Qualitative Factors: Company Factors
Qualitative factors are often the largest force behind the difference between market value and actual value. Since they cannot be easily measured, investors will come up with vastly different estimates. However, investors often agree on which qualitative factors are more important. Company features such as a well-recognized brand name and high-quality managers are usually heavily weighted. Industry features such as competition and regulation are also considered important.
A. Company Factors
1. What does the company do?
How the company makes its money is just as important as how much money the company makes. For example, there is a clear difference in business strategy for two major microchip companies, Intel and ARM. Both companies design microchips, but only Intel actually manufactures their microchips. ARM makes most of their money by selling the rights to their chip designs. This is an important piece of qualitative information for a potential investment.
You can find this information by reading the first part of the company’s 10-K filing, which describes the company’s business model. You will want to invest in companies where the business model is easy to understand and easy to maintain. If you don’t understand how the company makes their money, then you will not be able to accurately see future growth prospects. If you are uncomfortable with the company’s source of profits, then you should not invest.
2. How does the company compete?
You can think of this question in the same way as asking yourself, “How does this company attract customers?” How the company chooses to compete is a broader description of how the company makes its money. There are five main categories that describe the way that a company competes: Service, Experience, Price, Convenience, and Authority. Which type of competition takes place is heavily dependent on the business sector, but most companies compete in more than one way.
Service: Service is a common method of competition in the service sector (obviously), but can take many different forms. For example, the service of a utility company can be measured by their ability to repair infrastructure on Christmas day.
Experience: Experience can also be thought of like quality, or how the product makes you feel. For example, Coke products and Apple products are famous for the experience that people get while using their products. Some large retailers such as Cabela’s are famous for the experience that shoppers have while inside the store.
Price: Price is probably the most well-known form of competition, and Wal-Mart is one of the most famous companies that engage in price competition. Price competition is common in manufacturing.
Convenience: Convenience is a very simple concept. It is all about how easily customers can do business with the company. Many companies use the internet to compete with convenience; for example, online banking, online brokerages, or online retailers.
Authority: The idea of competition by authority is simply that the business has a very large knowledge base about their products. When someone wants to know about the hottest trends, they will look to the “authority” in that industry. For example, GameStop is well-known as an authority on video games, and someone looking to find the best games will look there. Authority competition is also common for magazines and newspapers and in the fashion industry.
3. Does the company have a sustainable competitive advantage?
Many investors who focus on fundamental analysis consider a sustainable competitive advantage (coined a “Moat” by Warren Buffett) to be one of the most important factors to making a successful long term investment. A competitive advantage is different from the form of competition. A moat is not made from great products, large size, efficiency, or great management. It is a built-in structural advantage that comes from the economic characteristics of the business. It is based on how easily companies can keep their customers.
Companies without a competitive advantage can be successful investments, but companies with a moat are more likely to be successful over the long term. Sources of this structural advantage come from intangible assets, customer switching costs, the network effect, and cost advantages.
Intangible Assets encompass brand names, patents, and regulatory rules.
For a brand name to include a moat, it must have pricing power. Netflix is a well-known brand name, but it does not have pricing power because attempts to raise prices have led to customers canceling their subscriptions. Apple is a well-known brand name with pricing power because it can charge significantly more for the same hardware as other computer companies.
Patents are a form of legal monopoly protection, but they are not always reliable moats. The only time when patents can be considered a durable competitive advantage is when the company has a long track record of producing many patented products. If the company relies on only a few patents for its business, it is likely that those patents will be challenged or quickly become obsolete.
Regulatory rules can also be a form of legal monopoly or create large barriers to entry, but they are also not always reliable moats. The best regulatory barriers come when a company must have the approval to sell their product but are not required to charge a specific price. For example, utilities must have regulatory approval but their prices are also set by regulation, so their intangible assets do not have as much value. It is also better to have a large number of small regulations than it is to have one big regulatory rule because it is easier to remove one regulation than many.
2. Customer Switching Costs
A switching cost is what it costs the consumer to switch to a competitor’s product. Companies with high switching costs are unlikely to lose customers even if their products and services are low quality. This is because a customer has to figure out if the effort of switching companies is worth the better service they might get somewhere else.
Switching costs come in a few different forms: Integration with the customer’s business, money costs, and retraining. These are most common for companies that offer products to other businesses. For example, a company thinking about switching from PC to Mac would have to consider the costs of re-writing their procedures, buying the new hardware, and training their employees to use the new systems. Some businesses with high switching costs are banks, distributors, and healthcare device makers. Retailers do not have high switching costs because it is easy for customers to go to another store.
B. Network Effects
Network effects are a form of size advantage. Being a big company is not the advantage. The advantage comes when being big is combined with creating extra value for customers. A network effect happens when the value of the “network” increases as the number of users increases. For example, when someone joins Facebook, the value of that network goes up for everyone else who is already on Facebook. Or a credit card network, where the more merchants accept a credit card, the more valuable the network is for people using that card.
Network effects can also be content based. For example, the more videos are put on Youtube, the more valuable the Youtube network becomes for its users. A company that can take advantage of network effects has a very powerful competitive advantage.
C. Cost Advantages
Cost advantages are well-known and easily understood, but the sources of these advantages are sometimes overlooked. Distribution networks, economies of scale, and niche markets can all provide cost advantages.
Having a high percentage of fixed costs (expenses that are not tied to the number of sales), is what creates a competitive advantage for large distribution networks and economies of scale. For example, UPS, SYSCO, Fastenal, and Wal-Mart create cost advantages by having large distribution networks. Utilities and manufacturers often have economies of scale.
Cost advantages are not based on the size of the company. They are based on the size of the company relative to its industry. For example, if a company operates in a market that is too small for large corporations, it can come to dominate that niche market.
4. Is management competent and honest?
Good management is not as important for a company that has a structural competitive advantage, but it is still critical for any company’s success. Many of the failed investment banks were considered good examples of firms with a competitive advantage, but their ultimate failure came from poor management.
When you are doing the fundamental analysis you are looking at a stock as being the owner of a business, so when you evaluate management you will want to look for managers who act like owners and don’t just do what everyone else is doing. This can sometimes be difficult to gauge, but there are some clues provided in the company’s annual report: What the management says is their plan and how they measure their success, and how they will be paid for their performance.
i. What they say and do:
What a CEO writes in the annual shareholder’s letter is the easiest way to figure out if they know what they are doing and if they are being honest. The best CEOs will outline the plans and difficulties from the previous year, explain how those plans were executed, and provide a fair outlook for the next year’s progress (even if the future is not very bright).
If you read a series of these letters and notice that the CEO readily admits mistakes and reviews their predictions, then that is a very good sign. If the CEO claims success every single year (even the bad ones), and always takes credit for this success, then you may not want to invest in that company. More detailed information can also be found in the Management Discussion and Analysis section of the annual report.
ii. Compensation and ownership
How the management is paid and how much stock they own can make a huge difference in the way the business is managed. Managers are often compensated by stock options, but it is better to see them buying stock with their own money. For smaller companies, the management team should own at least 10% of the company’s stock. The best situation you can find is where the founder of the company is still in charge.