Now that we've covered the top-down method, let's pick some stocks, shall we? This chapter walks you through analyzing individual Technology firms using the top-down method presented in Chapter 8. Specifically, we'll demonstrate a five-step process for analyzing firms relative to peers.
Every firm and every stock is different, but viewing them through the right lens is vital. Investors need a functional, consistent, and reusable framework for analyzing securities across the sector. While by no means comprehensive, the framework provided and the questions at this chapter's end should serve as good starting points to help identify strategic attributes and company-specific risks.
While volumes have been written about individual security analysis, a top-down investment approach de-emphasizes the importance of stock selection in a portfolio. As such, we'll talk about the basics of stock analysis for the beginning to intermediate investor. For a more thorough understanding of financial statement analysis, valuations, modeling, and other tools of security analysis, additional reading is suggested.
Security analysis is nowhere nearly as complicated as it may seem—but that doesn't mean it's easy. Similar to your goal in choosing industry and sector weights, you've got one basic task: Spot opportunities not currently discounted into prices. Or, put differently, know something others don't. Investors should analyze firms by taking consensus expectations for a company's estimated financial results and then assessing whether it will perform below, in line, or above those baseline expectations. Profit opportunities arise when your expectations are different and more accurate than consensus expectations. Trading on widely known information or consensus expectations adds no value to the stock selection process. Doing so is no different than trading on a coin flip.
The top-down method offers two ways to spot such opportunities. First, accurately predict high-level, macro themes affecting an industry or group of companies—these are your portfolio drivers. Second, find firms that will benefit most if those high-level themes and drivers play out. This is done by finding firms with competitive advantages (we'll explain this concept more in a bit).
Since the majority of excess return is added in higher-level decisions in the top-down process, it's not vital to pick the "best" stocks in the universe. Rather, you want to pick stocks with a good probability of outperforming their peers. Doing so can enhance returns without jeopar-dizing good top-down decisions by picking risky, go-big-or-go-home stocks. Being right more often than not should create outperformance relative to the benchmark over time.
Analyzing a stock against its peer group can be summarized in a five-step process:
These five steps provide a consistent framework for analyzing firms in their peer groups. While these steps are far from a full stock analysis, they provide the basics necessary to begin making better stock selections.
The first step is to understand what the business does, how it generates its earnings, and what drives those earnings. Here are a few tips to help in the process.
Industry overview. Begin any analysis with a basic understanding of the firm's industry, including its drivers and risks. You should be familiar with how current economic trends affect the industry.
Company description. Obtain a business description of the company, including an understanding of the products and services within each business segment. It's always best to go directly to a company's financial statements for this. (Almost every public firm makes their financial statements readily accessible online these days.) Browse the firm website and financial statements/reports to gain an overview of the company and how it presents itself.
Corporate history. Read the firm's history since its inception and over the last several years. An understanding of firm history may reveal its growth strategy or consistency with success and failure. It also will provide clues on what their true core competencies are. Ask questions like: Have they been an industry leader for decades, or are they relative newcomers? Have they switched strategies or businesses often in the past?
Business segments. Break down company revenues and earnings by business segment and geography to determine how and where they make their money. Find out what drives results in each business and geographic segment. Begin thinking about how each of these business segments fits into your high-level themes.
Recent news/press releases. Read all recently released news about the stock, including press releases. Do a Google search and see what comes up. Look for any significant announcements regarding company operations. What is the media's opinion of the firm? Are they a bellwether to the industry or a minor player?
Markets and customers. Identify main customers and the markets it operates in. Determine if the firm has any particularly large single customer or a concentrated customer base.
Competition. Find the main competitors and how market share compares with other industry players. Is it highly segmented? Assess the industry's competitive landscape. Keep in mind the biggest competitors can sometimes lurk in different industries—sometimes even in different sectors! Get a feel for how they stack up—are they industry leaders or minor players? Does market share matter in that industry?
