Investors often buy shares without doing their own homework. Nobody likes to lose money, yet people continue to invest hard-earned capital in companies they know little about.
Backing the right company requires a certain level of commitment. The goal is to figure out what shape it’s in, how it’s set up to deal with what lies ahead, whether it can operate better than before and, finally, if other investors have factored these projections into the share price. Often laziness prevails and these important considerations are sidestepped or outsourced.
A popular approach is to ride the wave of momentum and big themes. Some investors assume a company that’s made shareholders lots of money in the past will continue to do so, or that one catering to a megatrend is destined to succeed, even if it has loads of competitors.
Another common flaw is obsessing over financials. Quick-fix formulas measure certain performance metrics across entire indices to determine if there are any anomalies in share prices. Numbers are useful, but fail to capture everything. Basing long-term investment decisions on backward-looking figures open to manipulation, and earnings estimates crafted by some major brokerage firm with short-sightedness and a potential conflict of interest, can lead us down the wrong path.
Big-name investors, analysts and fund managers go on site visits, reach out to supply chains and give management a call. The rest of us probably don’t have chief executives and top customers on speed dial, although that doesn’t mean we cannot do some useful digging of our own.
Compiling research increases the odds of discovering interesting information that might have been overlooked. And even if you don’t find anything new, you can at least sit back with a clear conscience, aware that you’ve given it your best shot and got to know the company better.
Corporate management tools are a good place to start. Over the years, several strategies have been developed by academics to help companies identify their shortfalls and maximise their potential. In many cases, these same frameworks can also be used by investors to assess whether a stock is worth buying or selling.
Here’s a look at some of the classic, most popular ways to measure business strategies, demonstrated with case studies. They’re not always perfect and some of them cross over. However, combined, they can make a big difference, and will at least point you in the right direction of what to look out for.
The roots of SWOT, an acronym for strengths, weaknesses, opportunities and threats, can be traced back to Stanford University researcher Albert Humphrey. In the 1960s, Mr Humphrey was exploring ways to improve corporate planning, and half a century later his findings are still relevant, helping businesses and investors to objectively examine a company’s bull and bear points.
Users are asked to break down strengths, weaknesses, opportunities and threats individually. Following this simple framework enables managers and investors to look at a company through a wide lens, covering the key points that impact profitability, both in the present and the future.
Strengths: Companies must leverage their strengths to the best of their abilities. As investors, we need to recognise what they are, understand what facilitates them, and determine their sustainability. A good starting point is to consider what separates the company from its competition. Is it a market leader with superior products and a loyal, growing customer base? Is the business model scalable, the balance sheet strong and operating costs well managed?
Weaknesses: All companies have an Achilles’ heel, they just prefer not to mention them. Is the company consistently profitable and on the up, or dogged by legacy issues, crippling costs, macroeconomic headwinds, changing consumer trends and having difficulty adapting? Are customers and employees unhappy and does management get defensive when fielding questions? Consider these points and check out notes in financial statements, outlining risks and uncertainties.
Opportunities: Taking advantage of opportunities is critical to success. Read financial statements for details on the opportunities the company is chasing and consider whether it can realistically capitalise on them, based on management’s track record and the type of openings up for grabs. Remember, taking advantage or missing out on opportunities can make or break a company. Making promises is easy, delivering on them is much harder.
Threats: Are there any issues that threaten to derail the company’s long-term growth potential? Examples could include tighter government legislation, political uncertainty, trade tariffs, increased competition, changing consumer trends, supply issues, natural disasters, product liabilities and lawsuits. Again, management should mention some of the biggest threats it faces in financial statements.
Case study: Barclays
Barclays (BARC) is at an interesting crossroads. Chief executive Jes Staley has nursed it back to health and is pressing ahead with controversial plans to make the bank a global force again. Analysts have been supportive, claiming that the shares scream value. Investors are yet to be convinced.
