Company analysis: business and governance

Why study the company?

A company is a small unit in its industry and its economy, so outside forces shape its fortunes (Chapters 5 and 6). But how well each company does also depends on company-specific factors. Once the economy and industry are understood, the analyst asks:

1. What is the company's business? (This decides the industry, as in 6.2.)
2. What is its business model?
3. Does it have a competitive advantage over rivals?
4. Can it exploit opportunities and withstand threats?
5. Is management competent to pick and execute the right strategy?
6. Does management have a vision, and does it give visibility on short-term performance and long-term goals?
7. Is there a governance structure so that the board and management act for the company and its shareholders?
8. Is that structure actually implemented?

The business and its model

Buying a share means owning part of a business, so first understand the business. Start with three questions:

The most prominent question on a research checklist: "Do I understand the business?" If you cannot say what a company does in one clear line, do not move to the next question.

India has over 4,000 listed, active companies. No one can track them all. It is better to own a few companies you understand than many you do not. Warren Buffett, quoted in the book: "Wide diversification is only required when investors do not understand what they are doing."

Each sector has its own yardsticks. The book's examples:

Each company also has its own way of doing business, and how efficiently it makes and delivers its products drives its earnings. Management thinker Gary Hamel, quoted in the book: "Competition in the marketplace is not between products and services but between the Business Models of the competing companies."

Pricing power

Pricing power is a company's ability to set and charge its own price. With it, a company can pass on rising input costs to customers, and raise prices when demand is strong, so margins hold and grow.

SWOT analysis

Outside conditions keep changing. Each change opens opportunities for well-placed companies and creates threats for weak ones. The book's example: during Covid-19 lockdowns, companies with weak finances were extremely vulnerable, while financially strong ones survived.

SWOT = Strengths, Weaknesses, Opportunities, Threats. It helps judge both growth potential and risk tolerance.

Management and governance

Shareholders own the company; a separate team (CEO or MD and those below) runs it day to day and reports to a board appointed by shareholders. This separation creates agency risk: managers may serve themselves, or may not be capable.

7.6.1 Ten questions on management competency

1. Education in the relevant field? Often checked, but not conclusive.
2. Years of experience? More experience means more past challenges handled.
3. Track record in senior roles elsewhere? Useful, though results depend on other factors too.
4. Tenure here, and how the company did under them? Long, successful tenure makes repeat performance more likely.
5. Vision on long-term goals and strategic direction? They need not reveal every strategy to rivals.
6. Experience in executing the current strategy? An innovation strategy needs someone who has led research.
7. Do they give guidance, and meet it? Consistently meeting guidance shows control of the business.
8. Timely regulatory compliance? Failure suggests loss of control, and is a red flag on integrity.
9. Enough delegation? Concentrated decisions create key-man risk.
10. A succession plan? Ensures continuity if top managers leave.

7.6.2 Corporate governance

Corporate governance is the rules, processes and procedures for managing and running a firm, so that it takes care of all stakeholders: shareholders, lenders, employees, suppliers and customers. Regulation focuses on protecting investors, especially minority (non-promoter) shareholders. As per the book, SEBI's Clause 49 of the listing agreement sets the standards in India.

Regulatory standards are the minimum. Strong governance prevents agency risk, or at least catches and fixes it in time.

Risks in the business

Promoters love to talk about the grand future, rarely about the risks. Cheap foreign borrowing looks attractive until you add currency risk. Entrepreneurs can absorb shocks (the book mentions Rupert Murdoch failing three times before building the Star empire, and Steve Jobs being thrown out of Apple and later called back), but not all investors can.

Keep asking "What could go wrong in the business?" Promoters who say nothing can go wrong are "people who don't know that they don't know". Avoid them. A good businessperson knows the risks and how to guard against them.

7.8 Credit rating history

A credit rating rates a borrower's ability to service its debt. Rating agencies rate both the issuer and individual debt instruments, with separate ratings for short term and long term.

• Why equity investors care: shareholders get returns only after lenders are paid. So the rating shows the financial risk and shapes the return investors should expect.
• Why history matters: rating reports list the agency's key concerns. If later reports show the company fixed them, management responds well to outside feedback.

7.9 ESG

ESG = Environment, Social and (corporate) Governance. First used by a few "impact" investors, it has spread because it also has commercial value. Investors ask:

The ESG filter only shortlists. A shortlisted stock is not an automatic buy; all the usual analysis still follows.

Financial advantages claimed for ESG companies:

1. Environment focus: least disruption from regulation or environmental activism.
2. Social causes: positive recall, easier hiring and customer attraction.
3. Strong governance: lower risk perception, so lower cost of capital.

SEBI named the top 1,000 listed companies to make ESG disclosures in the Business Responsibility and Sustainability Report (BRSR) format from FY2023. In FY22, more than 175 companies reported on BRSR voluntarily.

7.10 Sources of information

Annual and quarterly reports are the most easily available, reliable and consistent source. Others:

All exam traps in this chapter

1. First question on the checklist: "Do I understand the business?"
2. Buffett: wide diversification is needed only when investors do not understand what they are doing.
3. Pricing power is driven mostly by industry factors; natural leadership, brand and low cost base set a company apart.
4. Three edges: product differentiation, competitive pricing (needs low cost), execution.
5. Strengths and weaknesses are internal; opportunities and threats are external.
6. High customer concentration is a weakness, not a threat.
7. SWOT approach 1 (S and W first) suits companies setting strategy; approach 2 (O and T first) suits outside analysts and the E-I-C order.
8. Agency risk comes from separating ownership and management.
9. Integrity is almost impossible to judge, so analysts study governance structure.
10. Concentrated decisions create key-man risk; succession plans ensure continuity.
11. Board: 50% independent with an executive chairman, else one third. Audit committee: two thirds independent.
12. Auditor: fees below 10% of income; rotation once in five years.
13. Remuneration committee: all non-executive, independent chairman.
14. Related party transactions: placed before the audit committee; pre-approval not mandated.
15. Pledging is not a red flag by itself; a high pledge adds market risk.
16. Credit ratings: issuer and instrument level, short and long term. Matter to equity investors because lenders are paid first.
17. ESG is a shortlist filter, not an automatic buy. Good governance lowers cost of capital.
18. BRSR: top 1,000 listed companies from FY2023; 175+ reported voluntarily in FY22.
19. Annual and quarterly reports: most easily available, reliable and consistent source.

For the group discussion

1. Describe a company you know in one clear line. Could everyone in the group do it?
2. Which Indian brand do you think has real pricing power? What evidence would prove it?
3. Do a quick SWOT for an Indian airline, starting with opportunities and threats.
4. A promoter has pledged 60% of their shares. What would you check next?
5. Would you buy a stock with a poor ESG score if everything else looked good? Why or why not?