Chapter 8

SECURITY ANALYSIS

Now that we’ve covered the top-down method, let’s pick some stocks. This chapter walks you through analyzing individual Telecommunications firms using the top-down method presented in Chapter 7. Specifically, we demonstrate a five-step process for analyzing firms relative to peers.

Every firm and every stock is different, and viewing them through the right lens is vital. Investors need a functional, consistent, and reusable framework for analyzing securities across the sector. Though 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.

Volumes have been written about individual security analysis, but a top-down investment approach de-emphasizes the importance of stock selection in a portfolio. As such, we talk about the basics of stock analysis for the beginner-to-intermediate investor. For a more thorough understanding of financial statement analysis, valuations, modeling, and other tools of security analysis, additional reading is suggested.

MAKE YOUR SELECTION

Security analysis is nowhere near as complicated as it may seem—but that doesn’t mean it’s easy. As with 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 with, 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 really no different from 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).

Because 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 jeopardizing 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.

A FIVE-STEP PROCESS

Analyzing a stock against its peer group can be summarized as 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.

Step 1: Understand Business and Earnings Drivers

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’s website and financial 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 its true core competencies are. Ask questions like: Has it been an industry leader for decades, or is it a relative newcomer? Has it 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 it makes its 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 and 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’s the media’s opinion of the firm? Is it a bellwether to the industry or a minor player?
• Markets and customers. Identify main customers and the markets it operates in. Determine whether 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 the industry 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 the firm stacks up—is it an industry leader or a minor player? Does market share matter in that industry?

Step 2: Identify Strategic Attributes

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. Because industry peers are generally affected by the same high-level drivers, strong strategic attributes are the edge in creating superior performance. Examples of strategic attributes include:

• Favorable regulatory regime
• High relative market share
• Low-cost production
• Superior sales relationships/distribution
• Economic sensitivity
• Vertical integration
• Strong management/business strategy
• Geographic diversity or advantage
• Consolidator
• Strong balance sheet
• Niche market exposure

• Pure play
• Potential takeover target
• Proprietary technologies
• Strong brand name
• First mover advantage

Portfolio drivers help determine which 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 in the Telecom sector is a diversified service provider. During periods of high user additions, the company’s low variable costs allow it to earn wide margins. However, when competition is fierce and customer churn is high, the service provider’s high fixed costs may be a headwind. Thus, it’s essential to pick strategic attributes consistent with higher-level portfolio themes and analyze the ones that may be more important 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, a telco may be strategically positioned in a geographic region with demand growth, but it can only capitalize on this advantage if it has access to the capital to make the investments necessary to meet this demand.

Identifying strategic attributes may require thorough research of a 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 an arduous task at times, but it’s also among the most important in security selection.

Step 3: Analyze Fundamental and Stock Price Performance

After 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, annual reports, and the company’s conference calls with financial analysts, first analyze the company’s recent financial performance. Ask the following questions:

• What are recent trends for revenues, margins, and earnings? What business activities are driving results, and how?
• Have earnings tended to be above or below company guidance? How did earnings compare to consensus estimates?
• Are earnings growing because of higher volumes, higher prices, or lower costs?
• Are headline earnings affected by one-off accounting items?
• Were there any major regulatory events? How might they impact future financial performance?
• Is the company growing organically, because of acquisitions, or for some other reason?
• Is the company generating sufficient operating cash flow to fund its capital investments? If not, how is it financing the difference? Can the company obtain capital at attractive rates?
• What is management’s strategy for the future? Will management invest in growth or return excess capital to shareholders?
• How sustainable is the strategy? Is it predicated on realistic macroeconomic assumptions?
• What is the financial health of the company? Does it have sufficient liquidity to meet its financial obligations?

After familiarizing yourself with the company, evaluate some of its peers. You’ll begin to notice similar trends and events affecting the broader industry. Take note of these so you can distinguish between issues that are company-specific and those that are industry-wide.

Once you’ve got a sense of the company’s fundamental financial performance, check the company’s stock chart for the last few years. In light of the financial statements you’ve reviewed, does the stock chart look like what you would expect?