Strengths: Barclays is an internationally recognised brand that’s well diversified. The bank operates in more than 50 countries, offering various financial services, including retail, wholesale and investment banking, credit cards and wealth management to its millions of customers. The group has a decent track record as an innovator, a decent trait to have in the competitive banking sector, and, financially, is in the best shape it has been in for years, thanks to management’s aggressive restructuring measures. Better dividends and share buybacks are expected to follow.
Weaknesses: Not all of Barclays’ past is covered in glory. It was at the forefront of the excesses that preceded the financial crisis and has been hit with plenty of costly, reputation-damaging fines. The group has been trying to right its wrongs and restore its credibility. Litigation has died down, although penalties for bad behaviour will always be a threat.
Bank shares are a hard sell at the moment. The sector is mature, competitive and more tightly regulated than ever. It is also very cyclical.
Opportunities: If Mr Staley’s contrarian strategy, Barclays’ first coherent one for a while, comes good, it could be a game changer. The former JPMorgan Chase (US:JM) boss doesn’t want to be overexposed to consumer spending in the event of an economic downturn. The answer? Ploughing more capital into its underperforming investment bank.
European banks have lost patience with the meagre returns generated from raising capital for corporations and governments. Mr Staley sees this as an opportunity. His goal is to transform Barclays into a transatlantic powerhouse, building an investment bank to rival Goldman Sachs (US:GS), Morgan Stanley (US:MS) and JPMorgan Chase.
Threats: Barclays’ ambition to boss capital markets could be its downfall. Some investors want the group to dedicate its resources to the better performing high street and credit card businesses and question how the bank can take on US giants and generate superior returns without spending an arm and a leg.
That way of thinking, shared by activist Edward Bramson and other influential shareholders, is creating divisions, infighting and undermining management. Political factors, including a rise in populism, Brexit and a US-China trade war, also risk destabilising the group. The prospect of persistently low interest rates and criminal charges from the Serious Fraud Office aren’t helping, either.
In the late 1960s, Harvard professor Francis Aguilar noted that political, economic, social and technological factors have major influences on the business environment and merit closer attention, even if they cannot always be controlled. Managers took note and steadily began to focus more on external forces in strategic planning, playing around with the name before settling on the acronym PEST.
Political: Companies have little control over the political environment. However, when possible, it should still influence decision-making as factors such as taxation, trade tariffs, antitrust, environmental, labour and safety laws have a huge impact on profitability. The political stability of the countries where the company operates requires attention, too, especially for those with operations in emerging and frontier markets.
Economic: Inflation and interest rates should be carefully monitored. Among other things, they impact the affordability of borrowing money, the spending power and confidence of consumers and the costs of importing and exporting goods. Investors are advised to keep tabs on central bank monetary policies and determine the knock-on effect for different sectors and companies.
Social: Society changes all the time. Things go in and out of fashion, shaping demand for the products and services that companies make a living from. Investors should examine how stocks are affected by shifting demographics, cultural attitudes, lifestyle trends and career patterns, and ascertain how capable they are of adapting to them.
Technological: Technological advancements are also in a constant state of flux, weighing on the profitability of many companies, with more limber peers threatening to put those less alert and with low barriers to entry out of business. Consider what breakthroughs are occurring and how the stock you have your eye on stands to benefit or lose out.
Case study: Tesco
Cost-cutting specialist Dave Lewis has masterminded big changes since taking the reins of Tesco (TSCO) in 2014, boosting profits and winning back customers. Still, it’s a tough time to be a supermarket. In a cut-throat environment, Mr Lewis made Britain’s largest retailer relevant again. However, it’s not out of the dark yet, hence why the share price is stuck in the same place it was when he first took over.
