Company Analysis — Business and Governance

Where this chapter sits

Chapters 5 and 6 looked outward — the economy, then the industry. Chapter 7 finally looks at the company itself.

The workbook is careful about the sequence. A company is only a micro unit in its industry, and in turn in the economy. Its fortunes are driven by external conditions — macro-economic factors and industry-specific factors. But those external factors hit every company in the industry. How one particular company performs also depends a lot on company-specific factors.

So once you know how the economy is doing and how the industry is likely to prosper, you still have to answer eight company-specific questions. Learn this list — it is the skeleton of the whole chapter:

1. What is the company's business? (This drives your definition of the industry, from section 6.2 — so answer it first.)
2. What is the company's business model?
3. Does it enjoy any competitive advantage over competitors?
4. Does it have the capability to exploit opportunities and withstand threats?
5. Is the management competent enough to identify and execute the right strategy?
6. Does management have a vision, and can it give visibility into short-term performance and long-term goals?
7. Does the company have the governance structure so that the board and management act in the best interest of the company and its shareholders?
8. Are those governance structures properly implemented and executed?

Two warnings the workbook adds. Follow-up questions will arise, and analysts must go to the depth to find real answers rather than accept superficial ones. And although most of these questions are qualitative, analysts should still obtain data that substantiates their findings. Qualitative does not mean vague.

Understanding the business and the business model

Equity investing is part ownership in a business. So the starting point of qualitative research is three plain questions:

• What does the company do, and how does it do it?
• Who are the customers, and why do they buy those products and services?
• How does the company serve those customers?

The workbook sets a hard rule here. In a research checklist, the most prominent question is simply "Do I understand the business?" — and no analyst should move to the next question if they cannot describe what the company does in one line with precision and clarity.

There are over 4,000 companies listed and active on Indian exchanges. Nobody can track them all. The workbook's advice is to buy a few you understand rather than many you do not, and it quotes Warren Buffett: "Wide diversification is only required when investors do not understand what they are doing." Note how that cuts against the usual advice — here, diversification is described as a substitute for understanding, not a virtue in itself.

Each sector also has its own evaluation parameters, and an analyst is expected to know them:

Finally, each company has its own way of doing business. The efficiency with which products and services are produced and delivered varies from business to business, and that significantly impacts earnings. Hence the quote from management guru Dr. Garry Hamel: "Competition in the marketplace is not between products and services but between the Business Models of the competing companies."

Pricing power

Pricing power refers to a company's ability to independently determine and charge the price of its products. It matters because it protects and grows the profit margin.

A company with strong pricing power can do two things:

• Pass on any escalation in input cost to customers.
• Raise prices when demand is strong, and grow margins that way.

Now the distinction the exam loves. Pricing power comes from two different places.

Industry factors — these affect all companies in the industry:

• Competition intensity in the industry
• Price elasticity of the product
• Level of commoditisation of the product

Company-specific factors — these position one company differently from its peers:

• Natural leadership position in the industry
• Brand affinity among customers
• Its cost base

The workbook's own examples: for several petrochemical products, smaller players price off the prices set by Reliance Industries Limited, because RIL is seen as the natural industry leader — which gives RIL the ability to price independently. A company with strong brand perception or brand loyalty can also price independently. And a low cost base lets a company keep pricing low without fear of rivals matching it, because matching that price may not be financially viable for a competitor with a higher cost base.

Studying pricing power is how you work out which industries will do well and which player within an industry will outperform its peers.

Competitive advantage — three areas, not one

The differentiating factors for a company versus its competitors fall into exactly three categories:

(i) Product differentiation. Better features that appeal to the target customer group — in quality or functionality. To execute it, a company needs a strong R&D team and a culture of innovation. In highly competitive industries where many players keep launching new products, leadership may keep shifting from one player to another — but those with strong innovation outperform those that lag. The analyst's job is to compare products against competitors on data, and not get carried away by superficial marketing claims.

(ii) Competitive pricing driven by operational efficiency. If customers see products as similar, they prefer the cheaper one. But — and this is the important half — competing on low price is sustainable only if the company has a low-cost advantage. Otherwise rivals simply copy the price cut. If your cost is genuinely lower, rivals cannot sustain a price below their own cost, so your advantage holds.

