Do You Understand the Business?

[RJT]

Source: http://musingzebra.com/do-you-understand-the-business/


“Buy things that you understand”, “Stick to what you know”, or “Stay within your circle of competence” – We hear these advises all the time so we don’t invest in stocks we know little about. But what define understanding? How do we know if we truly understand a business? If I know Apple designs, develops, and sells consumer electronics and computer software, is that enough to say that I understand the business? Or is it something more? Before we can set a parameter to separate understanding from the lack thereof, we should first understand why is it important to know a business. The reasons are both psychologically and analytically.


Put it simply, you want to understand a business so you’re not psychologically disadvantaged when the market goes against you. If you don’t know what you’re doing, there’s no way to plan and prepare. And when you’re not prepared, it’s easy to be surprised because you’ve no idea what can possibly happen. No one like surprises. Surprise create anxiety. How do we avoid surprises? We follow the market. You stay on top of the market so you can react fast. When the market moves, you want to know why. Since you don’t know much about the business, you rely on the daily share price to tell you what to do and get influenced by the market in the process. Hence, when something goes wrong, you tend to follow the crowd to sell assuming the market knows more than you. Occasionally, you decide to bet against the market. Instead of following the crowd, you look for supporting information to convince yourself that you’re right and the market is wrong. It is another way to avoid pain under a stressful situation by reassuring ourselves that our decision is correct. You become close-minded and force reality to fit into your own beliefs. You feel vindicated when the market turns your way. You become more interested in being right to uphold your ego than making the best decision. Whether you decide to follow the crowd or go against it, the outcome is clear. If you buy things you don’t understand, you’ll always be at the mercy of the market and fool yourself into making silly mistakes.

Understanding a business also improves the accuracy of our forecast. Consider this. You stand a better chance of correctly guessing a person’s age than say, the age of an emu. Why? Because you grow up together with other people. Over the course of your life, you acquired many reference points such as hair color, wrinkles, skin tones through interaction with others. These reference points create a mental model of how one should look like at a specific life stage. In contrast, unless you’re a zoologist, you probably know nothing about emu other than it is a huge bird. Your estimation will be totally off even if you have a huge margin of error. It is like move the Hubble space telescope an inch and you’ll be looking at the other side of the universe. You don’t know the average lifespan of an emu, therefore, much less to estimate how one should look like at any given age. Similarly, when you buy something you don’t understand, your forecast on the value of the business is going to be wrong most of the time. To make it worse, you rely on the share price as the reference point to prop up your confidence and make decisions. When the price goes down, you tell yourself “Buy at the dip” or “The market overreact”. When the price goes up, you take that as an indication that you’re right. You create an illusion of understanding thinking you know what you’re doing.

Now we have a basic idea why understand a business is critical—It increases forecast accuracy and reduce mistakes—we can create a guideline that defines the parameter of understanding. This guideline can be turned into 2 simple questions:

1. What are the risks that can cause the business to suffer a loss in earning power?
   
   
2. Have you included these outcomes in the valuation to derive an expected value?
   

The first question deals with negative surprises. As an example, all utility companies carry regulatory risk. A change in utility regulation can potentially impact the earning power of these companies. So, you have to ask, what needs to happen for this (regulation change) to be true? It could be a change of government, monopolistic industry, the emergence of new technology i.e clean energy, or a combination of these factors that increases regulatory risk. Once you’ve identified the risk factors associated with the characteristics of the business, you can prepare and plan ahead so when something goes wrong, instead of panic and rely on the market for direction, you can rely on your investment process to make the best decision.

The second question builds on the first. Your forecast is going to be more accurate when you consider all the possible outcomes and synthesize them into your valuation as opposed to only think about what you think will happen. Building on the example above, a change in utility regulation is a possible outcome. You’ll have to ask, what is the likelihood of that happening? And if it happens, how will that affect your valuation? It is difficult to know what’s the likelihood, much less so to know the effect on valuation since the change can either be good or bad. Nonetheless, the accuracy of your forecast will improve when you see things from multiple perspectives.

The objective of understanding a business is to improve judgment, stay prepared, and reduce mistakes. But the definition of understanding can mean different things to different people. Not to mention it is easy to rationalize our way when there’s money to be made. Therefore, these two questions can serve as a parameter to assess the level of our understanding, tame overconfidence, and improve return.