Political: Legislation is regularly introduced to protect customers, workers and the environment in the 13 countries where Tesco operates. These laws cost money to implement, weighing on profitability. Some of the biggest political challenges the group currently faces include foreign direct investment restrictions – some governments are keen to give local companies an advantage over foreign ones – and the prospect of Britain leaving the European Union (EU) without a withdrawal agreement. The retailer imports a lot of food from Europe, employs numerous staff from there and loses its spending power when the pound weakens. Thin margins mean at least a portion of any additional costs are likely to be passed on to customers.
Economic: Even when times are hard, consumers need to buy food, right? The issue is where. German discounters Aldi and Lidl are already thriving and would probably do so even more in a recession. Their cheaper business models make it much easier for them to slash prices than Tesco or the other established players.
What if a recession is averted and economic confidence returns? In theory, it should stimulate revenue growth. The problem is that in such a competitive environment, supermarkets might struggle to lift prices to account for stronger inflation. Even in good times, customers take pride in spending less on their weekly shop.
Social: Keeping up with rapidly changing customer needs isn’t easy. Of the big four supermarkets, Tesco has arguably done the best job of satisfying the nation’s preference for cheap food and drinks. The retailer led the way with its private-label products range, launched its own discounter brand called Jack’s, and cut prices while still growing margins. It also made strides accommodating increased demand for organic and fresh produce and improving its online shopping service.
Still, significant challenges remain. Delivering groceries ordered online generates little to no profit, Jack’s store openings risk cannibalising sales and efforts to cater to the bulk shopping trend came up short after non-food website Tesco Direct was put out of business by Amazon (US:AMZN). Worryingly, the famed US disrupter also has its eyes on the UK fresh food market.
Technological: In the retail sector, technology is constantly being revamped, often at substantial costs, to create the best possible shopping experience for customers. The challenge is convincing them not to shop around. Tesco has already increased usage of its Clubcard app and now wants to take that a step further by introducing a new loyalty scheme mirroring Amazon Prime.
The plan is to give its millions of supermarket customers greater incentives to sign up to its bank and mobile services. However, there are risks involved: the group’s challenger bank arm has already accumulated a lot of bad debt and Tesco’s handling of data is still a sensitive topic after the cyber breach of 2016.
In 1979, Harvard professor Michael Porter wrote an article titled: ‘How competitive forces shape strategy’. In the article, and a book that followed a year later, he discussed the limitations of corporate analysis tools and put forward an alternative method, known as five forces.
Profitability and long-term success hinges on holding a sustainable competitive edge. Mr Porter recognised this, introducing his five forces model to help business managers and investors assess how much power a company actually wields in its industry.
The five forces, as illustrated on page 24, are:
1. Threat of new entrants: How easy is it for competitors to enter a marketplace? Profitable industries attract new entrants, increasing competition and eroding profits. This can usually be averted when there are high barriers to entry.
Common barriers to entry include:
Economies of scale: As production rises, it should become less expensive to manufacture goods.
High start-up costs: New entrants are forced to cough up large amounts of capital on inventory, equipment and other things to have a shot at competing.
Brand power: Customers are sometimes willing to pay extra for certain branded products. Uniqueness is important and some things are even copyrighted and protected by patents.
Regulatory barriers: Certain goods cannot be sold or distributed without special authorisation from governing bodies. Permission isn’t handed out overnight and can be difficult to obtain, putting off potential new entrants.
2. Competition: When there’s a lot of competition in an industry it’s difficult to increase prices, particularly if products or services are similar to what rivals are offering. Companies are forced to keep prices competitive to prevent customers from shopping elsewhere and consistently need to find new ways to stand out from the pack. All of these factors weigh on profitability.
3. Threat of substitutes: Investors must also consider the various consequences of customers potentially one day switching to alternative products. Technological developments often yield significant price reductions and better performance. When they succeed, they can revolutionise entire industries, cripple pricing power and send sleepy incumbents packing. For example, think about the impact that robots and automation could have on recruiters or the effect the healthier living obsession might have on drug, energy and car companies.
