February 1, 2015

How to Analyze Companies in Industries new to you ?


Many times, we come across companies, which show promising signs of becoming good investment opportunities. We may find such companies while interacting with friends, watching television, reading magazines, vacationing, shopping or screening stocks online. 

We get interested and start searching about these companies on the internet. We visit their websites, glimpse through their financials and read about their management. We never forget to find out about their industries. These exciting companies usually belong to diverse industries. Some of them may belong to apparel manufacturing, some to consumer goods and others to food processing. Some may be vendors to large manufacturers and others may be providing unique solutions to everyday problems (Jugaad!). However, there is high possibility that the exciting companies that we come across, would belong to an industry that is out of our expert domain.

If the selected company belongs to an industry new to us, then we are left stranded with many unanswered questions:
  • How should we analyze this company? 
  • Which parameters should we look at? 
  • What factors make a company strong in this industry? 
  • Is this company's strategy the best in its industry? 
  • Does it have any advantage over its competitors? 
And so on. Answers to all these questions depend on our circle of competence, which is the limit of expertise that we currently have. 

Greatest of the investors of all times, be it Benjamin Graham, Warren Buffett or Peter Lynch, have stressed that we should always stick to investing in what we know or within our circle of competence. All of these geniuses were full time investors. They spent entire day analyzing companies, getting briefings, meeting industry people and built expertise over large number of industries. They had very large circles of competence.

However, with most of us doing a daytime job for survival, our circle of competence is limited to only a few industries. In most of the cases, the circle contains only one industry, the one in which we work.

What is the solution to this situation? Should we let the exciting opportunities that we come across on daily basis, go away? The answer is “No”.

Then more question arise in our minds:
  • What should we do then? 
  • How should we learn about the industry and relevant factor that might affect our newly discovered company? 
  • Where would we get an authentic guide about the industry? A guide that can give us answers of the questions that we have in our minds.


A Simple Guide to Learn about New Industries: 

 

I believe that whenever an investor is stuck in such a situation, she should visit the website of any Credit Rating Agency.

Credit rating agencies are organizations that analyze the debt facilities of borrowing companies and give their opinion about the risk of default contained in them. There are credit rating agencies in almost all the countries. Some of these agencies are global players like Standard & Poor’s, Moody’s and Fitch whereas other are national players like Credit Analysis & Research Ltd. (CARE) in India.


Credit rating agencies analyze different industries in detail. They create relevant parameters & benchmarks for rating companies in those industries. These parameters help these agencies in comparing one company with another within the industry. These agencies put the guidelines of these parameters as “Rating Methodologies” on their websites.

For common investors like us, these Rating Methodology guidelines can serve as a great tool in understanding any industry and the factors that influence the companies in that industry. This new learning can help us answer most the questions that arise in our mind whenever we analyze a company outside our expert domain.

I have tried to give a glimpse of the utility of Rating Methodology guidelines by analyzing the guidelines for rating Indian Cement companies by ICRA Ltd (ICRA), one of the credit rating agencies in India.


ICRA’s Guidelines for Rating of Indian Cement Companies:


ICRA’s rating guidelines of cement industry inform the readers that strength of any company depends on factors like markets, operational strengths, management quality, financial strength and government policies.

It gives an investor insight about the inherent dynamics of cement industry: its cyclical nature and irrelevance of imports:

"Cement, like other commodities, exhibits strong cyclicality in volume offtake and price realisations. However, the industry is relatively insulated against global trends as the large freight component makes voluminous imports unviable. Thus competition in the Indian cement industry is largely restricted to domestic manufacturers.

The report tells an investor that she should be more concerned about regional competition than national supply scenario:

“Cement being a bulky low-value commodity is highly freight sensitive, and bulk of the cement produced within a region is usually consumed within the region itself, with excess being transported to the adjacent regions. Thus, price trends and capacity utilisation levels are determined more by regional supply-demand dynamics than by the national supply-demand balance.”

An investor comes to know about the comparative advantage of location of manufacturing plants:

“ICRA takes a favourable look at manufacturers with plants in different regions, as geographical diversification usually allows players to better cope with local downturns."

