There are two generally accepted ways to look at stocks and
determine whether they are worth purchasing or not. This chapter will
concentrate mostly on Fundamental analysis, as this is the main underlying
factor behind most of the successful strategies that were researched. However,
technical analysis is also very useful to know and should not be neglected.
Both ways of analyzing stocks should be included in a successful investor's
strategy because both provide information about the stock and its price
movements that should not be missed.
Fundamental Analysis is a term for a technique for looking at
a security such as a stock or a bond and analyzing its value by looking at
certain underlying factors behind that specific security. As discussed before,
a purchase of a stock is a purchase of a certain part of a living breathing
corporation. Successful investors have always performed fundamental analysis in
order to determine how much a security that they are looking at is worth.
Investopedia calls it the cornerstone of investing. It does however merit to
say that a growth investor and a value investor will look at different aspects
of the company's fundamentals differently, each will undoubtedly perform
fundamental analysis in order to know what he or she is putting his money into.
By looking at certain fundamentals of a company, industry or a whole economy,
the investor can make educated guesses as to the well-being of the company he
or she is looking at. Some questions answered by fundamental analysis
include
· Is the revenue growing?
· Is it making a profit?
· How does the company stack up against competition?
· How is the industry the company is in is doing?
· How deep is the company in debt?
· How free is the cash flow through the company?
· Is there evidence of «creative accounting»?
· And many more.
However, all these questions really boil down to one specific
question. Should I put money into this stock and is this a good investment
which will make my money work for me?
The real purpose of doing any kind of fundamental analysis
for any security is essentially finding out the security's intrinsic value.
Essentially, this is based on the rejection of the Efficient Market Hypothesis
because after all, if the market were always correct in its pricing, there
would be no reason to look for undervalued stocks. This essentially brings
another assumption: In the long run, the market will reflect the fundamentals
of the company and price the stock accordingly. According to Warren Buffet,
«In the short term the market is a popularity contest; in the long term it
is a weighing machine."11 The trouble is however, that the long run
may be just a few weeks or a few years and knowing the exact time frame is
impossible. The other problem is that one doesn't know if his valuation of the
intrinsic value is correct. As previously mentioned, there is no correct way to
determine intrinsic value, and different investors will come up with different
valuations.
Technical analysis, on the other hand is at a completely
different range of the spectrum. While fundamental analysis is concerned mainly
with the value of the company behind the stock, technical analysis looks more
at the price and volatility patterns of the stock rather than the company
behind it. Technical
11 Robert Hagstrom, The Warren Buffet Way( 103)
analysts are generally interested in the price movements of
the stock on the market. Essentially it studies supply and demand and by the
direction of the charts, technical analysis attempts to determine where the
stock will head. Technical analysis assumes that the price of the stock will
always reflect all the information about the company and the market that the
price moves in trends, and that price movements repeat.
Another main way that technical analysis differs from
fundamental analysis is the time horizon. Technical analysts will look at data
in months, weeks, days, hours and minutes in order predict future price
movements. They are often called swing traders because they do not hold on to a
stock for a very long time. Fundamental analysis however focuses on a time
frame of years, looking at num bers from financial statements of the past five
years in order to determine the value of the company. In addition, things like
management, brand recognition, and other qualitative factors that fundamental
investors look at can only be analyzed by looking at historical data from years
ago. The fundamental investor will hold on to a stock for a number of years,
because he or she believes that in the long run, the market will reflect the
intrinsic value of the stock.
Fundamental Analysis
Here, this paper will focus on fundamental analysis, or
analyzing the company behind the stock. When performing fundamental analysis,
there are two types of factors that comprise the fundamentals of any given
company. The first and the most obvious type that one might expect to look at
are the quantitative factors. These are capable of being measured and expressed
in numerical terms. Examples of these can be Assets, Liabilities, Revenues,
Expenses and many other factors found on the financial statements of a company
as well as on the internet. Qualitative factors, on the other hand, include
everything else. Things that cannot be measured such as the efficiency of
management, brand value, future outlook, patents, proprietary technology,
competition, and everything else about a company that cannot have a specific
number assigned to it. Qualitative factors are the largest reason why when two
different investors are given the same figures, they can come up with two
drastically different valuations of the company. These factors cannot be
measured, but comprise a large portion of the intrinsic value of the
company.
Qualitative Fundamental Factors
10k and 10q
Before discussing qualitative fundamental factors, it is
important to mention these annual reports of a company's performance that have
to be submitted either yearly (10k) or quarterly (10q) by publicly traded
companies to the SEC. The 10k usually contains company history, organizational
structure, and much other information not contained on the annual earnings
report. The 10q discusses the company's financial position and performance.
These can both be pulled up from the EDGAR database at
secinfo.org along with the annual
report and other SEC filings by companies12.