4. Power of suppliers: Being held at ransom by suppliers can decimate profits. Companies that buy in materials from outside may find themselves in this situation if the items they purchase are rare, a crucial part of their end product, or only provided by a select few suppliers. Dependency gives suppliers huge bargaining power. They know the customer needs its products and can respond by hiking prices as they please. The buyer’s profit margin will tighten significantly, unless it’s able to pass these extra charges on to its own customers.
5. Power of customers: Companies may also get squeezed by their own customers. Clients will exploit any opportunities they can to drive down prices and are better equipped to dictate terms when the following conditions apply:
- They are important customers and purchase in large volumes.
- The product or service can easily be bought elsewhere.
- It’s not deemed a necessary purchase.
- The buyer could feasibly make the product itself.
Case study: Rolls-Royce
Rolls-Royce (RR.) is one of the few companies in the world that designs, builds and maintains engines and power systems. It isn’t an easy sector to operate in, though, as years of volatile earnings demonstrate. Chief executive Warren East is working hard to restore Rolls’ reputation as a national champion, but legacy issues, competitive pressures and demanding customers threaten to undermine his goal.
Threat of new entrants: Investors needn’t worry about tech nerds bursting onto the scene. Engines cost billions to develop and are subject to rigorous checks from strict regulators. New entrants would need to spend a fortune developing a competitive product and operate at a loss for years.
Competition: Rolls has one major competitor in its core civil aerospace business: General Electric (US:GE). Between them, they have pretty much monopolised the wide-body aircraft market. At present, the only threat to this stranglehold is Pratt & Whitney, the aircraft engine business of industrial conglomerate United Technologies (US:UTX). Lately, Pratt has been making a comeback, thanks to its ground-breaking geared turbofan design. Pratt’s resurgence adds unwelcome extra competition to an already cut-throat industry. Rolls’ mediocre return on sales and capital over the past decade highlights just how tough it is to make money in the sector.
Airlines aren’t very sympathetic. They demand cleaner, better technology, forcing engine makers to invest lots of capital to find a solution. With its rivals breathing down its neck, Rolls can’t afford to slip up.
Threat of substitutes: It’s unlikely that Rolls’ engines and power systems will be displaced any time soon, or that valid alternatives to air travel will emerge. During its long history, the engineer has stayed on top of all the latest developments, including the recent drive towards cleaner, environmentally friendly battery technology. High barriers to entry prevent potential competitors from entering Rolls’ turf. That keeps it in business, but doesn’t necessarily mean that it always prospers. Technology demands are consistently evolving, and developing new engines come at a substantial cost. It can take years to recoup these expenses, too. Money only really starts to pour in when aftermarket maintenance fees kick in.
Power of suppliers: Numerous companies supply Rolls with components. In the past, the engineer has been accused of delaying payments and demanding crippling liability insurance, indicating just how much sway it holds over many of them. There are exceptions, though. Some components are fairly standardised and readily available. Others are high-tech, critical and manufactured by only a select few, increasing the supplier’s bargaining power.
Power of buyers: There are two major companies that build planes: Airbus (FR:AIR) and Boeing (US:BA). They outsource some critical component work to other engineers, put everything together and then sell them to airlines ready for use.
Duopoly status gives Airbus and Boeing some leverage to be picky and drive down prices. Engine contracts are usually long-term, so missing out on them can be painful. That said, the suppliers aren’t desperate and will pull out of bidding if the terms don’t make sense. Engine manufacturers are also in short supply and able to stand their ground.
Rolls recently quit the race to power Boeing’s next mid-market plane. Durability issues with Trent 1000 engines served as an important reminder that entering a new, complex product into service without prior sufficient testing can be very costly. Fortunately for Rolls, rival companies have encountered similar challenges.
Airbus and Boeing sell more planes when customers are happy with the engines. They don’t like malfunctions, but limited alternatives mean they sometimes have to put up with them.