Once you have a good understanding of your financial goals and investing in general, you need to start considering how to find individual companies in which to invest. This article will be the first of many to discuss different ways of analyzing companies for stock investing.
While there are different ways to pick stocks; whether investing based on cheap values, fast growth or dividends the most basic theme remains that you are a partial owner in the company and its success. Due to this simple fact, the most enduring method of stock-picking is looking for companies with strong financial health in an industry with a good future forecast.
Best of Breed and a Rising Tide
The idea behind this two-prong approach is fairly intuitive. There are thousands of companies listed in the U.S. exchanges, but if you are going to take an ownership stake in one it might as well be one of the best in its line of business. In every industry there are a few companies that are special and stand out as, “best of the breed.” These companies have experienced management that is able to squeeze every penny of profit from ever higher sales.
Even the most profitable maker of horse carriages went out of business with the advent of the automobile. Not only do you need to pick stocks of solid companies but you also need to make sure the industry in which they operate has a strong outlook. Combine strong demand for the product with a management team that can deliver and you have the recipe for an excellent investment.
4 Places to Look for Company and Industry Success
A company’s operating margin is my favorite measure of fundamental strength. This is the percentage of sales left over after paying for materials and operational costs. It leaves out the effect of taxes and interest on a company’s performance. A well-run company can manage its cost structure and pass down more profits to its investors.
Costs are incredibly high in the auto industry and many companies have fallen on hard times over the last couple of decades. General Motors (GM) had an operating margin of just 1.8% as of the time of this writing while Ford Motor (F) sported 4.4% operating margin. The difference of 2.6% may not seem like much but that extra efficiency in operations helped Ford avoid taking a government bailout in 2009 and basically wiping out its investors.
Return on assets is another important measure of financial health. This is the amount of income a company is able to earn on its resources and ignores the amount of risk a company takes with debt. Management’s primary task is to earn profits for shareholders. Even a poorly-managed company can do this for a shorter-period by borrowing money and leveraging its assets but interest payments will eventually cause a bankruptcy. The best management can use their assets to produce profits with only a small portion of debt.
As with all measures, it is important to compare companies within the same industry. Some industries typically carry a greater amount of debt because sales are more stable.
Choosing industries with strong future growth is a little more difficult. Industry reports available through your online investment account or through brokers can help but really it comes down to looking at long-term trends like demographics and consumer preferences. Some industries and sectors, like technology, change more frequently while others, like consumer goods, are more consistent.
A SWOT analysis can be a useful tool for looking at the future growth prospects for either a company or an industry. SWOT stands for strengths, weaknesses, opportunities, and threats. The analysis of these factors is done relative to competitors and the general market.
- Strengths – What does the company do better than its competitors? These may be advantages like size, brand identity, supply chain advantages, or any other factor that is hard to overcome by competitors.
- Weaknesses – What does the company need to improve upon or de-emphasize? It may be tempting to use the same factor as a strength and a weakness, i.e. the company’s size allows it to borrow easily but makes it more difficult to manage. This should be avoided because it does not present a clear path for strategy.
- Opportunities – How can the company take advantage of the external environment to increase sales or income?
- Threats – Possible hurdles the company may have to overcome such as: regulatory, competitive, or consumer related.
SWOT analysis is often combined with analysis of Michael Porter’s Five Forces model, a framework for analyzing competitive forces for the company. A five forces analysis include:
- Threat of entrants – How easily can someone become a competitor? Factors that affect the ease of new competitors coming to market include: costs of startup, access to suppliers and customers, brand identity, and regulatory barriers.
- Threat of substitutes – How easily can customers switch to a different product that will satisfy needs? Factors that affect threat of substitutes include: relative prices of substitutes, product differentiation, and cost of changing products.
- Bargaining power of suppliers – How much negotiating power do the suppliers have? Factors affecting concessions given to suppliers include: number of available suppliers for the same part, differentiation in parts or services of suppliers, strength of distribution, and relative switching costs.
- Bargaining power of customers – How much negotiating power do the customers have? Factors that affect how much leeway the company will have to give in working with customers include: percentage of company sales to one or few customers, buyer information about the product or competitive products, availability of substitutes, and amount of fixed costs in the company.
- Intensity of competition – How competitive is the industry? This is extremely important as it determines profitability and factors effecting pricing. Factors include: rate of innovation in the industry’s products, level of advertising needed to sustain sales, relative percentage and importance of sales between traditional stores and internet websites.
Methods for picking good investments in companies and industries are about as numerous as political views. You own method may change over the years, especially as your financial needs change, but the basic strategy should remain intact. Choose companies that are well-managed in an industry with strong prospects for future growth.