Why is it important to study a company’s business model?

Most of us shortlist stocks by observing and listening to what other people are buying. It usually helps pin down a handful of stocks that have a good reputation. However, not all stocks with a good reputation or history can become good investments. One needs to dig deeper and study the business in detail.

There are many reasons why it is important to study a business in detail. Once you have a grip on the business model of a company, you will be in a better position to analyze the effects of external elements on your company’s stock. 

Let’s take the example of a company whose power source breaks down and it has to close the manufacturing plant. What will be its impact on the EPS? Most people would just say ‘negative’. But that is not a helpful answer for an investor. 

A good investor will know the contribution of that particular plant or factory to the EPS. He will quickly analyze its impact on the EPS and whether any sales lost will be recoverable later in the year. If there is minimal loss of profits, or if those profits can easily be recovered later, then the ‘negative’ impact is an obvious buying opportunity.

Similarly, the same company could have insurance for its plant. Once the plant breaks down, it may stand to gain much more in insurance money than it could from its operations.

As an investor, you want to know your company so well that you only need to consult its annual report to figure out how its business will be affected by any adverse event. Only then can you decide if a dip in price is a buying opportunity, or if it is better to just exit the stock and re-enter when things improve.

KAPCO – An example of bad management

A prime example of knowing the business of a company is KAPCO. Its power purchase agreement has already expired and the company has parked its cash in government bonds. Its revenue from operations is almost nil, but it generates a healthy income from its investment in PIBs, which it then gives out in the form of dividends.

Many people consider it a good investment, especially looking at its dividend yield. However, a deeper look at its management reveals that despite knowing the expiry date of its agreement, the management never bothered to come up with a business plan that would serve it post-expiry.

The above is an example of bad management in charge of a company. It has eroded shareholder value by not running the business well. Here is the 10-year history of the company:

EFERT – An example of good management

Compare that with EFERT, where the company is involved in a lot of litigation with the government. While many may consider it as a negative, the company’s management usually puts aside enough cash for the worst-case scenario. 

As an example, see how EFERT accounts for super tax, a matter it has already challenged in court:

While EFERT’s consistent dividends do make it a great investment, it is a great management that enables it to pay those dividends in the first place. As an investor, you are invested in the management, not in the dividends.

Imagine now that news breaks out that EFERT lost its appeal in court and has to pay the amount. Guess what, it has already accounted for that amount in its books, so it should have no impact. If there is a sell-off in the stock after this news, you know it is a buying opportunity!

Here is how EFERT stock has performed since 2014.

You can see clearly that management makes a big difference.

It is therefore important to know a company’s business well. Without it, you’re investing blindly.