After gaining a firm grasp of firm operations, the next step is identifying strategic attributes consistent with higher-level portfolio themes. Also known as competitive or comparative advantages, strategic attributes are unique features allowing firms to outperform their industry or sector. As industry peers are generally affected by the same high-level drivers, strong strategic attributes are the edge in creating superior outperformance. Examples of Strategic Attributes include:
High relative market share
Low-cost producer
Sales relationships/distribution
Economic sensitivity
Vertical integration
Management/business strategy
Geographic diversity or advantage
Consolidator
Strong balance sheet
Niche markets
Pure play
Potential takeover target
Proprietary technologies
Strong brand name
First mover advantage
Portfolio drivers help determine which kind of strategic attributes are likely to face head- or tailwinds. After all, not all strategic attributes will benefit a firm in all environments. For example, while higher operating leverage might help a firm boost earnings in the booming part of an industry, it would have the opposite effect in a down cycle. A pertinent example to Technology is a vertically integrated semiconductor firm—or one that owns all of its fabrication plants. During periods of strong demand the company will have better control over output and run its plants at higher utilization levels. This reduces fixed costs as a percentage of total output and boosts earnings. However, the firm will bear the entire negative impact of low utilization levels during periods of slow demand, whereas a company outsourcing production would not. Thus, it's essential to pick strategic attributes consistent with higher-level portfolio themes and analyze those holding more importance in the current environment.
A strategic attribute is also only effective to the extent management recognizes and takes advantage of it. Execution is key. For example, if a firm's strategic attribute is technological expertise, it should focus its effort on research and development to maintain that edge. If its strategic attribute is its position as a low-cost producer in its peer group, it should capitalize by potentially lowering prices or expanding production (assuming the new production is also low cost) to gain market share.
Identifying strategic attributes may require thorough research of the firm's financial statements, website, news stories, history, and discussions with customers, suppliers, competitors, or management. Don't skimp on this step—be diligent and thorough in finding strategic attributes. It may feel like an arduous task at times, but it's also among the most important in security selection.
Once you've gained a thorough understanding of the business, earnings drivers, and strategic attributes, the next step is analyzing firm performance both fundamentally and in the stock market.
Using the latest earnings releases and annual report, analyze company performance in recent quarters and determine why. Ask:
What are recent revenue trends? Earnings? Margins? Which business segments are seeing rising or falling sales?
Is the firm growing its business organically, because of acquisitions, or for some other reason?
How sustainable is their strategy?
Are earnings growing because of strong demand or because of cost cutting?
Are they using tax loopholes and one-time items?
What is management's strategy to grow the business for the future?
What is the financial health of the company?
Not all earnings results are created equal. Understanding what drives results will give clues to what drives future performance.
Check the company's stock chart for the last few years and try to determine what has driven performance. Explain any big up or down moves and identify any significant news events. If the stock price has trended steadily downward despite consistently beating earnings estimates, there may be a force driving the whole industry downward, like expectations for lower corporate IT spending. Likewise, if the company's stock soared despite reporting tepid earnings growth or prospects, there may be some force driving the industry higher, like takeover speculation. Or stocks can simply move in sympathy with the broader market. Whatever it is, make sure you know.
After reading the earnings calls of a firm and its peers (these are typically posted on the investor relations section of a firm's website every quarter), you'll begin to notice similar trends and events affecting the industry. Take note of these so you can distinguish between issues that are company-specific or industry-wide. For example, economic growth or higher component costs affect entire Technology industries, but import tariffs or government's tax policies may only affect specific companies.
There are two main types of risks in security analysis: stock-specific risk and systematic risk (also known as non-stock specific risk). Both can be equally important to performance.