Price differentiation is easy to spot in commoditised industries and hard elsewhere. The workbook's example: comparing a Toyota Camry with a Honda Civic — the Civic may be less expensive but the Camry likely has more features, so it is not a like-for-like comparison. In such cases analysts should ask which product offers better value for money, using primary research or the past performance of similar models.

(iii) Better execution. Companies that communicate better with customers, or run a better sales strategy through a focused approach, beat rivals. Execution is judged from the past track record of the company and of its management. The workbook names Flipkart, Airtel, Haldiram and Hero MotoCorp as good examples of competing through branding, advertising, strategic alliances and positioning across India.

SWOT analysis — and the one rule that decides most questions

Change creates opportunities and challenges together. Well-positioned companies exploit the opportunities; vulnerable ones perish in the face of the challenges. The Covid-19 pandemic is the workbook's example — a major threat, survived by companies with a strong financial position and devastating for those with a weak one.

SWOT stands for Strengths, Weaknesses, Opportunities and Threats. And here is the rule that decides more exam marks than anything else in this chapter:

Strengths and weaknesses are INTERNAL to the company. Opportunities and threats come from EXTERNAL conditions.

There are two approaches to running a SWOT:

• Approach 1: identify strengths and weaknesses first, then work out which opportunities they let you exploit and which threats you are vulnerable to.
• Approach 2: identify opportunities and threats first, then work out which strengths help you exploit the opportunities and which weaknesses leave you exposed.

Which one to use depends on who you are. The first suits a company deciding its own strategy. For an external observer such as an equity analyst, the second is more suitable — and in the E-I-C framework, where you study external conditions before the company, the second approach also falls in the logical order of things.

Strengths — internal capabilities that let a company exploit opportunities and withstand threats:

• Strong financial position
• Highly valuable intellectual properties
• Low customer concentration
• Low cost or high margins
• Support from parent company or government
• Strong execution capability and track record

Weaknesses — internal issues that make a company vulnerable, or stop it exploiting an opportunity:

• Weak financial position
• High fixed cost
• Low margins that can easily turn negative in a slowdown
• Higher customer concentration
• Significant legal cases that distract the company or can cause losses
• Lack of experience in executing a particular strategy or operating in a particular environment

Two refinements matter. First, relevance: focus on strengths and weaknesses related to the opportunities and threats identified. Lack of experience in self-driving cars is a weakness for an Indian auto company only if industry catalysts are likely to fuel that segment; otherwise it is still a weakness but not of immediate relevance. Likewise, a sequential decline in revenue or profit is not a weakness unless it makes the company lose a new business opportunity, makes it ineligible for a loan, or creates some other vulnerability.

Second, limits: an outsider cannot identify all strengths and weaknesses. No company will publicly disclose the clout it has in government or the strength of its lobby. And if a company has been hiding financial woes through creative accounting, an outsider will not find the fraud easily.

Opportunities are created by the external environment, and cannot all be listed. The workbook's indicative list:

• Events that create an inflection point in a growth curve — a new battery technology accelerating electric vehicles; or, post Covid-19, global companies wanting to move production and procurement outside China, which helps manufacturers elsewhere.
• New business from technological advancement or regulatory change — when the Companies Act 2013 was implemented, consulting firms got work implementing it; the Y2K problem created work for Indian IT service providers; ESG compliance is another case in point.
• Geographical expansion when capital controls or poor market conditions that once blocked a territory change.
• Consolidation from adverse market conditions — when Jet Airways suspended operations in April 2019, other airlines got the chance to increase market share. In recessions, low share prices and low interest rates let stronger players acquire weaker ones.

Threats are risks from the external environment. The workbook is explicit: while assessing a threat it is very important to distinguish threats from the external environment from risks arising from an internal situation. Its own example — high customer concentration is a risk, but because it is internal it is a weakness and not a threat. Sources of threat include:

• Economic recession
• Regulatory headwinds — e.g. a possible ban on single-use plastics threatens their manufacturers
• Technological disruption — artificial intelligence creates opportunity but is a threat to the BPO industry doing repetitive tasks
• Deregulation removing entry barriers — when the RBI decided to offer on-tap licences to new banks, existing banks faced the risk of increased competition

And a filter: focus on opportunities and threats with a reasonable probability of occurring. There is always the risk of a Black Swan event like Covid-19, but listing every possible threat makes the list too long to be useful.

