The Research that goes into Equity Investing
When investing in equities, we have all been told the following multiple times – invest in high quality companies, do your own research before investing, hold only the stocks you have conviction in, and many more variations of these. They all sound good in theory but what do they actually mean in practice?
Let’s take a step back to the basics first. An equity share is a financial instrument that represents ownership in a company. Hence, when you buy a share, you are investing in the underlying business. The paradox here is that an equity share is a simple standardized instrument but the underlying company is a complex, living, breathing organization that is constantly changing. It is this company that an investor must build conviction in, through what we call equity research. This might sound simple enough but this paradox often leads to many eager investors trading shares without enough due diligence on the underlying company.
So how does one decide whether a company is investable? It requires a comprehensive understanding of the company and its business. Most importantly, you should be able to form an educated guess on where the company is heading going forward. Remember, investing always has to be forward looking.
I started my career as an equity research analyst and worked across 3 organisations, including as part of the core research team of a domestic AIF and an Asia focused hedge fund. I spent all my time dedicatedly learning about companies and forming an opinion on them. Here’s what my work entailed:
1. Historical analysis – Going through the company’s past gives a lot of insight into their development as a company. Past Annual Reports are a good starting point, we would often go as far back as 10 years to gain more insight about successes and failures, consistency in strategy, ability to manage business/industry cycles, etc.
2. Financial analysis and modelling – Looking at the financial statements and in-depth analysis tells you whether the story has been backed by the numbers – I had found many examples where it did not. While the story of a business may seem encouraging, financial analysis and modelling help bring it down to reality. Further, we would build detailed financial models to estimate where the numbers could be heading.
3. Meeting the management – Observing the people in charge of running the company can significantly help build (or lose) conviction. They are the ones responsible for the future of the company and as such, investing in a company is betting on its management. Through my career, I interacted with the CXOs of nearly 100 companies. This gives a much deeper understanding on the people and their capabilities, company culture, strategic direction and much more – things not often discussed publicly.
4. Tracking quarterly results and business updates – Listed companies report their financial statements for every quarter, while many host a post-results conference call with investors/analysts to discuss the performance and outlook. Additionally, companies report other updates like M&A activity, change in management, dividends, etc. These updates help us keep track of whether the investment rationale is playing out and the company is indeed walking the talk.
5. Understanding external factors – Every company operates in an ecosystem with dynamic external factors. It’s vital to research and understand the industry dynamics, competitors, regulations, impact of technology and more. For example, with new age tech companies listing in India for the first time, we must look at American and Chinese tech names and their history for more insight. As such, your equity research should cast a net much wider than just the company itself in an increasingly disruptive business environment.
6. On ground channel checks – While a lot of the above research can be done at your desk, we must do consistent on ground research to gain a real-world view of the company. I have done plant visits, spoken to dealers and distributors, reached out to former employees and spent time with the regulators for various different companies. This primary research often works as a lead indicator as to the direction before it starts reflecting in reported numbers.
7. Corporate governance checks – Often the most overlooked yet the most important research. It is critical to ensure the integrity of the promoters – this plays a direct role in the wealth creation of minority shareholders. We have all seen multiple examples of well positioned companies sinking due to promoter greed. Accounting “creativity”, related party transactions, inflated capital expenditure are just some ways this greed is fulfilled. It’s vital to identify and avoid such promoters entirely. To identify such issues, analysts conduct forensic analysis of the financial statements, track related party transactions, insider trading and ensure with comprehensive research that everything adds up.
Equity research is a very wide reaching, comprehensive process. And it has to be. Investors are putting their hard-earned money into an entity they have no control over, in the hopes of significant wealth creation. Unfortunately, most individual investors don’t have the time, bandwidth or the resources to research all of the above points on their own. Hence, they can end up with a portfolio with substandard returns.
Professional fund managers have teams of research analysts working full time towards building greater insight in every investable company. The largest mutual funds manage lakhs of crores of rupees, giving them significantly higher resources to undertake equity research. With this scale, they are able to dig much deeper and form more educated opinions than individual investors can.
We urge all investors to undertake comprehensive due diligence before investing in any company. If you are passionate about equity research and are able to do the above, your portfolio will see the benefits of research driven investing. For everyone else, we advise you to take advantage of the professional fund manager’s expertise and scale. Identify the right funds and let them undertake the mammoth task of equity research for you. Their edge has led to consistent outperformance over retail investor portfolios.