Stock-specific risks, as the name suggests, are issues affecting the company in isolation. These are mainly risks affecting a firm's business operations or future operations. Some company-specific risks are discussed in detail in the 10-K for US firms and the 20-F for foreign filers (found at www.sec.gov). But one can't rely solely on firms self-identifying risk factors. You must see what analysts are saying about them and identify all risks for yourself. Some examples include:
Stock ownership concentration (insider or institutional)
Customer concentration
Sole suppliers
Excessive leverage or lack of access to financing
Obsolete products
Poor operational track record
High cost of products versus competitors
Late SEC filings
Qualified audit opinions
Hedging activities
Pension or benefit underfunding risk
Regulatory or legal—outstanding litigation
Pending corporate actions
Executive departures
Regional, political/government risk
Systematic risks include macroeconomic or geopolitical events out of a company's control. While the risks may affect a broad set of firms, they will have varying effects on each. Some examples include:
Commodity prices
Industry cost inflation
Economic activity
Labor scarcity
Strained supply chain
Legislation affecting taxes, royalties, or subsidies
Geopolitical risks
Capital expenditures
Interest rates
Currency
Weather
Identifying stock-specific risks helps an investor evaluate the relative risk and reward potential of firms within a peer group. Identifying systematic risks helps you make informed decisions about which sub-industries and countries to overweight or underweight.
If you don't feel strongly about any company in a peer group within a sub-industry you wish to overweight, you could pick the company with the least stock-specific risk. This would help to achieve the goal of picking firms with the greatest probability of outperforming their peer group and still perform in line with your higher-level themes and drivers.
Valuations can be a tricky thing. They are tools used to evaluate market sentiment and expectations for firms. They are not a foolproof way to see if a stock is "cheap" or "expensive." Valuations are primarily used to compare firms against their peer group (or peer average) or a company's valuation relative to its own history. As mentioned earlier, stocks move not on the expected, but the unexpected. We aim to try and gauge what the consensus expects for a company's future performance and then assess whether that company will perform below, in line, or above expectations.
Valuations provide little information by themselves in predicting future stock performance. Just because one company's P/E is 20 while another's is 10 doesn't mean you should buy the one at 10 because it's "cheaper." There's likely a reason why one company has a different valuation than another, including such things as strategic attributes, earnings expectations, sentiment, stock-specific risks, and management's reputation. The main usefulness of valuations is explaining why a company's valuation differs from its peers and determining if it's justified.
There are many different valuation metrics investors use in security analysis. Some of the most popular include:
P/E—price to earnings
P/FE—price to forward earnings
P/B—price to book
P/S—price to sales
P/CF—price to cash flow
DY—dividend yield
EV/EBITDA—enterprise value to earnings before interest, taxes, depreciation, and amortization
Once you've compiled the valuations for a peer group, try to estimate why there are relative differences and if they're justified. Is a company's relatively low valuation due to stock-specific risk or low confidence from investors? Is the company's forward P/E relatively high because consensus is wildly optimistic about the stock? A firm's higher valuation may be entirely justified, for example, if it has a growth rate greater than its peers. A lower valuation may be warranted for a company facing a challenging operating environment in which it was losing market share. Seeing valuations in this way will help to differentiate firms and spot potential opportunities or risks.
Valuations should be used in combination with previous analysis of a company's fundamentals, strategic attributes, and risks. For example, below is a grid showing how an investor could combine an analysis of strategic attributions and valuations to help pick firms.
Stocks with relatively low valuations but attractive strategic attributes may be underappreciated by the market (as shown in Figure 8.1.). Stocks with relatively high valuations but no discernible strategic attributes may be over-valued by the market. Either way, use valuations appropriately and in the context of a larger investment opinion about a stock, not as a panacea for true value.
While this chapter's framework can be used to analyze any firm, there are additional factors specific to the Technology sector that must be considered. The following section provides some of the most important factors and questions to consider when researching firms in the sector. Answers to these questions should help distinguish between firms within a peer group and help identify strategic attributes and stock-specific risks. While there are countless other questions and factors that could and should be asked when researching Technology firms, these should serve as a good starting point.
- Revenues and Earnings Breakdown.
How is the firm's revenue and earnings divided between businesses and consumers? Each is driven by different factors. Within the corporate market, are licenses enterprise-wide or seat-based? How much of sales and income are from licenses, subscriptions, maintenance, and support? This will reveal the firm's stability of operations and provide indicators on future growth.