“While the bulk of India’s cement production capacity is concentrated in a few clusters, which are essentially regions where limestone is widely available, the major consumption centers are often states that are far away from these production centers. ICRA favorably views plants that are located close to the major consumption centers and away from the major production clusters as they are likely to enjoy higher naked realizations and hence profitability over the long term on the strength of lower freight expenses.”

“In analyzing the locational economics, ICRA also evaluates the strategies adopted by individual companies to offset their locational disadvantages, if any. One strategy, for instance, is to set up stand-alone grinding units close to the consuming markets and the clinkerising unit near the limestone quarry. This helps the manufacturers to save the freight cost as clinker can be transported in open wagons or trucks.

An investor gets the understanding of the factors influencing the profitability of companies in the industry:

“Cement being a commodity item does not allow much premium pricing and thus most manufacturers are price takers in the markets they operate. In such a scenario, control over operating expenses is essential not only to maintain cost competitiveness and maximise profitability, but also withstand cyclical downturns, and is therefore one of the most important rating determinants. The major operating cost head for cement companies (apart from freight) is power & fuel. Power & fuel expenses in turn depend on two factors: the consumption norms, and the cost per unit of input consumed. Thus, ICRA analyses consumption norms such as kCal/kg clinker, kwh/kg clinker and kwh/MT cement produced for the manufacturer being rated. ICRA also assesses the manufacturer’s efforts at reducing input costs through measures such as setting up captive thermal power plants, using economic cost power from mini- hydroelectric plants, windfarms, etc., and using alternative fuels that are available locally.”

An investor also learns about the preferable product mix in the industry:

"Ordinary Portland Cement (OPC) which accounts for one-third of India’s cement production enjoys a premium over blended cement because of greater acceptability. Cement companies have popularised the use of blended cement, with the result that the proportion of blended cement in the total production has increased over the years. The cost of production of blended cement is lower vis-à-vis OPC as the cost of additives such as fly-ash and slag (which are used in blended cement) is usually lower than the cost of clinker. Further, blended cements allow a manufacturer to produce more cement using the same amount of limestone and clinkerisation capacities. Therefore, ICRA views favourably companies with a demonstrated ability to develop and promote blended products, as also special products such as oil well cement, railway sleeper cement, and sulphate resistant cement. Although the offtake of the special products is limited, they usually offer significantly higher margins, thus providing some stability to the revenues and operating profits of the company concerned."

An investor gets the learned view about the impact & desirability of branding efforts by her shortlisted company:

“In India, brand development for cement is still in a nascent stage, and as of now manufacturers do not get any significant pricing premium on account of branding or the perceived superiority of product quality. Brand equity also remains a largely regional factor (given that sales are regional), with some local players enjoying considerable brand equity in their areas of operations. ICRA views favourably sustained efforts by manufacturers towards brand development, as it expects brand strength to allow market acceptance in the long term.”

Thus, we can see that the Rating Methodology documents of credit rating agencies provide simple and concise industry specific assessment guidelines. These guidelines can prove to be a good starting platform for an investor to understand and learn about any new industry. Thereafter, the investor should subject the target company to detailed analysis and check whether it meets all her checklist criteria. She should consider investing in this company only if it passes the tests of her due diligence.

Read: How to conduct Detailed Analysis of a Company

Read: Final Checklist for Buying Stocks

Credit rating agencies publish such documents for all the industries where they do the credit rating for their constituent companies.

I believe that every investor should study the credit rating reports, whether summary or detailed reports, for any company that she is analysing for investment.

Read:  7 Important Reasons Why Every Stock Investor should read Credit Rating Reports

Rating Methodology document of Indian Cement companies by ICRA can be found here

Rating Methodology documents of other industries by ICRA can be found here.

Investors of almost every country can find similar resources in their country. For example, in Malayasia, Rating Methodology guidelines for different industries by:

For details of credit rating agencies operating in other Asian countries like Philippines, Thailand, China, Indonesia, Japan, Korea, Srilanka etc.  click here.

 

Your Turn:

 

I would like to know about your approach of studying about new industries, which are outside your current expert domain. What resources do you use for gaining knowledge about such new industries? How has been your experience with those resources? Your inputs can be of help to the author and the readers alike. You may provide your inputs in the comments below or contact me here.

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