The mistake a lot of investors make is not conducting their investment work on the right “level”of analysis. Focusing on the right level of analysis is important to properly frame the investment decision and help to determine what information is actually relevant.  Many investors either focus on things that are far too “big” or they misplace their attention on the incredibly “small.”

The primary unit of analysis should be the business with some additional analysis given to the industry in which it operates. By focusing on the business as the unit of analysis, investors help narrow their focus to a manageable set of information that is most closely linked to the long term success of the stocks they own.

 

Focus on the Business and the Structural Features of its Industry

 The Business

Ultimately over the medium to long term what will drive investment results is the cash earnings of the business. Given enough time,  investors in stocks will eventually get the results they deserve given the results of the underlying business.  Stocks that are undervalued given the cash their underlying businesses produce for their owners will rise, and stocks being driven by temporary fads or speculation will ultimately fall when it becomes apparent their underlying businesses do not produce the level of cash justifying the stock price.

Investors often fail to gather the relevant investment information about a business because they are distracted by levels of analysis that are either too broad or too narrow.  Because of this, investors fail to understand fundamental aspects of the investment they have just made.

When you buy a stock think of yourself as buying a piece of a business.  Because you are now an owner of a business, your investment results over time will be primary driven by the financial performance of that business.  So use the business as your primary unit of analysis.  Gather information about features of business in the most concrete terms possible with a focus on: the competitive position of the firm, the durability of the business over time,  the margins it is able to create, how much capital it takes to operate,  the business’s Return on Invested Capital, the business’s opportunity to reinvest for growth, etc.  These are the input factors that will determine the end of the day cash earnings of the business over time.

Since the value of a business results from the cash flows it produces for its owners over time, actually figure out how much cash earnings your potential investment is currently earning and how much it realistically will produce in the years ahead.  If you are looking at a potential stock investment and it currently has a market cap of $100m, figure out how much free cash flow the business is actually producing for that purchase price of $100m.  Does it earn $1M? 5M? 10M? 20M? Those are big differences.  But in any event, figure out how much money you are receiving in cash return for the market cap purchase price you are paying.

Many investors are market analysts, they make predictions about which way market prices are going.  But this is the wrong level of analysis. Become a business analyst. Use the business as the primary unit of analysis because when you buy a stock you have just bought an ownership interest in an actual business operation.  As a result, the wisdom of your investment will primarily be driven by the cash earnings the business is able to generate compared to how much you had to pay for the investment.

Industry Characteristics

While the business should be the primary unit of analysis, significant attention should also be given to the industry it operates in.  The industry can either enhance or detract from what ever firm specific competitive advantages the business you are analyzing might have. The key driver here is a focus on the structural relationship between the business in question and the larger operating environment of the industry.

The danger in analyzing the industry is that it is tempting to simply do a superficial assessment of the industry as to whether you happen to “like it” or not.  A lot of people want to make investments in certain industries because they are flashy, or they have a personal interest in that particular industry, or they have some general feeling that the particular industry has a bright future.  This is not sufficient analysis; we must dig in to the industry and determine what specific concrete factors make it likely that businesses in that industry will continue to earn economic profits even in the face of: existing competition in the industry, potential new competitors, customer bargaining power, supplier bargaining power, and potential outside substitutes.  These are called Porter’s Five Forces and they are useful in determining the structural attractiveness of an industry.

The key here is that we are not making unconstrained predictions or subjective personal assessments, we are focused analytically on structural features of the industry that:  create barriers to entry, limit current competition, create pricing power, create customer lock in, etc.  We want to invest in industries that are structurally attractive because it helps entrench the competitive position of our business, which can create sustainable above average returns on capital in our business, which leads to durable long term cash flows which are the ultimate source of value of a business.

McKinsey and Company found that when they tracked the economic profit of the world’s 2,393 largest companies over 10 years, they found that about 50% of a firm’s performance compared to the broader corporate universe is driven by the structural attractiveness of their industry.  In some instances the attractiveness is quite counter intuitive and you would miss them by doing a superficial analysis of whether you generally “like” the industry’s prospects or not.

