Thursday, September 13, 2007

Analyzing Companies – Adopting a Multi-Disciplinary Model

While reading through “The Essential Buffett” written by Robert G. Hagstrom while on a business trip in Cambodia, I was struck by the wisdom dished out by Warren Buffett’s long-time partner Charlie Munger. He mentioned that companies should not just be analyzed using one aspects (e.g. sales, marketing or financials), but that one should have various models in their mind in order to build a complete picture of a company, its industry and its potential. He goes on to stress that most people only specialize in one area (e.g. accountants do accounting, marketing people do marketing etc.) and thus fail to use a more holistic approach to looking at a company in order to assess if it is worth investing in.

What Mr. Munger is suggesting is that all of us should utilize various mental models (and, if possible, theoretical models as well) in order to analyze a company. Most people who undertake fundamental analysis of a company tend to look only at financials; or they may only look at one aspect of valuation such as price-earnings ratio. Fundamental analysis is closely tied to research for value companies but most people only scratch the surface when they look at a company. While it is true that most people tend to specialize in one field only, reading can be done in order to improve other aspects of one’s knowledge; and this is especially true for business analysis which requires one to have a good grasp of economics (supply/demand) and the way businesses operate. Obviously, taking a course on entrepreneurship is not going to make one understand how to run a business, any more than a bird can teach a fish to fly; but the idea is to try to build up a lattice of knowledge which can act as a strong mental framework which one can use to look at a company.

Such a meshwork of inter-connecting disciplines may sound daunting, but actually the task of looking at companies becomes much simpler when we ask several very basic questions about a company. These questions will, of course, eventually lead to more difficult drill-down-to-details questions; but the idea is to get a preliminary feel first before deciding if it is worth the effort to delve deeper. Such questions would include (but are not limited to):-

a) What industry is the company in and what is it doing ?
b) What are its sales and profits like and how is it planning to grow its business ?
c) Which markets does it sell its products and/or services to ? Are its customers other businesses (B2B) or final consumers (B2C) ?
d) What are its profit margins like (gross and net) ?
e) What makes this company special such that I deserve to put more attention to researching deeper into it ?

The above is just a simple sample of questions one should ask when faced with a potential investment. I would think if e) is not met, then one should just stop there and not waste too much time trying to pick the company apart. Should one need to delve deeper (as I mentioned), then one should look at these various macro-aspects of a company:-

1) Financial Model – Analysis of Balance Sheet, Income Statement and Cash Flow Statement
2) Marketing Model – What are it’s A&P activities ? What is its product life cycle like ? What is its target market, market segment and how is the product positioned ?
3) Business Strategy Model – How is the company planning to expand ? What is the pricing power which the company has ? Is the industry prone to competitive threats ?
4) Human Resource Model – What are the experience and qualifications of key management ? What makes them so competent in running this business and growing it ?

Once again, the above are some examples of models to use when analyzing a company deeper. Gurus such as Warren Buffett and Charlie Munger have, no doubt, all this hardwired into their craniums and its easy for them to apply when they look at companies. For ordinary folk, some effort must be put in if one wishes to achieve outstanding results.


Berkshire said...

WB and CM started off as ordinary folks too although without any doubt they are smarter than most people, not necessarily intellectually but definitely logically and emotionally.

As they age, they got smarter with each passing investment decision they made. In the early part, one big mistake was to purchase Berkshire Hathaway outright. In the end, with the capital that were outlayed by the shareholders, the total sum gotten back was paltry, if any at all. It took 25 years (as acknowledged by WB himself) in order for him to recognize the incentive of picking a business that has a moot which requires very minimal capital outlay to generate income.

All in all, success comes with hardwork and persistance. But then reading and learning from the right sources is also of utmost importance, bcos if one get from the wrong source, it makes no difference between one who learns from the wrong source to another who do not even bother to learn at all.

donmihaihai said...

I almost never hear fellow Singaporean using Multi-Disciplinary Model, mental models for investing.

Try this blog, it contains many CM materials. Read his speeches(must read), Poor Charlie's almanack(full ten speeches if you willing to pay almost $100)and books recommended by cm and see how he teach himself worldly wisdom make him a much better man.

donmihaihai said...

here is the link.

Berkshire said...

Hi Donmihaihai,

I agree worldly wisdom makes CM thinks and acts as a much better human being. And the more one thinks about the thoughts of the man, it also inevitably causes one to want to be a better person as well.

I can vouch that the cost of US$100 for Poor Charlie's Almanack is more than worth its price. It is an education by itself although not one you would expect by getting a certificate...well it is much better than spending $10K on any degree for that matter. Any serious investor should in time get this book in order to pick up more knowledge to improve on their investment skills and also to be a better person.