Interpretation and Inference of Fundamentals
In the previous blog, we discussed what drives a successful business. We came up with various characteristics that drive a successful business and give it a long-lasting advantage over its peers. However, one of the problems that an investor generally encounters is that most characteristics are highly qualitative in interpretation. As such, the probability of correct interpretation reduces for the retail investor as he may be flooded with various opinions about a particular business. Therefore, it becomes important to have a solid framework backed with sufficient data to arrive at a meaningful and fruitful investment division. In this blog, we’ll be discussing a particular characteristic of a successful business that fits our above-mentioned criteria, and that has repeatedly proven to be a safe framework to follow during depressing and euphoric market cycles.
The fundamentals of a business include specific characteristics and criteria that are not fully qualitative and have a certain quantitative aspect. An investor uses the quantitative aspect of fundamentals to confirm the qualitative assumptions about the business. This helps an investor to evaluate his judgment about the investment repeatedly. Some people use fundamentals as a filtering criterion to narrow down a group of companies and then use qualitative analysis to select out of the group. Hence we have tried to develop a list of fundamentals that can be quantified and easily incorporated into your investing style to support and help you make correct investment decisions.
Capital structure – The capital structure of the company identifies the sources business is using in its capital. It seeks to identify whether the business requires external funding sources, i.e., debt, or the business can fund its own growth, i.e., equity. Normally businesses would use the optimum mixture of debt and equity to achieve a higher return for their shareholders. Usage of debt is good until the interest on debt starts exceeding the earnings potential of the company. As a thumb rule, we recommend to our investors that a company should have a debt of no more than 50% of the total equity invested. This ensures that the company has a healthy mix of equity and debt and can grow for a significant amount of time. A higher amount of equity in capital structure also indicates that a business can fund its own growth, thereby proving the efficacy of the business model.
Profitability and Growth – A business’s ability to profit from its business activities is the fundamental law for the enterprise’s long economic moat and durability. The profit-making potential of the enterprise makes the business an attractive investment avenue. If the company can grow its profits significantly during a full business cycle, it shows resilience, the presence of a strong consumer base, and a durable franchise. The company must deliver profits in a steady manner driven by growth in other factors such as revenue, cash flows, etc. However, we must point out that the business landscape for profitability has changed somewhat after 2010 and a start-up boom. As a result, we find increasing businesses with high growth in revenue and low profits and, in some cases widening losses. Adapting to this new investing style has been challenging for a lot of investors. To counter this, if an investor were to encounter such a business, it should focus on revenue growth and scalability of the product. If the investor believes that a long-term earning potential exists in a business, they can allocate a small part of his portfolio to the company with constant monitoring.
Capital Allocation – The company’s capital allocation policy is perhaps one of the most complex and most defining characteristics that define the long-term survivability of the business. Capital allocation refers to the company’s ability to re-invest its profits towards a meaningful purpose that drives growth and allows the company to have higher earning avenues. The capital allocation policy directly impacts returns for shareholders and the future value of the business. Data indicates that companies having ROCE’s more than 20% have delivered a higher return for shareholders and are more likely to become valuable in the future. A company’s capital allocation policy can be judged by return on equity, return on Capital Employed, and long-term earnings compounding rate. As a thumb rule, I believe that values above 15% for each of the 3 variables can be a solid indicator for future outperformance. On the contrary, poor capital allocation policies have seen disasters for shareholders and years of underperformance by the companies compared to broader market indices. A superior capital allocation policy can also be adjudged to good management, which in turn, again, is an excellent qualitative indicator for a long-term investment.
Overall, the fundamentals offer the investors a robust framework for filtering and narrowing down on companies or confirming their beliefs about businesses. Such a tool helps the investors develop a scientific methodology that removes emotional turbulence and helps them stay on course towards their investing goals. If an investor follows the methodology during every stage of the business cycle, one can avoid the pitfalls and stick to quality businesses and gain wealth over their investing career.
In the next blog, we will discuss how and where these fundamentals can be found and analyzed.
Until Next time!