- Market Share.
What is the firm's market share in each of its business segments? Does the firm have pricing power for its products and services? Implementing and learning new software platforms can be costly and time consuming, making switching costs high and entrenched customers valuable.
- Research & Development.
How much does the firm spend on R&D as a percentage of total sales? Software is a highly competitive industry characterized by constant innovation. A lack of compelling new programs or upgrades increases the chance of falling behind peers.
- Upgrade Cycles.
How long have the firm's products been available? When are new versions being released? Are features on new programs compelling? Will support for older versions be discontinued? New software programs generally carry higher price tags and can help boost top- and bottom-line growth. Discontinuing support for older versions often forces customers to upgrade.
- Geographic Breakdown.
What is the firm's geographic mix? Does the firm plan to focus on one region or expand geographically? Do its core competencies jibe with that strategy? Demand can vary considerably by region due in part to varying economic conditions. Piracy rates also vary by region and can negatively impact results.
- Revenues and Earnings Breakdown.
How are sales and earnings divided between different business segments? Firms in this industry often have multiple product lines, some of which are more mature than others. This can help determine expected growth and whether the firm will be more profitable than its peers. Also determine if the company offers software or services. As more of its products reach maturity, additional revenue channels can help boost growth.
- Gross & Operating Margins.
This industry faces significant pricing pressure. Is the firm able to increase margins in a declining price environment? Does it offer compelling new products, and more importantly can it charge a premium for these products? Where are its manufacturing plants? Does it outsource? Labor costs can vary by region, giving companies with access to low-cost manufacturing an advantage.
- Geographic Breakdown.
What is the firm's geographic mix? Does the firm plan to focus on one region or expand geographically? Do its core competencies jibe with that strategy? Hardware saturation levels vary by region, and exposure to underpenetrated markets can often lead to superior growth rates. This can be crucial if there is little differentiation between products.
- Distribution.
How does the firm sell its products? Does it sell direct or use distributors? How is it positioned in the retail market? While no single category is always superior, some offer advantages given various forms of end-market demand. For instance, PC firms with a stronger retail presence would likely benefit from more robust consumer demand relative to enterprise.
- Business Strategy.
How does the firm maintain growth? Is it a consolidator? Is it expanding into new regions? Does it focus on being first to market with new innovations? Given the competitive nature of this industry, unique business strategies can be key in gaining market share.
- Customer Mix.
Who are the firm's largest customers? Is it the dominant supplier to these customers? Does it have exclusive contracts with telecommunication carriers? Sales of infrastructure equipment tend to be bulky and tied to large capital expenditure projects. Knowing the firm's customers and network build out plans will provide insight into future growth. Success of a mobile handset is also highly tied to the wireless carrier offering it. How much will the firm spend marketing the device? How large of a subsidy is it offering on the phone? Is the carrier adding subscribers faster than peers?
- Geographic Breakdown.
What is the firm's geographic mix? Does the firm plan to focus on one region or expand geograhically? Do its core competencies jibe with that strategy? Levels of fixed-line and wireless infrastructure vary by region. Some markets are better for profits while others are better for top-line growth. This is especially true for mobile handsets. Sales of high-end devices tend to be stronger in developed markets while low-end devices tend to do better in Emerging Markets.
- Innovation.
How much is the company spending on R&D as a percentage of total sales? Does the firm have a history of being a first mover or does it typically chase peers? Does it hold any valuable patents? New trends in this industry happen fast. If the firm is not setting the standard, it must react promptly or risk falling behind.
- Market Share.
What is the firm's market share in each of its business segments? Does the firm have pricing power for its products and services? Moreover, can it pressure its component suppliers to lower prices? Market share often leads to leverage over suppliers and can create significant advantages in this highly competitive industry.
- Inventories.
