Friday, May 9, 2008

Basics of Investing – Part II

Ascertaining the Value of Companies Qualitatively!

In order to assess the true value of companies that you plan to invest in, there are two dimensions you need to assess, namely Qualitative and Quantitative factors. Today, we shall discuss on Qualitative Factors.

Qualitative Factors
Qualitative factors are those intangible factors that cannot be qualified precisely in monetary terms. In other words, it’s something that has the accountants stumped, since they can’t put it in their Balance Sheet.

Think about it for a moment. How do you quantify something like the “X-Factor” that Richard Branson brings to Virgin Group or Steve Jobs brings to Apple Incorporated? Yet, most the mystique and value of these companies are dependent largely to the charisma and leadership qualities that their CEO brings. That’s why most CEOs are paid obscene amounts of money.

However, it is difficult to quantify these qualitative factors about companies. Fortunately, we can rely on Warren Buffett to provide the answer. In his interviews, he did mention two books that guided him in his investments. I have talked about the first one, The Intelligent Investor by Benjamin Graham.

The other is Common Stocks, Uncommon Profits by Phillip A. Fisher. So what’s so great about this book? Well, it provides a framework on how to analyze the qualitative factors of a company. And, currently the RICHEST PERSON IN THE WORLD relied on this book to make his billions!

In brief, Fisher suggests that you use 15 questions to evaluate a company. I am summarizing his 15 questions into THREE MAIN QUALITATIVE FACTORS to consider, which I will believe will serve you just as well. The other questions are mainly due to with Quantitative Factors, which I shall cover later.

1. Characteristics of Top Management
Integrity, Wisdom and Charisma! These are the qualities that Top Management should exhibit. In the end, Companies are made up of people. Most of the time, it is the Top Management that will set the tone for the rest of the employees to follow. A company whose Board of Directors exercise due diligence when making their decisions will act in the best interest of their shareholders (meaning YOU, if you invest in the shares of the companies).

These are people who will be frank in good times and bad. If they have made an error of judgment, they will openly admit it and move on. Charisma is also an important factor as most institutional investors base their decisions on the reputations and charisma of the CEOs. A more charismatic CEO may be able to convince analysts and investors to invest and support the Companies they lead.

2. Substantive Competitive Advantages (i.e. Moat)
What differentiates a Company from its’ competitors? Each Company must have its’ own unique offerings to the customer to enable them to maintain customer loyalty.

For instance, in the car industry, the Ferrari brand evokes an image of luxury, quality and success. The association of prestige to the Ferrari brand, is one of its’ main competitive advantages which allows Ferrari to charge premium prices for it’s’ brand.

If a Company is not careful, it may find that its’ competitive advantage being eroded by its’ competitors. Once its’ competitive advantages are eroded, a Company may find its sales dropping, cash reserves dwindling and brand name diminishing. If it does not do something soon enough, these events will turn into a death spiral leading to the Company being bankrupt or being taken over. That is why you must always ask yourself, how is the Company going to sustain its’ competitive advantages in the future.

3. Corporate Social Responsibility (CSR)
Most companies only talk about CSR but rarely practice what they preach. For them, CSR is a good Public Relations (PR) exercise but nothing more. That is why you should be wary of this. By CSR, I mean does the Company have a holistic view about its’ raison d’être (its’ purpose in life).

If the Company’s purpose is purely about increasing profits for the shareholders at the expense of the stakeholders, I suggest you do not invest in such Companies. These companies will meet a sorry end, sooner or later. Prime examples of such companies include Enron and WorldCom.

When a Company (and its’ employees) truly believes in the benefits that their products bring to the consumers, then the Company will naturally flourish. By ensuring that they are fair to all stakeholders, be it customers, suppliers, the government and employees – it’s a WIN WIN situation for everybody. These are Companies that have the potential to grow and to be around for a very, very long time. Genuine companies that grow together with their stakeholders will remain in business for a very long time. These are companies that you should invest in.

We have talked about qualitative factors of the Companies that you should be looking at. Obviously, its’ easier said than done, since you may not have all the information available to assess these Companies qualitatively. I shall be doing my own personal research on suitable companies to invest in July 2008 and assess them qualitatively, to see whether they are good investments.

My next topic will be on assessing the Quantitative Factors of a Company, so stay tuned.


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