Know the Business You are Investing In

Know the Business, Investing

One of the most admired gurus of investing, Warren Buffet belongs to the school of value investing. Value investors look for securities with prices that are unjustifiably low based on their intrinsic worth. But this is quite difficult to find from just observing stock prices or markets. Know the business you are investing in as investments will truly give you the full power of compounding and provide stable everlasting returns.

One needs to do a lot of homework in understanding the fundamentals of a company to get a reasonable estimate of its Intrinsic Worth or Fair Value. Value investors hunt for companies or stocks that are under priced. In other words they look for stocks that trade below their Fair Value just the say may regular shoppers look for discount deals. But the level of analysis and information required is more complex and intuitive in case of stocks or investing.

For more on Warren Buffet’s investing style one Value Investing you can read “Warren Buffet’s Investing Style” written by me in the past.

We will try to understand each aspect of the business and the company gradually. One must try to understand in detail instead of having a vague idea or fad or fancy theme that one hears on TV or from a friend. However, in many cases it would be difficult for laymen (including me) to know the entire spectrum of a company or its business, but atleast I should know what it is doing currently, what are the future prospects and how the business s model works in general.

Know the Business

My friend Mr.Champaklal invested in an IPO of a tech company whose credentials were not well known. On further questioning he smartly answered by saying that the company is in to information technology solutions and services to financial services firms. He said he expects some listing gains if market is good, else he can sell out with a marginal gain or loss.

On listing he lost a lot of money because the market price came down to one-fifth of its original price – meaning a whopping 80% fall!  This clearly shows a case where the investor is just acting like a punter or gambler. Although Champaklal smartly answered my questions he was not aware of the company and its business. He has some surface level knowledge which he read or heard somewhere.

Before you Know the Business you are Investing Into – Know the Following

  1. What does the company do?
  2. Which industry does it belong to?
  3. Does the company have presence in one segment or multiple segments within the industry?

For example Indian Hotels Company, one of the largest hotel chains in India is a part of the Tata Group. The company and its subsidiaries are also known as Taj Group of Hotels and Resorts.

What Does the Company Do?

It is in to hotel business and provides hospitality and other ancillary services.

Which Industry Does It Belong To?

The company belongs to the hotel (hospitality) industry in India.

Does the Company have Presence in One Segment or Multiple Segments within the Industry?

The company operates in the luxury, premium, mid-market and value segments of the market. For example – For each segment the company has different brands: Taj for luxury, The Gateway hotel for premium/mid-market and Ginger for economy or value segments.

Disclaimer: The examples discussed here are only for illustrative purposes. They are not a recommendation to buy/sell or hold.

Know the Business – Business Model & Streams of Revenue

The business model or revenue model of a company could be straight forward in some cases and too confusing in other cases. Since we are all involved in our own occupations, jobs and professions we may not have the time to analyze and research on companies or industries and business models. However, we must have some basic idea about how the company makes revenues.

For example BPCL (Bharat Petroleum Corporation Ltd.) derives most of its revenues from its core business of selling and distributing petroleum products and by-products. There are lakhs of petrol bunks or stations in India retailing petrol, diesel, engine oil and other by-products.

Companies in this segment such as HPCL, BPCL and IOCL are commonly referred to as ‘oil marketing companies’. The revenues are dependent on retail petrol prices which are controlled or regulated by Govt. to an extent and also subsidized by government.

Lets take a global technology products company Oracle. The company is primarily in to developing products, maintenance, consulting and related activities. The business model can be broken up in to the following components:-

  • Licensing:
  • Customization
  • Maintenance

To put it in simple language revenues for the company come from these three activities or steams. For a better understanding please read the table below to understand each activity and revenue pattern.

