Investment Analysis Questions

Investment Analysis Questions

Last Updated by WikiWealth

Investment Analysis Questions

Is the Business Simple to Understand?

(click for example: UPS)

  • This questions asked whether the company has a simple product and industry. Simplicity lowers risk, which is fundamental to Warren Buffett's investing style. A simple business stays within their area of expertise. A company that makes 5 different types of steel is simpler than a company that makes airplanes and websites, which are two different industries. The more dissimilar the industries, the more complicated the business. Conglomerate (multiple products and services) are complicated businesses. Any drastic changes in the company can make forecasting results difficult and could potentially harm a company that tries to change from what has worked for them. If a company must change to survive, then there is risk that those changes may not work out.
    • Five Stars: Simple business, focused mission
    • Four Stars: Simple business, multiple products
    • Three Stars: Average
    • Two Stars: Complicated business, multiple products
    • One Star: Conglomerate, no mission focus, multiple unrelated products.

Is the Company the Dominant Industry Leader?

(click for example: Wal-Mart)

  • Dominant industry leaders are usually larger companies that have the personnel, experience and financial strength to beat competitors. Industry leaders are the hardest to beat, therefore, they provide the most safety for investors. If the company is the largest in the world, they are a five star industry leader by default. Companies that are among the largest in the world should get three to four stars. Anything below the largest set of companies will have to complete against rivals, and are thus, not dominant. A company subject to intense competition is one star. A company can be dominant in more than one market (GE), but overall, they usually possess strength in one or two main markets. Warren Buffett would rather buy 10% of the Hope Diamond (best diamond in the world), versus 100% of any lesser jewel.
    • Five Stars: Industry Leader
    • Four Stars: Amongst the largest in an industry
    • Three Stars: Average position
    • Two Stars: Amongst the smaller competitors
    • One Star: Intense competition, small competitor

Is the company's management pay in line with financial results?

(click for example: google)

  • It is important that the people running a company have an interest in it's performance. This is best displayed by Warren Buffett and the founders of Google who have the majority of their wealth in the companies they run. If management has the wrong incentives, they may not run the company in the best interest of the owners. Employee stock options are a terrible long-term solution to align management with financial results. Since options are short-term, management may undermined shareholders so they can profit over a short period of time instead of thinking about the long-term health of a company. Share ownership is the best solution to align management (five stars), but also bonuses tied to long-term performance measures such as cash flow margins will give high ratings for this question. Some industries, such as banking, have large bonus structures, which tend to align the firm towards a singular goal.
    • Sources:
      • The best source for this information is the percentage of shares owned by insiders in the company (enter symbol). As the companies shares price goes up, so does the value of the employees holdings in the company, therefore, they have an incentive to think long term about the companies potential. A little ownership can go a long way to align management's interest. % Ownership star guide:
        • Five Stars: 15% and above
        • Four Stars: 5% to 15%
        • Three Stars: 1 to 5%
        • Two Stars: 1%
        • One Star: 0%
      • The lower half of this page, by yahoo, shows management compensation and the corporate governance rankings for each company. Enter the stock symbol to search for each individual company. http://finance.yahoo.com/q/pr?s=goog
      • Bonuses ties to free cash flow - Warren Buffett's preferred method - is another important variable to consider.

Does the business have significant barriers to entry?

(click for example: Coca-Cola)

  • This question is most easily answered in the SWOT analysis (strength) section of each research report. A significant barrier is something that gives a company an insurmountable advantage over competitors. Think of a giant castle with a very large moat. Possessing a significant barrier to entry makes defending your company from rivals easier. Coca Cola has their secret receipt and Microsoft has their Windows monopoly. Barriers are formed a variety of ways, but they all have the same ability to protect a company in some way. A medical device or drug company has patents and regulatory approvals, which limits other competitors from competing on the market. Economies of scale are a significant barrier, power over suppliers or even brand name can provide barriers to entry. The better the barrier, the better the companies ability to survive over time.
    • Examples of barriers to entry include: technology (patents), brand name, economies of scale, buyer power, supplier power, natural monopolies from investments, strong network relationships, predatory pricing, customer loyalty, vertical integration, brand positioning (through advertising)
    • Five Stars: Absolute barrier against competition (patent)
    • Four Stars: Very difficult for companies to compete with you
    • Three Stars: Average position
    • Two Stars: Competitors compete against you easily
    • One Star: Competitive blood bath

Conclusion

These questions and WikiWealth's quantitative (math) model provides a more complete picture of the valuation process that Warren Buffett uses to find undervalued investments. Warren Buffett focuses on reducing risk, which these questions also seek to accomplish. The answers to these questions should appear in the SWOT analysis; if some are missing, please add your input to the SWOT analysis. Better stock research = better investments.