Take tobacco as an example. On simple analysis you might think the tobacco industry would be quite unattractive–people don’t smoke as much anymore, smoking is bad, tobacco companies suffer from bad public relations, they have government regulation, etc. But as you dig into the structural relationships of the industry you find that the tobacco industry is actually one of the most attractive in the world. There were 12 tobacco companies in McKinsey’s research sample, and nine of those companies made it into the top 20% of all performers. The tobacco industry is so attractive because: 1) it is dominated by only a few huge companies who don’t undercut each other but rather carve out customers based on brands 2) Their large size allows them to exert leverage in sourcing tobacco from farming operations that are much smaller 3) There is little threat of new competition because government regulation and public perception makes it unattractive to start a new tobacco company 4) There is huge customer loyalty which allows the companies to consistently raise their prices over time.

On the other end of the spectrum you might think on first pass that something like construction materials would be a great industry. Think about how much stuff has to get built and construction materials are in everything we see.  It has to be a good industry, right?  But you have to dig in to the structural characteristics of the industry.  Construction materials are essentially a commodity which gives customers, not the companies, the advantage.  Customers can simply go to a competitor for a better price, and they will because there is very little brand loyalty.  Unlike the tobacco industry, the construction materials industry is fragmented and more companies are able to enter the market all the time. Because of the large number of players, competition is intense and companies are undercutting each other on price all the time. These factors make construction materials structurally unattractive.

McKinsey concluded that the the role of industry in a company’s position is so substantial that you’d rather be an average company in a great industry than a great company in an average industry. The median pharmaceutical company (India-based Sun Pharmaceuticals), the median software company (Adobe Systems), and the median semiconductor company (Marvell Technology Group) all would be in the top 20% of chemicals companies and the top 10% of food products companies.

The Problems With Other Levels of Analysis 

 

The Problem with the Really Big Picture

Let’s start at the top two levels of the diagram above. One of the downsides to making your investment decisions based on the large scale levels of analysis is that investors risk being swamped in the complexity and sheer amount of information available. Trying to understand the complete workings of the global or even a national economy would be nearly impossible. There are so many moving parts and so many opinions about each particular piece of information that investors suffer from information paralysis.

In addition, given the number of interactions in a complex modern economy there are a large number of unknown intervening factors that could produce results not easily predicted.  For example, let’s say you correctly predict that the GDP for a given country will be less than others expect. You would likely assume that weak GDP would cause stocks to fall so you might short them.  But what if the weak GDP report causes the central bank to lower interest rates or Congress unexpectedly passes a spending bill to help stimulate the economy.  In both those cases stocks could actually rise even though you had correctly predicted weak GDP.  The large number of unknown variables makes the accurate prediction of stock prices from economic forecasts quite difficult.

Furthermore, in forming opinions based on large scale economic factors there likely has to be some attempt to simplify the information. However, in an attempt to simplify all of the moving parts, investors risk the temptation to start cherry picking information that fits a particular story about the economy.  Given the sheer amount of competing information you can find facts to support almost any theory you want.  In this way operating at these large scale levels of analysis is analogous to a blank canvas that allows the investor to project whatever preexisting inclinations they might have.

The Problem with Political and Financial Headlines

Moving to the third level down in the above diagram, rather than invest on the basis of economic forecasts, some investors make investment decisions on the basis of current political or financial news flow. The problem with this is that current events are just that: they are only current.  The information immediately becomes stale when the media focus shifts to the next supposedly big thing.  By investing in this manner, it can become difficult to have a consistent approach as the news oscillates between positive and negative.  Investors have a tendency to get whipsawed back and forth as the news flow changes with the day.

There is also the problem that reacting to news flow tends to be a poor proxy for investment analysis.  Investors tend to react in fairly simplistic way: if they assess the current news as “good/positive” they use this as a reason to buy and if the news is “bad/negative” they quickly want to sell.  The problem is the mechanism for determining good news from bad news is never analyzed or developed.  The goodness or badness of a piece of news information is either determined by 1) preexisting personal biases or more likely 2) the general reaction of other people.  If the news and other people make a big fuss about a current event either good or bad, most people will simply mirror the general tone of the crowd. But by reacting in the same manner to the same pieces of information as every other investor, you almost guarantee yourself results that will be at best average.

