executive, and executive directors.
    • SEBI Regulation: Majority should be independent directors; specifics vary based on the chairman’s role.
  2. Separation of Chairman and CEO/MD Roles:
    • Purpose: Ensures CEO is accountable to the board.
    • Requirement: Mandated by SEBI for top 1,000 listed companies in India.
  3. Nomination Committee for Independent Directors:
    • Composition: Should ideally consist only of independent directors.
    • Objective: Ensures true independence in the appointment of directors.
  4. Auditor Fees and Independence:
    • Critical Aspect: Auditor’s fees from a company should be less than 10% of total income.
    • Goal: Maintains audit independence.
  5. Auditor Rotation:
    • Frequency: Change auditors every five years.
    • Reason: Prevents collusion and uncovers concealed facts.
  6. Audit Committee Composition:
    • Ideal Makeup: Entirely independent directors.
    • SEBI Requirement: At least two-thirds should be independent.
  7. Related Party Transactions:
    • Monitoring: All material transactions should be reviewed by the audit committee.
    • Regulation: SEBI requires disclosure, especially if not at “arms-length”.
  8. Remuneration Committee Composition:
    • SEBI Stipulation: All members should be non-executive, with an independent director as chairman.
  9. Remuneration of Independent Directors:
    • Disclosure: Complete earnings from the company should be transparent.
    • Purpose: Allows shareholders to assess the independence of directors.
  10. Beyond Regulatory Standards:
    • Aspiration: Companies should aim to exceed the minimum standards set by regulators like SEBI.

Promoter Holdings

Promoter holdings refer to the shareholdings of the promoter group in a company, typically comprising individuals who were part of the founding team or are controlling shareholders.

Topic Pointers:

  1. Promoter’s Role:
    • Legal Definition: Identified as an investor named or recognized as a promoter.
    • Practical Aspect: Usually includes founders or controlling shareholders.
  2. Impact on Management:
    • Control: Promoter shareholders often have significant influence over management.
    • Advantages: Increased likelihood of management acting in shareholders’ interests.
    • Risks: Potential for actions favouring promoters at the expense of minority shareholders.
  3. Analysing Promoter Shareholdings:
    • Focus Area: Analysts should assess the shareholding percentage and its changes over time.
  4. Pledging of Shares:
    • Purpose: Promoters may pledge shares as collateral for loans instead of selling them.
    • Process: Lenders apply a haircut to the market price to maintain collateral value.
    • Implications: Not inherently a governance concern, but requires scrutiny of the pledged share amount.
  5. Risks of High Pledged Shares:
    • Market Impact: High pledged shares can intensify market risk during price falls.
    • Consequence: Price drops may lead lenders to liquidate the shares, potentially causing further price declines.

Risks in Business

Risks in business encompass the various challenges and uncertainties that can impact the journey from a business idea to its successful realisation.

Topic Points with Details:

  1. Promoter Optimism vs. Reality of Risks:
    • Typical Promoter Behaviour: Focus on positive visions, often underplaying potential risks.
    • Example: Attractive international borrowing ignoring currency risk.
  2. Entrepreneurial Risk-Taking Nature:
    • Characteristics: Entrepreneurs often possess a higher tolerance for risk.
    • Historical Examples:
      • Rupert Murdoch’s early failures before creating Star Empire.
      • Steve Jobs’ initial ousting from Apple and subsequent success with another venture.
  3. Investor Risk Tolerance:
    • Contrast with Businessmen: Investors may not share the same risk tolerance as entrepreneurs.
  4. Types of Business Risks:
    • Range: Can include operational, execution, and other business aspects.
    • Nature: Risks can be both apparent/known and hidden/unknown.
  5. Analysts’ Approach to Risks:
    • Key Question: Continuously assess “What could go wrong in the business”.
    • Red Flag: Promoters claiming no risks exist in their business.
  6. Good Business Acumen:
    • Awareness: A competent businessman recognizes potential risks.
    • Preparation: Takes steps to mitigate these risks.

History of Credit Rating

Credit rating is the assessment of a borrower’s ability to fulfil debt obligations, provided by credit rating agencies for both issuers and individual debts, and differentiated between short-term and long-term obligations.

