CHAPTER 7

SECURITY ANALYSIS

Now that we’ve covered the top-down method, let’s pick some stocks. This chapter walks you through analyzing individual Financials firms using the top-down method presented in Chapter 6. Specifically, we’ll 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. 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 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.

Top-Down Recap
As covered in Chapter 6, you can use the top-down method to make your biggest, most important portfolio decisions first. However, the same process applies when picking stocks, and those high-level portfolio decisions ultimately filter down to individual securities.
Step one is analyzing the broader global economy and identifying various macro “drivers” affecting entire sectors or industries. Using the drivers, you can make general allocation decisions for countries, sectors, industries and sub-industries versus the given benchmark. Step two is applying quantitative screening criteria to narrow the choice set of stocks. It’s not until all those decisions are made that we get to analyze individual stocks. Security analysis is the third and final step.
For the rest of the chapter, we assume you have already established a benchmark, solidified portfolio themes, made sub-industry overweight and underweight decisions and are ready to analyze firms within a peer group. (A peer group is a group of stocks you’d generally expect to perform similarly because they operate in the same industry, possibly share the same geography and have similar quantitative attributes.)

MAKE YOUR SELECTION

Security analysis is nowhere near 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: spotting opportunities not currently discounted into prices. Or, put differently, knowing something others don’t. Investors should analyze a firm 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 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 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:

1. Understand business and earnings drivers.
2. Identify strategic attributes.
3. Analyze fundamental and stock price performance.
4. Identify risks.
5. Analyze valuations and consensus expectations.

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 understanding 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 descriptions 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 its financial statements readily accessible online these days.) Browse the firm’s 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 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/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? 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 their 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 solid 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. Since 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
Strategic Attributes: Making Lemonade
How do strategic attributes help you analyze individual stocks? Consider a simple example: There are five lemonade stands of similar size, product and quality within a city block. A scorching heat wave envelops the city, sending a rush of customers in search of lemonade. Which stand benefits most from the industry-wide surge in business? This likely depends on each stand’s strategic attributes. Maybe one is a cost leader and has the cheapest access to homegrown lemons. Maybe one has a geographic advantage and is located next to a basketball court full of thirsty players. Or maybe one has a superior business strategy with a “buy two, get one free” initiative that drives higher sales volume and a bigger customer base. Any of these are core strategic advantages.

Portfolio drivers help determine which kind of strategic attributes are likely to face headwinds 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 Financials sector is an asset manager focused on equity investments. During periods of rising equity prices, the company’s exposure to equities will allow its assets under management (AUM) to increase naturally and drive higher revenue. However, when equity prices fall, this exposure can quickly erode its AUM. Thus, it’s essential to pick strategic attributes consistent with higher-level portfolio themes and analyze those that are 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 bank may be strategically positioned in a geographic region with demand growth, but it can capitalize on this advantage only if it has sufficient capital to support a growing balance sheet.

Identifying strategic attributes may require thorough research of the firm’s financial statements, Website, news stories and 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.

Step 3: Analyze Fundamental and Stock Price Performance

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, 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 or 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 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 drop in housing prices will elevate future loan losses.

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 achieve the goal of picking firms with the greatest probability of outperforming their peer group and 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 Financials firms have lower price to earnings than most information technology companies, but that doesn’t necessarily make the sector a better value—IT companies earn their premium valuations 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. There are many different valuation metrics investors use in security analysis. Most look at the company’s current share price relative to some financial metric—based on either 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 and/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 that may provide a company with a higher—or lower—valuation than its financial performance might imply. For example, if an insurance company is in the midst of a contentious proceeding with its regulator, investors may assign a lower valuation multiple than its financial performance might otherwise imply. Or perhaps investors speculate an investment bank is a viable takeover target and provide a higher premium.

Once you understand the reasons for a financial company’s relative valuation, you can then attempt to determine whether it’s justified. For example, perhaps you find a company that has a low valuation because of an expected dividend cut. If your analysis leads you to believe analysts’ 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 because it allows you to determine whether you believe reality will turn out to be better or worse than expected.

FINANCIALS ANALYSIS

While this chapter’s framework can be used to analyze any firm, additional factors specific to the Financials sector 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 Financials firms, these should serve as a good starting point.

