Great Companies
Let's delve into the detailed analysis of the essential elements to discern between a quality company and an underperforming one. There is no doubt that evaluating a company is not a simple task; thorough consideration of a multitude of factors is required. However, the purpose of this exercise is to simplify this process, thus facilitating the understanding and analysis of companies. Identifying outstanding companies involves both a qualitative and quantitative approach. To do this, I have prepared a list with 7 points that cover various dimensions, from financial strength to organizational culture. These points will serve as a practical guide, allowing us to deepen our understanding of what makes a company truly excellent.
By considering this list, we can dive into a full assessment of each company, exploring everything from its business strategy to its financial performance to its commitment to corporate responsibility. This comprehensive approach allows us to not only understand a company's current position, but also glimpse its future potential.
Therefore, to fully enter this journey of business discovery, we arm ourselves with a set of valuable tools that allow us to unravel the mysteries of the business world. By better understanding what makes a company successful, we can make better decisions and cultivate relationships with companies that excel in all aspects.
Let's go action!
"Exploring the Keys to Identify Outstanding Companies"
Check list 7 points
1. Growth
First and foremost, the company should grow. A company should have a high growth or in line with the sector. A growth in sales higher than that of its competitors is a good sign. Growth is measured annually (CAGR, compound annual growth rate) and there are companies that, depending on their own characteristics, grow faster than others, depending on the sector in which they operate. In the technology sector, large companies tend to grow at rates of 15%~20%, industrial companies at 3%~5%, IT service companies between 6%~10%, to give some examples. These figures can be compared to the historical average GDP of 3%~4% and logically, we will look for companies that grow at a higher rate. Sales growth can be seen easily on any finance website (links in the description)
2. High ROIC
If I had to choose one metric, of all the existing ones when analyzing a company, I would probably choose the ROIC (Return on invested capital) or return on invested capital, it is the best reference for the profitability of a business. It measures how good a company is at taking money from investors and generating a return on capital. In other words, how efficient is a company in using all its assets (factories, personnel, investments, etc.) to generate money for its shareholders. It can be seen in the same way that a fund manager is able to generate a return on the investor's investment. The higher the ROIC, the better chance you have of finding a good company. (> 15% can be considered an optimal ROIC, of course it will depend on the sector)
3. High margins
Margins is another key indicator to know if a company is doing well or poorly. A high EBIT margin indicates that a company is efficient in terms of its operational processes. The EBIT or operating profit is the result before interest or taxes, in which operating expenses (labor, electricity, water, etc.) are discounted. In companies with stable consumption it is usually 14% or higher, in IT service companies it is usually 10%~12%, and in the technology sector where companies often reach margins between 30%~40% in many cases, to give a few examples. A margin expansion gives us a clear signal that the company is doing well year on year. On the contrary, a compression of margins over time indicates a loss of competitive advantage of the company.
4. Repurchase of shares
A company buying back its own shares is another clear sign that something is right with the company. In this way, the company withdraws shares in circulation, making the part corresponding to each investor greater. If management decides to buy back shares, it is because they know the real value of their shares at the correct purchase point and believe that this option is better than spending the money in another way (dividends, investments or acquisitions). The reverse process is the capital increase, (it is a kind of financial engineering), when companies issue new shares, diluting the shareholder. It's like having a cake with four pieces, and suddenly we cut it into eight, the cake is still the same, but now each piece is smaller. This is what many poorly run companies do or when their core business ceases to be the engine of the business and they issue shares to finance their needs, diluting the shareholder, and making it smaller and smaller. (A capital increase is not always a bad sign, especially in the initial stage, it may be necessary)
5. Understand the business
It is something that seems logical, but few investors consider this point when investing. Questions like What products or services does the company sell? What lines of business do you have? In which countries is it present? Is it growing with respect to its sector or its rivals? Do you gain or lose market share compared to your rivals? Do we understand how the company makes money? Nike is a fashion garment manufacturer with three divisions, sports shoes represents 62% of sales, sportswear 29% and accessories 3%. 40% of sales come from its own stores and the other 60% through wholesalers, granting this part better margins. NIKE is currently migrating the business model to online sales, which will mean an expansion of margins. Rolls Royce is a manufacturer of aviation engines, not cars, and its income comes mostly from engine maintenance and not from manufacturing, 41% of its sales come from commercial aircraft (it manufactures and maintains engines for Boeing and Airbus), 31% for military aircraft and 25% developing power systems for hospitals and other infrastructure. Insurers don't make money selling insurance, their profits come from the float, which is the money that insurers have each year for insurance payments that have not been paid and that invest for your benefit.