Management quality and governance — the agency problem

In a company, ownership is separated from management. Shareholders own it; a management team of the CEO / Managing Director and others below them runs it day to day; that team reports to a Board of Directors appointed by the shareholders.

That separation creates agency risk: management may pursue personal interests at the cost of shareholders, or may simply not be capable enough to run the organisation.

So an analyst must evaluate the competency and integrity of management and the board. But the workbook is unusually frank about how hard this is: analysing competency is challenging; analysing integrity is almost impossible. Unless there is reasonable evidence it is inappropriate to cast aspersions on anyone's integrity. The practical response is to focus instead on the corporate governance structure, and check whether it has the controls needed to prevent inappropriate governance actions. You cannot see inside a promoter's conscience. You can read the board composition.

Judging competency — ten questions

The top management typically includes the CEO, CFO, COO and other C-level officers. An analyst is unlikely to have the skills to assess all of them. So the workbook gives ten questions instead:

(a) Do they have the educational qualifications in the relevant discipline? (Often looked at, but not definitive.) (b) How many years of experience? More experience means more past challenges faced. (c) If they held senior roles elsewhere, how did those companies perform then? Useful, but not definitive — performance depends on external conditions and other managers too. (d) How long have they been with this company, and how has it performed during their tenure? Success in one company does not guarantee success in another; a long, successful tenure here is more predictive. (e) Does management have a vision for long-term goals and strategic direction? Note the caveat — this does not mean disclosing every strategy, since competitors would learn the details. (f) Do they have experience executing the current strategy specifically? If the strategy is innovation, you want someone who has led successful research projects. (g) Does the company give guidance on near-term performance, and does it typically achieve that guidance? Consistently meeting guidance suggests better control of the business. (h) Has management ensured timely regulatory compliance? Failure suggests they are not in control — and is also a red flag on integrity. (i) Is there sufficient delegation in decision-making? Broad-based delegation gives continuity through churn; highly concentrated decision-making creates keyman risk. (j) Is there a succession plan for top management?

Judging corporate governance — nine checkpoints

Corporate governance refers to rules, processes and procedures followed in the management and operations of a firm. The objective is to ensure the company is run to take care of all stakeholders — shareholders, lenders, employees, suppliers and customers.

Regulatory standards focus on protection of investors, with additional focus on minority or non-promoter shareholders. In India, SEBI's Clause 49 of the listing agreement sets the corporate governance standards.

Then the sentence that generates the hardest questions in this chapter: regulatory standards are the MINIMUM a company must follow. Some companies set higher standards for themselves. Strong governance either prevents agency risk, or at the very least detects and rectifies it in time. So for several of the nine checkpoints below, two different standards exist: what is ideal, and what SEBI requires. Keep them apart.

The board may include independent directors, non-executive directors (not part of management, but not independent either) and executive directors. That three-way split is worth memorising — non-executive is not the same as independent.

Two more points. The audit committee is responsible for reviewing the financial statements and for nominating the auditors. The remuneration committee decides the remuneration of directors and senior management. SEBI has several other provisions on directors' meetings and committees; good governance should encompass all of the above, but it would be preferable if companies follow even stronger practices than the regulator mandates.

Promoter holdings and pledging

The concept of promoter is somewhat unique to India. The legal definition does not really define their role — the law simply states that a promoter is an investor who has been named or is identified as a promoter. In practice, the promoter group comprises the founders or the controlling group of shareholders.

For other investors, a strong promoter shareholder cuts both ways:

• Positive: the promoter group has a higher level of control on management, which raises the likelihood that management acts in the best interest of shareholders.
• Negative: that same influence creates risk for minority shareholders, because the promoter group may push management into actions — such as related party transactions — that benefit the promoter group at the cost of minority shareholders.

So analysts should watch the promoters' shareholding and the changes in it.

When promoters need funds they often pledge their shares rather than sell them. The lender applies a haircut on the market price towards margin and lends against the balance. The haircut protects the lender if the asset price falls.

Read the workbook's judgement here carefully, because it is more balanced than most candidates expect: pledging may be done in the normal course of raising funds and does not necessarily signal any concern about corporate governance or business fundamentals. What matters is whether the amount pledged is high or low.

A high amount of pledged shares aggravates market risk if the price falls. The mechanism is a loop:

1. Share price falls.
2. The lender's margin is reduced or eliminated.
3. The lender may be forced to liquidate the shares.
4. Sudden liquidation of a sizeable number of shares creates further downward pressure on the same share price.

