The Dynamics of Business Fundamentals

We exist in a world where everything is in constant change, and such rapid changes are exacerbated by the use of technology which can instantly connect two people and make information exchanges all the more rapid. The same goes for businesses in this rapidly evolving world – they also change constantly and their fundamentals never stay the same. As any observer can see, industries come and go; products are launched and die out. It’s the life cycle of businesses, companies and industries, much like the lives of human beings as they go through the phases of growth, maturity then decline.

As such, when one looks at “business fundamentals”, one must be aware that this is ever-changing. Most investors refer to the term fundamentals as if it were a static event and frozen in time, but the reality is that a business is fluid and always adapting to its surroundings. If a business remained stagnant for too long, then it would be in danger of being overtaken by competitors or closing down due to poor sales. The life-cycle of a business would depend on its environment (political, economic, legal and social), industry, trends, products, services, pricing and many other aspects. Thus, the “fundamentals” alone would imply that many such factors have to be looked at, and is not just a simple matter of looking at one facet of the company. If it were really so simple, then most people would have figured things out easily and made tons of money. But in reality, most investors and traders end up losing money by purchasing businesses which cannot stand the test of time, and failing to bail out before the crisis.

How does one know when the company’s fortunes are going to turn ? Generally, a keen observer who keeps track of the company will first be aware of changes in the macro-environment, or industry. Industry developments are very important in determining whether a company can continue to flourish, or is on the verge of decline. For example, in the oil and gas industry, I am aware that oil prices will remain high (around US$70 per barrel) and this makes investing in Ezra and Swiber viable as they depend on high oil prices to generate demand for their services. Should there be an instance where alternative fuels threatened to totally replace crude oil (an unlikely scenario) or if the prices of oil dropped to below US$40 due to over-supply, then the intelligent investor would be able to deduce that companies in the oil and gas industry will start to see deteriorating fundamentals. Thus, it is a matter of being alert and pre-empting the decline, as no company can remain on the growth track forever. I will touch on the product life cycle in a future posting, in order to make my point clearer.

A seasoned and shrewd investor will look out for early signs of trouble in the companies he is vested in, in order to quickly assess the situation and sell out in case of a lingering, fundamental severe problem. These would include (but are not limited to) Acts of God (e.g. earthquakes, fires, floods destroying crops or factories), severe competition, permanent and irreversible erosion of margins, obsolescence of products, serious cash flow mismanagement etc. The difficulty, of course, is in distinguishing a temporary or minor problem from one which is going to cripple the company. In this respect, an understanding of the business and industry does help to give a clearer perspective of the problem, and to rationalize it objectively to see whether it will linger or disappear.

In conclusion, I would like to reiterate again that businesses are dynamic by nature, and that past performances or successes are NEVER an indication of future performance (e.g. Creative Technologies and OSIM). Some companies or industries have their glory days but fall into the doldrums after some time, while “long-term” investors always hope and pray for a miracle and that the stock price will somehow fly once again. Such unrealistic expectations only serve to incapitate the investor and cause him to hold on to a company whose fundamentals and business have eroded beyond recognition. Such is the harsh reality of the business world, and we must learn to cope with it or be destined to lose out in the long-run.

Next Post: I will be posting my usual portfolio summary and review of my investments tomorrow as it is the final day of August 2007; after which my next post will probably be on Swiber's announcement of the acquisition of 4 vessels.