[soros]

Most public ahareholders are only allowed to know about what is in Company's Annual Report and most persons including myself don't really understand the accounting information presented inside the report. This also applies even to better educated people and professional people. The problem may be due to our inadequate school education.

[Kaimin]

Very big problem for OPMI. We only get the information from the annual report, which is especially scant on the details of the business - who the customers are, breakdowns of sales of different produces, and descriptions of products. Their future expansion plans are almost always a generic phrase buried in the message to stockholders like "We will continue to cut costs, expand into new markets and increase shareholder returns".

[specuvestor]

-You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick “no.”

http://fortune.com/2014/02/24/buffetts-a...vestments/

Understand the business MODEL: how they make money, what is their edge, what is the management track record. You don't have to know how many cashiers they employ or how to plant seed in what season. That's operational and CEO's job.

Once understand the business model and hence their cashflow estimation, one can have rough idea of their valuation. So when things happen, one can react much faster by knowing what is a critical detriment ie get out sign vs noise ie opportunity

And that's one part of Asset-Business-Structure. Yes investing is hard else ETF is an option

[Greenrookie]

Specuvsestor and VB

Beside reading on industry news, articles, company and competitors AR, and making a judgement call, how else would we know we know a business model?

[Kaimin]

-You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick “no.”

http://fortune.com/2014/02/24/buffetts-a...vestments/

Understand the business MODEL: how they make money, what is their edge, what is the management track record. You don't have to know how many cashiers they employ or how to plant seed in what season. That's operational and CEO's job.

Once understand the business model and hence their cashflow estimation, one can have rough idea of their valuation. So when things happen, one can react much faster by knowing what is a critical detriment ie get out sign vs noise ie opportunity

And that's one part of Asset-Business-Structure. Yes investing is hard else ETF is an option

That's out of reach for most opmi  

>how they make money
Details of contracts and sales are rarely released. Like any semiconductor company will not release any channel backlog info or even prices of their goods. Some industries like construction you understand the income recognition as it's built contract, but that's general information. And related to your link, REITs never publish rental rates information or when leases will expire, only utilization percent. 

>their edge 
This is virtually impossible. We're basically at the mercy of the company, who often claim edges we cannot verify. Like Citic Environtech claims they have a new circulating fluid bed technology which gives them the edge over other competitors, but we cannot verify this because citic and its rivals would need to publish boiler efficiency statistics. And even when they do publish, IIRC Hyflux claimed they could produce water much more cheaply, that never materialized  

>management track record 
This is possible sometimes, but the smaller companies whose CEOs ran private businesses which we have no idea did how well, we can't tell. And like Graham pointed out, the lack of scientific and objective methods to quantify management skill leads to some circular reasoning with management track record. Companies with good management are those whose stock prices have increased to high levels, and companies who have high stock prices have good management

[Kaimin]

Specuvsestor and VB

Beside reading on industry news, articles, company and competitors AR, and making a judgement call, how else would we know we know a business model?

Lynch wrote that amateur investors have the edge as regular Joe consumers, compared to Wall Street analysts. We for example spend a lot of time in Capitaland Malls where we can see how well it's managed, how clean the toilets are, whether the shops are doing good business. We know what our friends think of the malls, VivoCity is atas and expensive, Tampines mall good because new interchange, Eastpoint so so. Most of us take smrt everyday (although now privatized). We know how it's priced, we know about the price and discounts of monthly adult cards, we know that people deposit their money first to charge cards meaning smrt gets paid before it gives the service. We know people lose cards and have to pay to get new ones.

But this advantage ends at industrials. We'll never by an AEM product for example  

Another way is to call your broker and ask for specific info. I'll be trying this as soon as I find her number, and I'm cautiously hopeful she can get the kind of treatment investment analysts get from companies (getting visits, telling them things and explaining their business model et cetera.)

[karlmarx]

The best way to understand a business is to read its share/bond offering prospectus. Prospectuses are much more comprehensive than Annual Reports, so investors should start there if they want to know what the business is all about. How did the business start, what its sells, what its inputs are, where it lies in the value chain, what is its value add, who are its type of customers, what might cause its business to decline, what properties/assets it specifically holds, etc; these can all be found in the prospectus. The few hundred pages might seem intimidating, but most of the stuff are standard information that you will find in all prospectuses and you can skip those. You won't get every detail of the business like who its customers specifically are, but there is sufficient information for you to have a good picture of how the company operates (i.e. its business model).