Value Indicators - SWOT Analysis

What makes for a good investment moat?

When strengths and opportunities substantially exceed weaknesses and threats, an investment has great long-term investment potential.

Are the company's strengths greater than their weaknesses?

  • This question is easily answered in the SWOT analysis. Two variables should dictate your answer. One, count the number of strength versus the number of weaknesses and the one with the high number/advantage should have a higher number of stars. Two, measure the significance of the strength versus weakness. If one strength is overwhelmingly favorable and two weaknesses are not important, then the strength deserves more weight. In general, a company with more strength has more advantages in the industry and a better chance as a long-term investment.
    • Five Stars: Strengths dominate weaknesses (both quantity and quality of SWOT statements)
    • One Star: Weaknesses dominate strengths (both quantity and quality of SWOT statements)

Are the company's opportunities greater than their threats?

  • This question is easily answered in the SWOT analysis. Two variables should dictate your answer. One, count the number of opportunity versus the number of threats and the one with the high number/advantage should have a higher number of stars. Two, measure the significance of the opportunity versus threats. If one opportunity is overwhelmingly favorable and two threats are not important, then the opportunity deserves more weight. In general, a company with more opportunity has more advantages in the industry and a better chance as a long-term investment.
    • Five Stars: Opportunities dominate threats (both quantity and quality of SWOT statements)
    • One Star: Threats dominate opportunities (both quantity and quality of SWOT statements)

Country Analysis

Economic Freedom Ranking?

Per The Heritage Foundation's definition: Economic freedom is the fundamental right of every human to control his or her own labor and property. In an economically free society, individuals are free to work, produce, consume, and invest in any way they please, with that freedom both protected by the state and unconstrained by the state. In economically free societies, governments allow labor, capital and goods to move freely, and refrain from coercion or constraint of liberty beyond the extent necessary to protect and maintain liberty itself. (See the Methodology.)

WikiWealth uses the Heritage Foundation's ranking as a base to describe the potential economic growth that countries can provide for their citizens and for the companies, which operate within their boards. Great economic freedom brings greater potential, which increase the value of countries and associated companies operating within their boards.

Government Transparency and Stability?

Transparency and stability affect risk. As risk increases, potential decreases. To increase the value of a currency and companies, a government should increase transparency of their operations and increase the stability of their economic and political environment. Tariffs and brides act directly as a tax on goods, but those types of taxes are unknown, so they are difficult to anticipate with clarity. Uncertain government legal regulation acts to decrease transparency and increase risk.

Economic Diversity and Opportunities?

Countries operate like much like companies. If a company is dependent on a single product, they have more risk than companies that have a boarder array of products and services to compete with. Diverse economic opportunities also allow citizens to adjust from declining industries towards industries that have more potential for growth. Diversity also brings economic stability, which decrease risk.

For example, the Russian economy is dependent on energy exports for the large majority of its revenue. As the revenues from energy decreased sharply, the country was in a serious economic condition for having relied on a single source of economic growth. Sales of items such as cars and houses decreased significantly, because much of the revenue to fuel those industries derived from the energy sector. If an investor bought assets in the Russian car industry, they would see a significant decrease in value even though a fall in oil prices should spur car sales.

Commodity Analysis

Difficult to Expand Short Term Supply?

When commodity prices having difficulty expanding in the short term, a sudden increase in demand will increase the commodity price, because producers can not quickly meet new demand with new supply.

Demand Not Sensitive to Price Changes (also call elasticity of demand)?

When a commodity becomes so important that price increases have little affect on demand, this benefits commodity sales. When prices increase, demand decrease as consumers use substitute products or services, but if none are available, the consumer has no choice but to continue buying the commodity at whatever price is available. This helps the commodity to increase revenue significantly as prices move higher, because demand decrease by a small relative amount.

Gasoline is a classic example of this phenomenon. As prices for gasoline in the United States increased from 100% (from $2 to $4), the demand for gasoline only decrease by roughly 5% to 10%. If their were better substitute goods for gasoline, the demand would decrease by much more.

Lack of Good Substitute Commodities?

The lack of good substitutes mean that when a particular commodity increases in price, the option to substitute that product with a similar product is minimal. If no substitutes exist, a consumer, must continue buying the commodity that increased in price. Substitute goods act as competitors to their primary good.

Sources:
http://www.heritage.org/index/Default.aspx