Qualitative Factors
What are the Qualitative factors which affect stock investing?
Qualitative factors are based on the quality or character of something, often as opposed to its size or quantity. It mainly involves understanding those aspects of the business that are not associated with numbers, i.e. the intangible factors which cannot be quantified but needs to be taken under consideration while analysing a company. Before diving into a company's financial statements, it is very important to look at the qualitative aspects of the company. In this section we are going to highlight some of the company-specific qualitative factors that one should be aware of when performing fundamental analysis.
The different types of qualitative aspects we consider are:
- Business Model:
Even before an investor looks at a company's financial statements or does any research, one of the most important questions that he should ask is; what exactly does the company do? This is referred to as business model- it's how a company makes money.
In simple terms, a business model is referred to as from where does the cash flows into the company. The total revenue of a company producing only one product A is the product of 'P', the price it charges for 'A' and 'Q', the number of units of A it sells. Thus, the total revenue is equal to 'PQ'. The business model primarily refers to understanding how much of the product 'A' that the company is producing and how much quantity 'Q' of A is it able to sell depending on its control of the price 'P'.
Sometimes business models are easy to understand. Take McDonald's for instance, which sells burgers, fries, soft drinks, etc. It is a simple model, easy enough for anybody to understand.
On the other hand, some business models can be very complex. For example, the business model of Reliance Industries is extremely difficult to understand because they have a number of business segments like refinery, oil & gas exploration, chemicals, etc. Understanding a particular segment would require an in-depth knowledge of each of the products and their complex functioning.
You should at least understand the business model of any company you invest in.
Thus, unless you understand a company's business model, you don't know what the drivers are for future growth and you leave yourself vulnerable to being blindsided.
As Mr. Buffett rightly says- "If a business does well, the stock eventually follows"
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- Competitive Advantage:
A company's long-term success is largely driven by its ability to maintain a competitive advantage - such as Coca Cola's brand name and Microsoft's domination on the personal computer operating system. It creates a 'moat' around a business allowing it to keep competitors at bay and enjoy steady growth and profits. An economic moat is a term coined by Warren Buffett, which is the competitive advantage that one company has over other companies in the same industry.
The competitive advantage depends largely on the ambit of the moat. By having a well-known brand name, pricing power and a large portion of market demand, a company with a wide moat possesses characteristics that act as barriers against other companies that are eager to enter the industry.
When a company can achieve a competitive advantage, the shareholders of that company are rewarded for decades. This is clearly the case of the top multi-baggers of the past. From the likes of Hindustan Unilever to Pidilite Industries, each of the companies have huge brand equity and pricing power. These companies have created great shareholder wealth.
- Corporate Governance:
This is the framework of rules, practices, and processes that direct and control the firms as well as involves balancing the interests between management, directors, and stakeholders. Investors should always invest in companies that operate ethically, fairly, transparently, efficiently and whose management respects its shareholders' rights and interests. They should ensure that the communications made to them are clear, transparent and understandable.
Investors must avoid companies that benefit at the cost of the minority shareholder.
We would recommend going through our Corporate Governance module to get a better hang on this topic.
- Management:
Just as an army needs a general to lead it to victory, a company relies upon its management to steer it towards financial success. Some believe that management is the most important aspect for investing in a company. It makes sense - even the best business model is doomed if the leaders of the company fail to properly execute the plan.
It becomes crucial for an investor to analyse management integrity so that he/she can avoid wealth destroyers such as Yes Bank & Suzlon.
Retail & Individual investors are at a disadvantage as compared to professional investors in this case. You cannot set up a meeting with the management if you want to invest a few thousand rupees. On the other hand, if you are a namesake fund manager, there is a good chance you can schedule a face-to-face meeting with the upper management of the firm.
Every public company has a corporate information section on its website. Usually there will be a quick biography on each executive with his or her employment history, educational background and any applicable achievements. However, this information is hardly useful because we are looking for red marks in the company's management and no company is going to put negative information on the corporate website.
Instead, here are a few ways for you to get a better grasp:
- Conference Calls:
The Chief Executive Officer (CEO) and Chief Financial Officer (CFO) host quarterly conference calls. (Sometimes, you will get other executives as well.) The first portion of the call is management reading off the financial results. What is interesting in the con-call is the question-and-answer portion during the call. This is when the line is open for analysts to call in and grill the management over its performance as well as future plans. Answers to these queries can reveal a lot about the company. Now the thing to judge here is, do they avoid questions, like politicians, or do they provide the right answers?
- Management Discussion and Analysis (MD&A):
The Management Discussion and Analysis is found in the annual report. In theory, the MD&A is supposed to be a frank commentary on the management's outlook. Sometimes the content is worthwhile; other times, it is boilerplate. One tip is to compare what management has said in past years with what they are saying now. Is it the same material rehashed? Whether the strategies are actually being implemented? If possible, sit down and read the MD&As of the last five years; it can be illuminating.
- Ownership and Insider Sales:
If company's top promoters or managers are continuously reducing their stake in the company quarter after quarter, this is a big red mark on the company's fundamentals. This was precisely the case with Satyam Computers in India where the promoters' stake fell from around 30% to a mere 4.5% over the course and time and what happened next is known to all.
- Social Media buzz:
Although not exactly a reliable source of information, it can prove to be quite useful when the company is not actively engaged with the shareholders. Market commentators have interesting insights to offer on the business that can add value to your decisions.
