What's the biggest mistake investors make?
Analyzing a company's prospects without paying any attention to the bigger picture.
With that in mind, here's how to assess the big picture so you can make the right call.
The Industry Matters
In many respects, your best investments will come from picking the right industries, not the right companies. Your analysis should always start with a 'top-down' approach. After all, a lagging company in a winning industry is bound to fare better than a leading company in a lousy industry.
Have a hunch that retailers focused on teens will fare better in 2011? If your hunch is correct, stocks of companies like Aeropostale (NYSE: ARO) , Abercrombie & Fitch (NYSE: ANF) and Hot Topic (Nasdaq: HOTT) are likely to rise.If you don't want to rely on a hunch to find the next high-potential industries, the key questions to ask are: Where are we in the economic cycle? And which industries and sectors tend to do well at in this stage of the cycle?
Defensive industries tend to fare better in a slow economy -- think consumer staples and utilities -- and cyclical businesses like industrials and retailers do better in a rising economy.
[Click here to learn more about how sector rotation can help you find the best stocks to buy now.]
Once you've established a favorite sector, it's time to gain some insight as to which company is the best horse to ride, a strategy known as 'bottom-up' investing. This is where you really need to develop a feel for how a company operates, how popular its products are, how lean its cost structure is, the relative strength of its balance sheet, etc.
Some investors like to use a formal framework known as SWOT analysis. SWOT analysis involves analyzing a company's Strengths, Weaknesses, Opportunities and Threats. Factors internal to the company are usually classified as strengths and weaknesses, while external factors are classified as opportunities and threats. SWOT analysis can be extremely useful when trying to figure out a company's competitive environment.
Strengths: A firm should always be trying to harness its resources and capabilities in order to develop a competitive advantage over its competitors. Example of strengths can include patents, brand names, a good reputation, proprietary knowledge, exclusive access to natural resources and access to valuable distribution networks.
Weaknesses: If a company doesn't have the factors that would be considered strengths, it makes sense to view them as weaknesses. For example, lack of patent protection or expiration of patents, weak brand recognition, bad reputation, high cost structure, lack of access to natural resources or lack of access to distribution networks can all be viewed as weaknesses.
Note that the strength/weakness categorization can change with the macroeconomic environment. For example, a firm may have a large amount of manufacturing capacity. While it may be a strength in a growing economy, it could be a weakness in a slowing economy.
Opportunities: Opportunities generally lay outside the firms operating environment. They include external factors like unfulfilled customer needs, arrival of new technologies, loosening of regulations or removal of trade barriers. Remember -- Just because a firm has exposure to opportunities doesn't mean it will be able to take advantage of them.
Threats: Like opportunities, threats generally reside outside the firm itself. Threats include shifts in consumer tastes, development of substitute products/services, new regulations or new trade barriers.
Some analysts prefer to organize their research into a SWOT matrix as a way to get a visual representation of their analysis.
You can actually gather a lot of information about a company's changing dynamics by reading its annual reports. If you read a few in succession, you'll notice how the dialogue changes from year to year. In what ways is the company playing offense and in what ways is it playing defense?
You can also do a SWOT analysis on a rival and then stack up the two companies against each other. If you did this exercise with McDonald's (NYSE: MCD) a few years ago and compared its results to Wendy's/Arby's (NYSE: WEN), you would have seen an emerging winner, well before its shares took off. Since the start of 2007, shares of McDonald's have doubled while shares of Wendy's/Arby's have fallen more than -60%.
How could you have known this an investor? Most obviously by visiting the stores regularly and understanding how each company fits within its competitive environment.
McDonald's started to post an impressive rebound in 2007 by sprucing up its stores and menu. Wendy's has failed to undergo the same transformation, and sales traffic has been noticeably weaker. Its Arby's division has also been extremely weak.
Both operate fast food chains that target similar segments of the population. While each firm generates around 30% gross margins, McDonald's enjoys the benefit of a far larger store base to cover its operating overhead. So while operating profit margins at McDonalds now approach 30%, Wendy's barely ekes out any operating profit at all.
Key Factors By Industry
Here are a few examples of questions to ask yourself as you start looking for a firm's competitive advantage (or lack thereof) within its particular sector or industry:
Do the companies have pricing power?
Pricing power comes from scarcity, so if the market is flooded with goods from low-cost producers, profit margins are bound to be weak. That's what happened in the auto industry. Too many vehicles were produced and profits completely disappeared. Nowadays, they've cut costs and are showing more restraint in terms of output, which has restored pricing power and profits.
Will technological obsolescence come into play?
If you invested in typewriters in 1980, you were eventually wiped out. These days, companies like Apple (Nasdaq: AAPL) and Google (Nasdaq: GOOG) are making firms like Microsoft (Nasdaq: MSFT) look like dinosaurs. If Microsoft doesn't come up with a better game plan soon, its sales may head into a terminal decline.
How does government spending affect business?
It's no secret that the budget deficit is forcing major changes in Washington. That may explain why defense contractors such as Raytheon (NYSE: RTN) and Lockheed Martin (NYSE: LMT) have both seen their shares fall -20% in the last six months.
All the research you do should lead you toward the answer to this question: Why can some industries/companies, like McDonald's, maintain profit margins that are so much higher than others?
Successful companies are able to build economic moats that help them defend their territory from marauding competitors. The wider the moat, the longer a company can hold rivals at bay and continue generating outsized returns for shareholders. In addition to the SWOT analysis described above many analysts examine Porter's Five Forces (competition, barriers to entry, threat of substitutes, supplier power, customer power) to complete their industry analysis.
[Click here to learn how to Use Porter's Five Forces to Lock In Long-Term Profits.]
This may all seem like a lot of work. And it is. But we're talking about your hard-earned money here, and if you are looking for a long-term winner, then the upfront legwork will have seemed like a very wise move down the road.