Risks in the business

Promoters love talking about the grand future they dream of. They rarely talk about the risks on the way. The workbook's example: borrowing in the international market at low rates looks attractive — add currency risk to the discussion and the whole thing turns on its head.

Entrepreneurs are risk takers by nature with the psychological ability to bear shocks. Rupert Murdoch failed thrice before creating the Star empire. Steve Jobs was thrown out of Apple, his own company, started another successful venture in the meantime, and was later called back. Businessmen can bear these shocks. Not all investors can.

Every business has risks — business, operational, execution and others — and they may be known or unknown. Analysts should focus heavily on risk in various dimensions and continuously ask: "What could go wrong in the business?"

And then the sharpest line in the chapter: if promoters state that nothing could go wrong in the business, they clearly fall into the category of "people who don't know that they don't know". These types of promoters need to be avoided. A good businessman always takes cognizance of the risks and the steps needed to protect the business from their effects.

Credit rating of the company

Credit rating refers to the rating of the ability of a borrower to service its debt-related obligations. Ratings come from a credit rating agency and are issued at the issuer level as well as at individual debt levels, and separately for short term and for long term.

Credit rating is about debt — so why does an equity analyst care? Because a company can provide returns to equity investors only if the lenders are serviced first. The rating therefore tells an investor the level of financial risk involved, and that drives return expectations.

The second use is subtler and is what the exam tests. Going through the historical evolution of a company's credit rating shows how management reacts to external feedback. A rating report states the factors behind the rating and what the agency treats as key concerns. If the company has since worked on those concern areas, that indicates management is very responsive to external feedback.

(For completeness, the rating symbols themselves are defined later in this same workbook, in the risk chapter: SEBI has standardised the symbols used by rating agencies; AAA and A1 indicate the highest degree of creditworthiness while D represents default status; and moving AAA → AA → BBB → B → D represents progressively higher credit risk. A rating is not static — it changes whenever the company's fundamentals change.)

The ESG framework

Most investors focus on the profit-generating ability of a business. Over recent years, societal discussion has also turned to sustainable development and corporate social responsibility. That gave traction to an investment theme focused on Environment, Social and Corporate Governance (ESG). It began with a handful of "impact" investors and gradually gained traction because the framework also provides commercial value.

The three criteria:

1. Environment — how do the company's activities affect the environment? Companies with low carbon emission and that are low contributors to pollution rank better.
2. Social — what does the company do for social development? This includes human rights, gender equality and similar factors. Companies contributing more rank better.
3. Governance — the corporate governance standard followed by the company.

Now the mechanical point candidates get wrong: ESG investors use the ESG filter to SHORT-LIST potential investments. Once short-listed, a stock does not become an automatic investment — investors still perform all the other regular analysis to identify a suitable investment. ESG is a screen, not a buy signal.

Although ESG looks more ethical than financial, its proponents cite three financial advantages:

• Companies focused on environment face minimum disruption from regulatory intervention or environmental activism.
• Companies working towards social causes generate positive recall value in society, which makes it easier to recruit employees and attract customers.
• Strong corporate governance reduces risk perception and in turn reduces the cost of capital.

Equity analysts can include ESG discussion in reports so that investors who care about ESG factors are guided.

On regulation: SEBI has proposed strengthening ESG disclosure regulations for listed entities to enhance credibility, and has named the top 1,000 listed companies to make ESG disclosures as per Business Responsibility and Sustainability Report (BRSR) parameters from FY2023. In FY22, more than 175 companies voluntarily reported on the BRSR framework.

Sources of information

There are many sources, plus various paid and free databases. The workbook's list, in its own order:

• Annual / Quarterly reports — described as the most easily available, reliable and consistent source of information
• Conference call transcripts
• Investor Relation (or Company) Presentations
• Management interviews on the internet
• Company website
• Ministry of Corporate Affairs website
• Research reports from credit rating companies
• Research reports from various other sources — media reports
• Parent company's annual report and website
• Competitors' websites, including international competitors
• Print media reports on companies
• Discussion with suppliers, vendors, consumers and competitors
• BRSR report for ESG disclosures

Note which one carries the superlative. If a question asks for the most reliable and consistent source, it is the annual and quarterly reports — not the management interview, not the media report.