In fact, when other investors are selling because of negative news this can be an opportunity to buy.  And as other investors become wildly optimistic because of positive news this can be the opportunity to sell stocks as they become overpriced.  However, most investors spend too much of their “reacting” to news rather than engaging in objective independent analysis that reveals opportunity by acting differently than current market sentiment.

The Stock Market Game

One thing that will never go away is investors’ desire to talk about “the market.”  For as long as there have been capital markets, people have had opinions about what is going to happen next with stock prices.

Most people allow market price fluctuations to dictate their investment decision making.  Their view on which way they think the market is going dictates their investment decisions.  There are a few major problems with this.  The first is that in the short term price fluctuations are dominated simply by the supply and demand for shares among investors.  Price swings based on how in demand the shares currently are does not address the question of what the shares are actually worth.  All current price action tells you is what is popular and what is not; it does not tell you what is likely to be the best returning investment over time.

Another common problem with making decisions based on a directional view of the market is that it assumes all stocks are just one thing. This mode of thinking lumps all stocks together and ignores the major differences between potential investments.  Different industries and businesses have varying degrees of structural attractiveness and at any point in time businesses sell at differing valuations that provide better or worse return opportunities. So in making broad declarations about “the market” there is a tendency to throw the baby out with the bath water.  In short, allowing your views about what the Dow Jones Industrial Average to overwhelm a more nuanced analysis causes one to miss the opportunity associated with evaluating opportunities on their own merit.

The Problem With Analyzing At Levels Smaller Than the Business 

The last three levels of analysis were all larger than the business and its industry, but there are also drawbacks to conducting your analysis at levels smaller than the business.  I would say generally the problem with these very micro approaches is that it leads to false precision, it can be too short term oriented, and it can fail to properly incorporate important features of the business.

Looking at the earlier diagram, one level down from business analysis is forecasting company specific events or major company “drivers.” The one that most easily comes to mind is making investment decisions based upon some viewpoint on the company’s product cycle.  For example, almost every quarter many analysts try to forecast the number of iPhones that Apple will sell.  They try to determine down to a fairly precise number how many will be sold and then based on this info whether investors should buy or sell. Along with this forecast is some additional commentary on whether the next iPhone edition will be good or not, whether investors should maybe wait a quarter or two and try to catch the next product launch, etc.

Of course as an Apple investor you would want the company to sell more iPhones than less; its not that the number of units sold is completely unimportant, its just that the problem with focusing on any one driver of company performance, like iPhone’s sold in a quarter, is that instead of making your investing success based on the long term cash flows of the business, you are making your success dependent on your ability to predict the future in regard to precise product sales.  If you trust your crystal ball this might be a good strategy, but for the rest of us we would probably do better avoiding making our success contingent on specific company events coming to pass. Remember what matters most to long term stock performance is the business’s ability to generate cash flow for its owners over many years.  Trying to predict one component of the business can detract from an objective long term assessment of the company’s earnings power.

On the most micro level are investors who engage in extensive financial modeling down to the point where they are forecasting every individual line of the balance sheet and income statement. The problem here is you can fall victim to false precision. Its easy to think that because you are using numbers and being precise that you are acting with scientific accuracy.  You can get lulled into a false sense of security, but in fact many small errors in assumptions add together to where you end up with results very far detached from reality.  For these types of investors they should probably engage in more thinking and less calculating.  Instead of trying to calculate down to the micro level, investors should restrict their financial assessments to the overall business.  Use all your mental energy to figure out cash flows at the business level, and support this with an objective analysis of the business’s competitive position, as well as the structural attractiveness of the industry it operates in.

Takeaways

• The primary unit of investment analysis should be the business
• The cash earnings in each year into future is what creates the value of a business
• The structural attractiveness of the industry should be integrated into an assessment of the durability of the business’s long term cash flows
• Industry analysis should focus on the structural relationships of the industry and the effects on existing competition, barriers to entry, supplier power, customer power, and potential substitutes
• Making investment decisions based on too broad or too narrow levels of analysis creates distractions by causing the investor to focus on information not directly tied to the long term performance of a stock investment