Comparing a Company with Its Direct Competitors

Fundamental analysis, while generally thought of as applying to a single company, has equal importance in comparisons between corporations in the same industry. This is where the idea of normal margins, rates of growth, and all other statistical results can be put into perspective.

Comparisons within a single industry help to demonstrate the relative strength or weakness of the subject corporation to the norm and to other companies. It helps to identify not only which company is the leader today (in terms of competitive market share and profits, for example), but how that comparison changes over time. You should never assume that today's leaders will continue to lead in the future; company-to-company comparisons should play a significant role in your fundamental program—not only because comparisons can be made more valid in that manner, but also because emerging changes are the most likely form of fundamental analysis that will change a hold decision to a sell decision.

e KEY POINT

Today's industry leaders can change. Never assume that the current status within a particular industry will remain the same forever. Change is the only constant.

First, what is the subject company's position in the industry? You might want to invest in the clearly dominant company today and then monitor that position, deciding to hold as long as the company remains dominant. Or, you might want to try and use fundamental indicators to pick a likely heir-apparent to that position, the competitor that seems destined to take over the lead. The leading company's stock might be overvalued in comparison to another company in the industry, so that correctly forecasting the leader a decade from now could be more profitable than investing in the industry leader. That is more easily said than done, however; no one can know how the future will shape up, and it is very difficult to pick future industry leaders, even with the best fundamental analysis available.

As new leading industry competitors emerge, a series of events occurs that is worth watching. These events may include:

•   Increased share of sales relative to other competitors

•   Attraction of higher-quality management talent

•   Innovation in new product and service technology

•   Increasingly higher ratings for customer service

•   Excellent reputation for relations between management and employees

•   Rapid and profitable expansion of geographic markets

•   Well-conceived expansion in lines of business; that is, diversification

Many other indicators will add to the equation. The absence of these and other attributes does not eliminate a company as a future leader; and the presence of these attributes does not ensure a change in leadership either.

A mistake made by many investors, especially in comparisons between companies within a single industry, is to assume that things never change; for example, that IBM will always lead the computer industry or Woolworth's will always lead in the retail sector. But change is not only inevitable; it is the nature of free enterprise. Change occurs as an attribute of competition itself. As competitors threaten to take over market share, others in the industry try harder, innovate more, take greater risks, and fight to not only hold on to what they have but to expand. New technology opens new markets, just as new generations of people create new consumer demands. The radio was replaced by the television, which today is being replaced rapidly by the Internet. It is difficult to imagine what future technological changes and consumer demands will drive markets, but by always being aware of the nature of change, you probably can spot industry changes as they begin to emerge.

No one should pretend that fundamental analysis—which is based on history—can accurately predict future trends and changes in competition and markets. However, the fundamentals are valuable precisely because of what they do provide: the first indications of change. It is not enough to identify change and then determine whether it is positive or negative. You also need to be able to understand why change occurs. For example, let's say you have invested in an industry that is losing profitability. These changes will show up in the fundamentals. By careful study of those trends, you may determine that it is time to sell. However, you also identify the cause of the change, which points to greater potential in a different industry. This gives you the clues you need to know where to invest your capital to maximize future growth.

eKEY POINT

Fundamentals cannot predict the future, but the insightful analyst can use fundamentals to identify the first indications of emerging changes.