Explain any big up or down moves in the company’s share price, and identify any significant news events. If the stock price has trended steadily downward despite ostensibly strong financial performance, the market may be discounting an expected future event—perhaps the market is expecting a negative outcome in future regulation changes.

Or if the company’s share price has soared despite weak financial performance, there may be some unseen force driving shares higher, such as speculation the company may be a takeover target. Sometimes, stock-specific financial performance may be overshadowed by broad industry trends, such as rising interest rates or changes in regulation. Or stocks can simply move in sympathy with the broader market. Whatever it is, make sure you know.

Step 4: Identify Risks

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:

• Regulatory proceedings
• High earnings sensitivity to commodity prices
• Customer concentration
• Supply chain risks
• Excessive leverage or lack of access to financing
• Poor operational track record
• High cost relative to competitors
• Late SEC filings
• Qualified audit opinions
• Hedging or trading activities
• Pension or benefit underfunding risk
• Outstanding litigation
• Pending corporate actions
• Executive departures
• Stock ownership concentration (insider or institutional)

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:

• Economic activity
• Commodity prices
• Interest rates
• Industry cost inflation
• Supply chain disruptions
• Legislative risk
• Geopolitical risks
• 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 but still performing in line with your higher-level themes and drivers.

Step 5: Analyze Valuations and Consensus Expectations

Valuations can be tricky things. 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.” For example, most Telecom firms have lower price to earnings than most Information Technology (IT) companies, but that doesn’t necessarily make the sector a better value—IT companies earn their premium valuation by providing higher returns on capital and growth rates.

Investors are usually best served by comparing a firm’s valuation to that of its peer group or relative to its own historical average. Investors use many different valuation metrics in security analysis. Most look at companies’ current share prices relative to some financial metric—either based on historical performance or future expectations. Some of the most popular include:

• P/E—price to 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

Even within a peer group, relative valuations in and of themselves do not provide insight into future stock performance. Just because one company’s P/E is 20 while another’s is 10 doesn’t mean you should necessarily buy the one at 10 because it’s “cheaper.” When valuations are different, there’s usually a reason, such as different strategic attributes, growth and profitability expectations, or stock-specific risks. The main question for investors is thus, “Are valuations justified by fundamentals?” To answer this question, compile the valuations for a peer group and try to estimate why there are relative differences in valuation. Often, there’s a strong relationship between valuations and financial performance.

However, valuations are not determined solely by a single financial metric. There are other, more qualitative factors which may provide a company with a higher—or lower—valuation than its financial performance might imply. For example, if a telco is in the midst of a contentious proceeding with its regulator, investors may assign a valuation multiple which is lower than its financial performance might otherwise imply. Or perhaps investors speculate the telco is a viable takeover target and provide a higher premium.

Once you understand the reasons for a telco’s relative valuation, you can then attempt to determine whether it’s justified. For example, perhaps you find a company which has a low valuation because of an expected dividend cut. If your analysis leads you to believe analyst earnings expectations are too conservative, you might conclude the company’s dividend will be higher than expected, and thus the company’s valuation multiple will expand.

Ultimately, valuations tell you what other investors think about a company’s current and future prospects. Because stocks trade on the unexpected, understanding what investors expect is critical since it allows you to determine whether you believe reality will turn out to be better or worse than expected.

TELECOM ANALYSIS

This chapter’s framework can be used to analyze any firm, but there are additional factors specific to the Telecom sector that must be considered. The following section provides some of the most important factors and questions to think about 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. And while there are countless other questions and factors that could and should be asked when researching Telecom firms, these should serve as a good starting point.

Chapter Recap

Security analysis is not nearly as complicated as it seems. In the top-down investment process, stocks are essentially tools we use to take advantage of opportunities we identify in higher-level themes. After identifying an attractive segment of the market, we attempt to determine the firms most likely to outperform their peers by finding firms with strategic attributes. While the five-step security selection process is just one of many ways to research firms, it is an effective framework for selecting securities within the top-down process.

When researching Telecom firms, do not limit yourself to the questions posed in this chapter; they are just some tools that can 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.