Leverage ratios: Regulatory and non-regulatory leverage ratios can give a snapshot of a company’s health. Many times, a company can have sufficient capital according to regulators, but this does not always match ratios the market demands. How much regulatory capital does the company have? What about other leverage ratios, such as the tangible equity ratio or leverage ratio?
Liquidity: Since the Financials sector is the most leveraged sector, it is highly reliant on credit markets for funding. How does the company fund its operations? Which sources of liquidity does the company tap? What is the company’s loan-to-deposit ratio?
Exposures: Again due to the relatively high degree of leverage, it is important to properly scale a company’s exposure to risk. What are the company’s exposures relative to the company’s equity? Is it taking too big of a bet?
Asset liability sensitivity: How will the company’s balance sheet react to rising or falling interest rates? What about the income statement?
Product mix: It is important to know if a company is levered to products in a growing or shrinking category. Which types of loans does the company offer? What is the mix between consumer lending and business lending? Are the loans collateralized? Is the company exposed to fixed-income management or equity management?
Earnings variability: Financial companies are known for recurring “one-time gains and losses,” but what do core earnings look like? How are core operations trending?
Sales growth: Net sales growth is a positive sign for a business, but as a stock analyst, you must determine how top-line sales growth is derived if you are to determine the quality of the sales growth. Was the top line influenced primarily by acquisitions or divestitures, or was it organic growth from ongoing operations? You can extrapolate organic growth into the future with more confidence than you can acquisition-based growth, so it is generally considered a more relevant analytic.
Geographic diversity: How wide is the firm’s geographic reach? Does the firm have meaningful exposure to high-growth international markets? Is the firm concentrated in a slow-growth, mature market? Geographic diversification can help smooth earnings trends as growth in one market can offset weakness in other markets. If a company is expanding internationally, what are the region’s penetration rates, and what do margins look like in those markets? For internationally diversified firms, keep in mind fluctuations in foreign currency values influence the way sales and earnings are reported in US dollars.
Competition and barriers to entry: What does the competitive landscape look like? Are there firmly entrenched market share leaders who are insulated from smaller competitors via high barriers to entry? Are there substitutes for the company’s products or services?
Margins: Are margins growing or shrinking, and what is driving this movement? Has the company historically offset higher costs with higher prices? How do its margins compare to those of peers?
Business strategy: Has the company recently been acquiring or divesting businesses? If so, what are the drivers behind such activity? If the company is a consolidator, does it have a successful track record of creating positive synergies like increased operating leverage, capacity utilization and distribution network efficiencies? If a firm is in divestment mode, what were the catalysts, and what is the strategy looking forward? Is it moving into higher growth categories?
Management: What is management’s reputation? Is a seasoned team with a strong track record of building the business and adding shareholder value in place? Has it executed on stated goals and met guidance to the Street? Has there been management turnover?
Brand equity: Is the brand highly recognizable and respected? What are the firm’s strategies in promoting the brand? A well-respected brand gives a firm the ability to price its product above the competition and to more easily expand into new geographic regions.
Political risk: Financials and politics are closely tied together, and legislative changes can happen on a relatively frequent basis. Does the firm currently operate in a favorable regulatory environment? How does it compare to other geographic regions? How might regulation change?
Financial strength: Does the company have enough cash and cash flows to operate well into the future? Compare the firm’s interest costs with the amount of operating income the business generates (interest coverage ratio). Will the firm require additional funds in the future to expand its operation? If so, is there capacity to take on more debt, or would the firm have to engage in an equity offering that may dilute existing shareholders? You can investigate financial health by comparing balance sheet financial ratios to peers’. Ratios such as long-term debt to capital and the current ratio can be used to assess a firm’s capitalization structure and liquidity level. Comparing credit ratings to peers is another tool at your disposal. The primary credit agencies are Standard & Poor’s, Moody’s and Fitch.
Recall debt isn’t necessarily a bad thing when defining financial strength—many firms generate an excellent return on borrowed funds. Understanding the capital structure of a firm and its history of generating returns on capital will help you appraise the optimal level of debt.
Dividend yield: Confidence in the sustainability of a company’s cash flow and dividends is crucial. How stable do they appear? What’s the company’s payout ratio (dividend/net income)? Although there’s no rule, if it’s less than 0.7, it’s probably less likely to be cut than a peer with a higher ratio.
Reinvestments: If a company’s payout ratio is low, it may mean the company is investing a higher percentage of profits into future growth. Often, earnings growth is fueled by capital expenditures (capex) to increase coverage and capacity. How much of sales are capex? How efficient does the company’s spending appear to be? What’s the capex efficiency ratio (EBITDA/capex)? How do these ratios compare to peers’?

Create Your Own Metric

We have covered common industry factors, but with a little creativity, you can come up with your own. For example, if you’re interested in finding stocks with a high dividend yield that aren’t too volatile, create a yield/beta ratio. Finding companies with the higher yields per unit of beta may be an easy way to compare companies and identify a superior investment.

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