Part 2 – Where do we go now?

1-Understand the business model

My view is that the success in stock investing will always be dependent on the success of the underlying business. So first of all an investor must become an expert in understanding business models. Only if you have a deep comprehension of the business model can you go after the evidence that supports the performance of a given business unit. If you want to know more about business models you can find valuable information in the book Business Model Generation.

2-Avoid commoditized product portfolios

As a general rule you should avoid companies whose products or services are mostly commoditized (exception made for regulated activities). I believe you can do this by thoroughly analyzing the company’s product portfolio and compare it to the main competitors’ portfolios. If you identify a clear driver (excluding the price), that would make a customer buy the company’s product instead of the competitors’ product, then you have a non-commoditized product.

3- Evaluate the company’s product innovation skills

However, it is not sufficient to have a good business model in the present, it is also necessary to have it in the future and to do so we need future products. The key point is product innovation. This is one of the hardest areas to evaluate since we are dealing with qualitative information. This is critical, since the future of the company depends a lot on keeping the innovation stream alive and healthy.

There are several sources that can reveal a little about the current state of the company’s innovation skills (a business case study about a company, an interview with the CIO an article in a specialty magazine). However, this will always need some double checks. A good thing to do is the check the recent track record in terms of new products. Then, check who was responsible for them and confirm if this person is still in the company leading new projects. These are simple steps that, in my opinion, can support or refute your rationale.

4-Evaluate the production skills of the target company

The improvement in process efficiency is the next critical factor. The company’s industrial plants should be organized in a way that allows them to continuously search for areas where waste is generated, new ways of organizing production that increases efficiency, and new technologies of production that decreases the production time and increases the quality of the output.

Toyota was the most notable company in assimilating this view, with its famous Toyota Production System (TPS) or “Lean Production” practice.

Most of all, we need to be sure that the company has a widespread culture of continuous search for improvement. All the workers must be part of the effort to reduce waste, through the increase of standardized processes and reduction of overburden activities and processes. This will be reflected in some performance indicators such as the gross margin. Also, in Industrial companies the production is at the center of the company’s attention, we must ensure that the management is competent in terms of production management, but also be sure that the company is not getting “production oriented,” thus forgetting about developing new products at the expense of the current ones. Companies that get production oriented, seeking economies of scale, usually get sucked in a spiral of price reductions which ends-up destroying margins (Marketing Myopia Theodore Levitt). The constant introduction of new, differentiable, products is the solution to this trap. By developing products that the competition does not have yet, the company is able to maintain premium prices, thus sustaining or even improving margins.

A good way to verify the production skills is to check some performance indicators like the gross margin or inventory turnover.

5-Think out-of the-box when looking for information

Today, we can find most of this information in the internet. Frequently, I note that investors:

– follow the Graham’s tradition of religiously reading the annual reports;

– accompany blogs with gossip about a given industry or company;

– accompany patent registrations and speculate about it;

– speculate about the line of products soon to be introduced by a given company.

Although, I see benefits from any of the previous sources, I think that to be successful we will need to validate some facts, which is not possible if we do not extend our research sources. The internet allows us to explore sources like employees’ reviews, business case studies from reputable academics, executives’ interviews, executives’ biographies, scientific papers concerning new technologies. We have a wide-range pool of intelligence at our disposal.

One example of an unorthodox approach: when I want to understand how a given company’s employees feel about their company, I just go to a job review website (the ones directed for people looking for a new job) and read the comments about that company, sometimes it is really enlightening.

Thank you for reading this article.