How are the firm's inventory metrics trending relative to peers? Rising inventory levels could indicate the firm's products are obsolete and not selling well. The opposite could be true if the firm's inventory levels are declining faster than peers. But be wary, the firm could also be dumping older products into the market at reduced prices, which may negatively impact profits.
- Regulation.
How are the firm's operations affected by regulation? How might that change? Telecommunications is the single largest driver of sales in this industry. Telecom also happens to be an intensely regulated sector, and capital expenditures can vary in periods of favorable and unfavorable regulation.
- Market Share.
What is the firm's market share in each of its business segments? Does the firm have pricing power for its products and services? How sustainable is its market share? The semiconductor industry is highly cyclical. Dominant players with larger scale are often better equipped to handle the industry's volatile nature.
- End-Market Breakdown.
What markets are the firm's chips sold into? How is demand trending in each? Are its end-markets diverse or concentrated? If it's an equipment maker, is it leveraged to the front end or back end of the semiconductor production process? What kind of chips do its customers make? Semiconductors are incorporated into virtually every electronic device, making these factors vital when reviewing both chip and equipment producers. Leverage to stronger end-markets can lead to better operational performance relative to peers.
- Economies of Scale.
Does the firm have more capacity than its peers? Is it the low-cost producer? How are its yields relative to peers? The ability to more efficiently produce chips on a large scale reduces fixed costs as a percent of revenue. A lower cost structure allows firms to price more competitively and gain market share.
- Manufacturing Strategy.
Does the firm do all of its own manufacturing or does it outsource production? Each strategy can wield advantages depending on demand conditions. During periods of high demand, a company owning all of its manufacturing facilities will have tighter control over production. It will be able to add capacity at will and benefit from higher utilization levels. A company outsourcing production would not have the same level of control and could unwillingly fall short of demand. The opposite can be true during periods of slow demand.
- Supply/Demand Dynamics.
How is product supply trending relative to demand? Are inventories building across the industry? Are chip manufacturers expanding production as prices fall? Several semiconductors have become commoditized where supply/demand dynamics are the single most important driver of price. Firms with large economies of scale tend to be better positioned in these environments. More advanced manufacturing techniques can also offer advantages over peers when there is little differentiation between products.
- Technology & Innovation.
What kind of advantage does the firm's equipment or chips offer relative peers? How much does the firm spend on R&D? Are its chips positioned at more advanced technology nodes (e.g., 45 nanometer vs. 65 nanometer)? Does its equipment result in higher chip yields? Maintaining the lead in technology is crucial to gaining market share. Manufacturing at more advanced levels also offers cost benefits as it generally requires less production materials.
- Bookings.
How are bookings trending relative to sales (book-to-bill ratio)? Is this ratio increasing or decreasing? This is especially important for equipment manufacturers. A company growing its book-to-bill ratio faster than peers may mean its products are in higher demand.
- Balance Sheet.
How are the firm's debt levels in comparison to peers? Does it have access to cheap financing? Manufacturing semiconductors is a capital intensive business. If a firm is overburdened with debt, it may not be able to expand capacity to meet demand.
- Revenues and Earnings Breakdown.
How are sales and earnings divided between different business segments? Who are the firm's customers? Does it have exposure to government spending? All of these are important questions as different forms of services have varying margin profiles. Governments can also be large spenders on IT services and generally represent stable sources of income. Moreover, governments often prefer domestic versus foreign providers for mission critical IT programs.
- Corporate History.
What is the firm's history and how long has it offered IT services? Does it have a track record of expertise in certain end markets? IT services can be used by any company in any industry. Firms with deeper experience in specific end markets will generally be better positioned for new business wins.
- Geographic Breakdown.
How large is the firm's geographic footprint? What countries and regions is it most heavily leveraged to? Global scale is becoming increasingly important in the IT services industry. Demand for payroll processing and related services is also highly dependent on employment environments, which vary by region. Additionally, some credit card and transaction processing firms fall into this industry. These companies are driven by consumer spending, which again varies considerably by region.
- Competition.