6. Aligned management
Another point to take into account is the management team, undoubtedly a well-run company has all the ballots to achieve success. The managers must be aligned, this means having a significant number of company shares, in this way they will go in the same direction with the shareholders and ensure good results (skin in the game). Managers must comply with what they say, it is important that their words are consistent with the facts. Salaries must be fair, not abusive, and proportional to the size of the company. They must make good use of the capital, allocation of capital (capital allocation) and at all times protect the interests of the shareholder.
7. Competitive advantages or MOAT
This is one of my favorite points. The MOAT is the competitive advantage that makes certain companies last over time, making them very difficult to replicate. A moat protects companies from certain threats. Rivals are constantly trying to assault you with similar products, they try to lower prices, new companies appear that do the same, substitute products, and it is a constant struggle. The competitive advantages that protect the company from these rivals are intangible assets (such as trademarks, patents, licenses), replacement Costs (the inconvenience of changing software or banks), network (product increases with the number of users, such as Facebook or Microsoft), cost advantage (Scale of production) low-cost but critical product for the client (specific software), monopolies such as airports (Aena), share of mind such as Coca Cola or Apple. These points protect a company from its possible rivals and make it more durable over time, giving us a better long-term investment.
To these points, more security layers can continue to be added, ¨all those that each investor deems appropriate ¨, until a result is achieved that makes us feel comfortable.
Classification of companies according to Peter Lynch:
In addition to the 7 previous points, it is important to be clear about the type of company we want to analyze. According to Lynch, companies can be classified as follows.
Low-growth companies: Growth somewhat higher than GDP, about 3% or 4% per year, some of these companies may be energy, railways, industrial.
Stable companies: Titans that are not very agile to scale, but are safe during crises. Consumer companies such as Procter & Gamble, Unilever, Coca Cola, Nestlé, etc. with average growth of 5% per year. They are companies where people with or without a crisis will continue to consume their products.
High growth companies: New, small and aggressive companies, have a growth rate of 20-25% per year. They are companies that can multiply from 10 to 40 times, even 200 baggers. Here we have companies like Nagarro, Spyrosoft, Epam or Globant. They do not necessarily belong to a high growth sector. The winning stocks of the economic correction are usually growth companies, we must be careful with exaggerated enthusiasm in these companies, it can lead us to a value trap.
Cyclical companies: In cyclical companies, timing is everything, and we need to learn to detect the first signs of decline or resurgence. If you work in a related profession, it will be easier to analyze them. Sales and profits go up and down on a regular basis. Within the cyclical companies are the automobile industry, airlines, tires, paper, chemicals, steel, defense. They flourish with the end of a recession and the recovery of the economy. Cyclicals should be purchased at the due point on the slope.
Recoverable companies: They come from a crisis situation with almost no growth. Do not confuse a recoverable company with cyclical companies at their low point. They have little relation to the general evolution of the market. They tend to be big companies, but in bad shape. A company like Boeing is a clear example.
Hidden asset companies: Companies that own something valuable and we know about it, but the people on Wall Street don't. Here we find companies of raw materials, pharmaceuticals, companies with land in certain areas of possible surplus value, companies that have a large percentage of shares of other companies, in short, some hidden value in the eyes of bargain hunters.
Links to financial pages to analyze companies, sales, margins, profits, EPS.