Apart from qualitative information of the company, there are also financial statements (P&L, BS, CF) which most investors will be familiar with. Consumed together, they allow the investor to understand each better. In other words, understanding the business model will assist you in understanding the financial statement, and vice versa. For example, why has Boardroom's profit not grown over the past 10 years? It used to do more corporate secretariat and accounting work, which has a higher value-add and hence generated higher NPM and ROA. Boardroom now has much lower NPM and ROA, due to a lower proportion of these higher value-add jobs. This has been replaced by more shareholder registry jobs, which are simpler and hence lower value-add. Boardroom's business model changed from one that is more dependent on higher skilled labour, to one that is lower-skilled. Hence, while revenue has increased, the same may not be true for the intrinsic value of Broadroom.

A good test to know whether you understand the business is if you know what its Achilles heels are, and where its true strength lies (if any). These may or may not be explicitly revealed in the prospectus or annual reports. Often, it requires the investor to read everything to see where the strengths and weaknesses are. There are many areas where these weaknesses could lie; the company could be relying on revaluation gains on its assets as a form of profit, or it could be using long-term debt to finance short-term contracts, or it could be buying goods at fixed price and selling them at spot price, or it could be relying on a small number of clients/suppliers, or it could be required to frequently spend lots to update its equipment, or it could be financing its dividends from depreciation/loans, or it could be too aggressive in revenue recognition, or it could be required to pay suppliers first before it collects receivables from customers, etc. In conglomerates or companies with more than 1 business unit, the segment results usually reveal the key profit contributor. For example, beer and beverage products of ThaiBev are popularly known but contribute poor profits. Its gem lies in its less widely marketed spirits business.

Lynch's scuttlebutt approach may help investors to understand a product, but it does little to enlighten on the business model of the company that sells/manufactures the product. Knowing the product and knowing the company that sells/manufactures it is quite different. If you bought ThaiBev based on your consumer knowledge of Chang Beer, you would be surprised to find out how the company dependent more on its spirits sales. Or if you bought Khong Guan based on your consumer knowledge of its biscuits, you would be surprised to find out you actually bought an investment trader with some real estate and a poor biscuit business.

Of course, if you have access to the same information that management has, you may be able to understand the business better. But most of what is publicly available will suffice in providing an adequate understanding. Sometimes it requires a little thinking, and if you have attended business school classes, it should come quickly to you. If, like me, you have not attended business school, then you'll just have to do a bit more thinking. If you're willing to spend time to read the publicly available information and think them through, most companies are not beyond an average person's ability to understand.

[Porkbelly]

Thanks Greenrookie for asking the question
and
Thanks to Kaimin & Karlmarx for sharing your views..
Appreciate it very much..

[RJT]

I think another thing to stress is improving thinking skill is as important as the amount of information you have, perhaps more. I recall an experiment done on horse bettors that show as more pieces of information were given to them i.e from 10 pieces of information to 40 pieces, to forecast which horses will come up as the top 3 winners, their confidence doubled, but their accuracy remains the same, and in fact, dropped on the 40 pieces of information. What get us into trouble is not low accuracy, since if our level of confidence is well calibrated with the level of accuracy, a low accuracy level just mean you sit there and do nothing. Or in Buffett's baseball analogy, sit on the sideline. You don't have to swing as often if you know your accuracy is low, just wait for the fat pitch. What actually get us into trouble is when there is gap between our confidence and our accuracy - when we think we know when we don't know. This doesn't mean we shouldn't pursuit for more information. We should, but ultimately, it is our ability to interpret the information at hand that determine the decision we make and the outcome. As an example, if you can think probabilistically, and use Bayes rule to update your perception everytime you receive a new pieces of information, you are going to be more accurate in term of putting the correct weighting on the information than those that are not using it.

Another worth mentioning is do not mix analysis with gathering information. We tend to analyse information when we are gathering them, it is intuitive and automatic. But the danger is when you're analyzing them, you're going to create biases in your perception of the company, those biases is going to go into how you treat those information you gather subsequently. If you already form a favorable view of the company, your mind automatically filters out any conflicting information during the gathering stage and only remember ones that agrees with your perception. What happen to your analysis? You going to like the stock and buy it that's for sure. That is the danger when we read analyst reports, which is normally where we discover new ideas and 'decide' if we going to dig into a company. Put it in another word, we formed our liking before we even study it, which makes perfect sense, since if you don't like a company, you won't study it in the first place. But just remember you have to collect information objectively, and analyse them after you gather them, not during.