Business Component

Description of Activity

Revenue Pattern

Licensing Initial sale and set up/installation services One time license revenue
Customization Configuration and customization according to customer’s needs in terms One time or ad-hoc
Maintenance Annual maintenance contracts Stable revenue for contracted period

We spoke about BPCL, but what about companies like ONGC, Cairn, etc.? These companies are in to oil/gas exploration and production and belong to the oil exploration segment. So we have Oil Industry which can be broken down in to two segments – Oil Exploration/Production and Oil Marketing.

The exploration companies have a different business model. They sell crude oil or gas and the pricing for these are based on international crude or natural gas prices. The revenue for oil exploration companies would be a factor of the total sales volumes and price per unit.

Is the Business Model strong and sustainable?

Once you know the business of the company and the revenue model, the next step is to make an assessment of how good it is? If you find that the business model of a chosen company is not good, then start looking for alternate options or stick with leaders in the industry.

The tech company that Mr. Champaklal invested is not at all comparable to players such as TCS, Infosys or Wipro. Although the big three IT companies go through ups and downs, they have a strong history and experience behind them. These established players also have stable revenues streams for the next few years given their well-planned pipeline of projects.

For most established industry the strength of the business model can be gauged. But one has to answer the question whether it is sustainable in future or whether the company will generate growth and thrive in future. Businesses such as Fast Moving Consumer Goods (FMCG), banking, personal care, autos (particularly 2-wheelers), etc have a good potential given that they have a significant domestic demand and growth story to take them forward in the coming years and decades.

Nascent Industries & Companies

For a new or nascent industry like doc com industry in the year 2000. This was a new industry emerging and there were hardly any proven business models, so there was not much data or past history to rely. These companies are to be avoided.

A company getting in to a new segment or launching a new product is risky, but when the whole company’s operations are in a nascent industry its better to avoid unless you are a professional venture capitalist or investment banker who has the knack of picking start-ups that can become tomorrow’s multi-baggers.

How do I pick the Best Businesses?

There is no strict formula or method to accomplish this. If we did have such a methodology most of us would be millionaires and market gurus by now. This also requires one to take risks, have patience to invest for long term and have conviction in the business potential. If things go wrong despite all efforts, one must try to book losses and readjust their portfolio accordingly. There are a few pointers which can help you pick businesses with good potential:-

  1. Try to select industries or sectors that are fairly well established
  2. Select a few leaders from an industry or industry segments (e.g. Hindustan Unilever, Nestle in FMCG)
  3. Avoid small, new or unknown players
  4. Observe the growth and past trends and performance of the company over market cycles
  5. Assess the future potential and sustainability (will the company survive in the next decade?) Can it adapt to new changes in technology, regulations, market conditions, etc.

Common Sense and Experiential Knowledge

One must use common sense and experience in addition to financial data and prices. Which company is going to get affected by the slowdown in US and Euro regions? A software export company or a company selling washing powder? The software company should get affected assuming it has significant exposure to US/Euro markets, but the washing powder sales are not going to see much impact.

There are some industries that thrive irrespective of economic conditions – e.g. toothpastes, medicines, food, consumer goods, personal care products, etc. Moreover all segments within an industry will not be affected equally – for example a slowdown in jobs may lead to slowing of car sales, but two-wheeler sales may remain stable.


Let me conclude with a simple analogy. Lets say you have Rs.1 lakh to invest. You can invest it in a bank or you can lend the money to Mr. Khanna who wants to start a business. The bank offers 9% interest p.a. whereas Mr. Khanna offers 18% p.a. Obviously the bank is safer because you know what the bank does with your money – it basically lends to individuals or companies at a higher rate of interest to earn and pay your interest.

Similarly, established companies with proven business models have a systematic way to generate huge cash flows that are sufficient to run the business and provide stable return on equity.

Know the business you are investing in, as understanding the fundamentals of a company will provide you a better insight into their profit pattern and helps you in making a better investment decision.


About the Author

Sridhar is a financial analyst and his work experience spans areas of financial analysis, modeling, valuation and research on companies, specific sectors, etc. Sridhar is an MBA graduate with Finance major from Maharishi Institute of Management.

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