Topic Pointers:

  1. Credit Rating Scope:
    • Issuer and Debt Level: Ratings are given to both the overall issuer and specific debts.
    • Time Frame: Separate ratings exist for short-term and long-term debts.
  2. Relevance to Equity Investors:
    • Priority of Payment: Equity investors receive returns only after lenders are serviced.
    • Risk Indicator: Ratings inform investors about the financial risk and influence return expectations.
  3. Historical Evolution Analysis:
    • Insights: Reviewing past ratings offers perspectives on management’s response to external feedback.
    • Rating Reports: Often detail the rationale behind the rating and key concerns.
  4. Management Responsiveness:
    • Indicator of Competency: Addressing concerns raised in credit rating reports shows proactive management.
    • Insight Source: Changes in concerns over time in successive reports reveal management effectiveness.

ESG Framework for Company Analysis

The ESG (Environmental, Social, and Governance) framework is an investment approach that evaluates companies based on their environmental impact, social responsibility, and governance standards.

Topic Pointers:

  1. Emergence of ESG Focus:
    • Shift in Investment Theme: Beyond profit, focusing on sustainable development and corporate social responsibility.
    • Adoption: Gaining traction among a wide range of investors, not just “Impact” investors.
  2. Environmental Criteria:
    • Evaluation: Assessing a company’s impact on the environment, such as carbon emissions and pollution contribution.
    • Higher Ranking: Companies with lower environmental impact score better.
  3. Social Development Criteria:
    • Focus Areas: Includes human rights, gender equality, and other social factors.
    • Ranking Factor: More contribution to social development leads to a higher ranking.
  4. Corporate Governance Standards:
    • Assessment: Reviewing the governance practices of the company.
    • Importance: A key criterion in ESG evaluation.
  5. ESG Investment Process:
    • Selection: Using ESG criteria to shortlist potential investments.
    • Further Analysis: Conducting regular financial and strategic analyses post-ESG filtering.
  6. Financial Benefits of ESG Compliance:
    • Reduced Regulatory Disruptions: Environmentally focused companies face fewer regulatory interventions.
    • Positive Societal Impact: Socially responsible companies enjoy better brand recall, aiding in recruitment and customer attraction.
    • Cost Savings: Sustainable practices can reduce power and water costs.
    • Lowered Risk Perception: Strong governance practices can reduce the cost of capital.
  7. SEBI’s ESG Disclosures Initiative:
    • Regulation Enhancement: Strengthening ESG disclosure requirements for listed entities in India.
    • Transparency: BRSR (Business Responsibility and Sustainability Report) parameters for the top 1,000 listed companies from FY2023.
    • Adoption: Over 175 companies voluntarily reported on BRSR in FY22.

Sources of Information for Company Analysis

Multiple sources of information are available for analysing a company, ranging from official documents to informal discussions.

Topic Pointers:

  1. Annual/Quarterly Reports:
    • Features: Reliable, consistent, and easily accessible.
    • Content: Financial performance, management discussion, and company strategy.
  2. Conference Call Transcripts:
    • Utility: Offers insights into management’s perspective and responses to analyst questions.
  3. Investor Relations (or Company) Presentations:
    • Purpose: Provides the company’s official viewpoint on performance and strategies.
  4. Management Interviews on the Internet:
    • Benefits: Presents management’s vision and responses to current issues.
  5. Company Website:
    • Information: News, press releases, product/service details, and company history.
  6. Ministry of Corporate Affairs Website:
    • Relevance: Legal and regulatory filings, especially for companies in India.
  7. Research Reports from Credit Rating Companies:
    • Insights: Independent assessment of the company’s creditworthiness and risks.
  8. Research Reports from Various Other Sources:
    • Examples: Media reports and industry analyses.
  9. Parent Company’s Annual Report and Website:
    • Context: Broader corporate perspective, especially for subsidiaries.
  10. Competitors’ Website Including International Competitors:
    • Comparison: Understanding market position and strategy in contrast to competitors.
  11. Print Media Reports on Companies:
    • Scope: News, expert opinions, and market analysis.
  12. Discussion with Suppliers, Vendors, Consumers, and Competitors:
    • Value: Ground-level insights and external perspectives on the company.
  13. BRSR Report for ESG Disclosures:

Significance: Environmental, Social, and Governance reporting for responsible investing.

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