The world outside the well

The world outside the well

The trend on trends

You must have heard analysts on CNBC talk about business trends. What is that about and how do they help gauge a company's health? Don't financial ratios determine whether the company is in good financial health and measure all parameters of company efficiency, besides tracking their growth? 

There is an entire gamut of basic ratios that value businesses--book value, EPS, PE, RoE, RoCE-- which are relevant to stock-picking. But while that helps in valuing the financial health of the company, there is still a lot more that goes into buying a good company. There are factors prevailing in the environment that determine profitability and growth. Which is why the study of trends comes in. 

Let us take a look at business environments in the next few paragraphs. Our objective is to suggest which factors to look for while picking a successful business. How not to believe everything you see. Financial ratios follow good business trends, i.e. they happen after the business cycle.

Being alert to and using external trends

"Despite the management's continuing effort to improve efficiency and control cost, and achieving higher throughput, the operating profit before depreciation, interest and tax had gone down by 18%. This was mainly due to the decline in net sales realisation as a result of very competitive conditions prevailing in the market." - Directors Report, ABC Ltd for FY2008. 

What went right? The efficiency of the manufacturing business improved. All internal factors that could result in cost saving were implemented. This ideally should have led to a higher profit margin. Did this happen? No. While the company was cutting its costs, the sale price of the final product came down because of competitive (external) pressures. The business was in a state of oversupply, which was pushing down selling prices and reducing profits.

But does the reverse hold true? Let's look at two companies in the technology sector: XYZ Ltd and PQR Ltd. XYZ Ltd and PQR Ltd are talking in forked tongues, though they operate in practically identical businesses. 

Says the Director's Report, FY2008, of XYZ Ltd: "The Indian software exports industry demonstrated healthy growth during the year. The year saw your company winding down its BFSI-related engagements, in line with its risk management strategy. Your company has successfully managed the transition from being purely BFSI focused to now catering to diversified verticals." 

Goes PQR Ltd's Director's Report for FY2008: "During the same period, due to turmoil in the global financial sector, BFSI services revenue also declined sharply." 

The latter reported a profit of Rs12.12 crore, a fall of 65% over the previous year, while the former reported a 125% growth in profit. How do these two cases correlate? Well, both operate in the same environment and the same industry.

Controllable vs Non-controllable

With ABC Ltd, the downfall in profit was due to external factors, something companies rarely are able to influence, rather than internal factors such as cost saving, which it dutifully took care of to no avail. Meanwhile, the management of XYZ Ltd was farsighted and had implemented a risk management strategy by diversifying its portfolio.  PQR Ltd is a case of how a company can falter by not being alert to trends forming in the industry.

How business environment affects companies

An environment builds the platform on which a company survives and grows; it has to be supportive to the business's growth. Not too many companies can continue to grow when their economic environments are clouding over. The basic economic factors hold true while looking for a business to invest in. Does the demand-supply equation favour the company's operation to be viable and make money? Of course, that is the idealistic scenario, but the viability of the business centres on the broad parameters of demand and supply in the industry.

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