IMPORTANT KEYS TO SIZING UP A COMPANY

These are factors to weigh when you are buying or selling, writes Martin Pelletier.

Having worked on both the sell side and buy side of the investment industry, I’ve seen my share of analyst reports.

Unfortunately, many investors aren’t as familiar with them, and can struggle to decipher what is important and what isn’t — especially when the sell side has a tendency to focus only on the bullish factors. That said, analyst research can be very useful when complimented with additional research of your own from various sources, such as company presentations and SEDAR filings. Being organized and knowing what to look for is also a great way to sort through all of the noise.

Below, we’ve listed five key factors we generally try to assess when analyzing companies with the aim of making buy or sell decisions.

STRATEGIC POSITIONING

We begin by reviewing the attractiveness of the broader sector or industry and how well the company is positioned strategically within it. It is paramount that the company has strong market share that is not easily disrupted by its existing competitors or new entrants.

A great example of this is the Canadian telecommunications industry, which has few participants and extensive barriers to entry given the current regulations preventing outsiders, such as larger American companies, from coming in and offering a higher-quality service for a much lower cost. As a result, the existing companies for the most part enjoy robust profit margins in a very stable business environment — for now at least.

PROFITABILITY AND MARGIN OUTLOOK

Depending on where a company is in its life cycle, it will attract different kinds of investors.

Management’s ability to navigate that life cycle, even as the investor base changes, is a key determinant of a company’s level of success.

For example, the merits of a company with high revenue growth should eventually show up on its income statement in the form of earnings.

This is something to look for when analyzing those companies that focus on growing through acquisitions. The failure to translate revenue growth into earnings should be a red flag for investors.

For those that have already become highly profitable, the question becomes whether the model is sustainable or not and how long the profitability can be passed along to shareholders through dividend hikes.

FINANCIAL POSITION

A company’s balance sheet strength is paramount to its long-term survival, unless it happens to be fortunate enough to have a dual-class share structure and a direct line to the government for subsidies.

A good management team will know how and when to use debt and equity and maintain a proper balance between the two. In particular, we tend to lean toward those companies who are more conservative in nature with their level of debt, especially those that operate in more volatile sectors such as oil and gas.

NEAR-TERM CATALYSTS

It is important when reading reports and various research material to try and determine if there are any other potential catalysts that could impact the company’s near-term operational outlook. This could be the case when something has already transpired causing the company’s share price to sell off or move higher but it is up to you to determine if it is a justified move or not.

VALUATION

There are times when a company may be undervalued or overvalued and one of the most difficult things is determining which is which.

The danger is that a company that looks undervalued can end up being a value trap, in which management destroys shareholder value over time and as a result the company perpetually looks cheap, sucking in the next unsuspecting investor.

There are also instances when a company appears to be overvalued but management is great at unlocking additional value over time for shareholders, thereby surpassing expectations.

While there is no secret sauce to approaching this, a great place to start is by asking what management’s track record is when it comes to capital programs, and how much value you think they will create with their existing capital program. Then try to determine if this is already priced into the stock from an upside versus downside perspective.

Put it all together and you have your own recommendation, free of bias, which you can structure a trade around.