Who are the firm's major competitors? While this seems simple, many competitors are likely to come from other industries. Both hardware and software firms alike are moving into the IT services industry. For instance, IBM is classified as a hardware firm but also happens to be the number one global provider of IT services.
- Market Share.
What is the firm's market share in each of its business segments? Does the firm have pricing power for its products and services? How sustainable is its market share? What is the firm's share of page views and unique page views relative to peers?
- Geographic Breakdown.
What is the firm's geographic mix? Does the firm plan to focus on one region or expand geographically? Do its core competencies jibe with that strategy? Success in this industry is often determined by the number of users able to access the Internet. Penetration levels vary by region and companies with access to more users will generally have an advantage.
- Brand Name.
How strong is the firm's brand name? Does it vary by region? Switching costs are very low for consumers using search engines or content websites. A stronger brand name can help retain customer loyalty.
- Traffic Acquisition Costs (TACs).
What are the firm's traffic acquisition costs as a percentage of total advertising revenue? How does this compare to peers? TAC is indicative of a firm's scale, efficiency, and ability to monetize traffic on its website. In other words, is it becoming more or less expensive for the firm to bring in additional advertising revenue?
- Regulation.
How are the firm's operations affected by regulation? How might that change? Discussions surrounding Internet regulation have increased in recent years. Taking note of regulation in telecommunications is also important as it can have a direct impact on Internet firms.
- Content & Services.
This is a simple but important concept. Is the firm's content better than peers? If so, how is it better and can this be maintained? Does it offer a wider selection of products, better search technology, more third party vendors? How does it differentiate itself?
- End-Market Breakdown.
What markets are the firms products sold into? How is demand trending in each? Are its end-markets diverse or concentrated? This industry is very broad and includes many companies that cannot be classified into other industries. Leverage to stronger end markets can lead to better operational performance relative to peers.
- Customer Mix.
Who are the firm's largest customers? Performance of many firms in this industry is ultimately determined by others. If it's a component manufacturer, what products are the components going into and is demand for those products strong? If it's a distributor, what products does it carry more of? If it's a manufacturing service provider, are its customers increasing or decreasing the level of outsourced manufacturing? Are these firms building new products or going through a refresh cycle? Understanding customers is vital in this industry.
- Manufacturing & Distribution.
Where are the firm's manufacturing locations? Labor costs vary by region and can mean all the difference in low-margin industries like outsourced manufacturing services. How many distribution centers does the firm have? Where are they located? For technology distributors, quick and easy access to customers is crucial.
- Operating Margins.
How are the firm's operating margins growing relative to peers? Technology distributors and electronic manufacturing services are both low-margin businesses. Those better at converting sales into profits can hold advantages over peers.
- Revenues and Earnings Breakdown.
How are sales and earnings divided between different business segments? Firms in this industry often have multiple product lines, some of which are more mature than others. This can help determine expected growth and whether the firm will be more profitable than peers.
- Equipment Installations.
How are the firm's equipment sales growing relative to peers? Majority of sales and profits in this industry are annuity based and include services, consumables (such as toner and ink), and financing. Equipment installations are a forward indicator of growth in these "post-sale" categories.
- Research & Development.
How much does the firm spend on R&D as a percentage of total sales? Office Electronics is a highly competitive industry characterized by constantly changing product portfolios. A lack of compelling new products increases the risk of falling behind peers.
Chapter Recap
Do not limit yourself to the questions provided in this chapter when researching Technology firms—they are just some tools to help you distinguish between firms. The more questions you ask, the better your analysis will be.
Stock selection, the third and final step in the top-down investment process, attempts to identify securities that will benefit from our high-level portfolio themes.
Ultimately, stock selection attempts to spot opportunities not currently discounted into prices.
To identify firms most likely to outperform their peer group, we must find firms that possess competitive advantages (aka strategic attributes).
A five-step security selection process can be used as a framework to research firms.
Firms within each industry have specific characteristics and strategies separating potential winners from losers. Asking the right questions can help identify those features.