Company Level
Business Model
When Warren Buffet invests in a stock, he makes sure to treat
the investment as though he were buying the whole company.13 And
anyone buying a whole company would like to know its business model, and
understand it. The business model gives the answer to the most important
question - how does the company make money. It's possible to get a good
overview of the business model by looking at the company's website or checking
out the company's 10k filing (described below). In addition to looking over the
business model, it's necessary to understand it. Buffet talks about a circle of
competence, by which he means knowledge of a particular sector. He does not
invest in tech stocks not because he is afraid that they are too volatile, but
rather because they are out of his circle of competence - he does not
understand them. If an investor cannot understand a company's business plan, he
does not know what the drivers are for future growth, and investing in it could
be extremely risky.
12 Can be found at
secinfo.com
13 Robert Hagstrom, The Warren Buffet Way
Competitive Advantages
The competitive advantage of a company is also extremely
important. If the company does not differentiate itself from its competitors,
what is there to keep it in business? It can't get more market share, and
therefore is stifled in growth. Michael Porter, a Harvard Business School
Professor says that very few companies can compete successfully if they are
only doing the same things as their competitors. He argues that sustainable
competitive advantages can be obtained in several ways:
· Unique position in the market place
· Clear tradeoffs and choices vs. competitors
· Activities that are tailored to the company's strategy
A high level of integration across activities (The activity
system)
· A high degree of operational
effectiveness14
Signals of these factors can be seen in news reports, and also
the investor can get clues to these by looking at the financial statements
(discussed below).
Management
What good is a great business plan when the management is a
bunch of crooks, or they are stupid enough not to implement it correctly? Every
investor needs to know a lot about the management of the company. While
individual investors can't really get a face to face meeting with managers like
analysts that work for multi-million dollar funds can, it is possible for the
average investor to get a good feel for management in several different
ways.
Conference calls are hosted quarterly by the CEO and CFO of
the company. The first portion of the call is dedicated to reading off
financial results, but the really juicy part is the question and answer part.
This is where the line is open and different analysts can ask questions from
management. The answers here can be revealing, because analysts know what to
ask. But the more important part is how the management answers. Are they
answering like politicians or are they straightforward about their answers.
In addition, the Management and Discussion portion of the
annual report is where the management gets to be honest about the company's
outlook and is fully at management's discretion. A good thing is to look at
some annual reports from several years ago and compare them and see if the
management has followed up on what they have said and if the changes they
wanted to make have been implemented.
If the people who run the company have a material interest in
its success, they are more likely to work harder to make it succeed. The
investor should look for a large stake in the company to be owned by insiders.
It is especially crucial for small cap companies as management is crucial in
the success of the company, and the investor should look for management to be
invested in the company. In addition, it is worth noting that while insider
buys are worth looking, insider sells are worthless information, unless several
key executives are selling at the same time. The reason for this is that people
sell stock all the time to finance their child's education, make a down payment
on a house, or many other different reasons.
14 Michael E. Porter, Cynthia A. Montgomery, Strategy:
Seeking and Securing Competitive Advantage. (182)
Industry Level
Assessing the company in relation to its industry can help the
investor to obtain an understanding of different external factors affecting the
company and how in control the company is of those factors. Customers
Some companies only cater to a few customers, while others
serve millions. A big red flag comes up when a business relies on only a few
customers for a large portion of its sales simply because of the question, what
if they go away? For example, if a company has the government as its sole
customer, what will happen to the company when there is a policy change and the
government no longer requires the company's product?
Market Share
The market share of the company can tell the investor a lot
about the company itself. If the company possesses most of the market share,
the investor can judge the stability of the company in the industry. In
addition, companies that hold a large amount of market share have an economic
safety guard against competitors and because of economies of scale they are
capable of absorbing costs a lot better and still maintaining the lead.
Industry Growth
If the industry where the company operates has a bleak outlook,
how can the company grow? This factor needs to be carefully considered before
investing in any company.
Competition
Some companies have one or two competitors while others can have
hundreds. Companies with hundreds of competitors can have a harder playing
field compared to those with only one or two.
Regulation
Is the company's product regulated? For example in the
pharmaceutical industry, the FDA has to approve any drug before it reaches the
market. This can take years and billions of dollars. This needs to be
considered in the attractiveness of the investment.
Several Guidelines for Performing Fundamental Analysis / Looking
At Ratios
When performing fundamental analysis, it's important to keep
several things in mind regarding ratios and other numbers. The first and one of
the more important things is that ratios are best looked at as a long term
trend. Even though it's useful to compare a ratio to a universally accepted
standard, or the industry, a ratio compared over five or ten years can tell a
lot more about a company. In addition, as previously mentioned the validity of
some numbers found on the financial statements often needs to be questioned and
adjusted in order to get a clearer picture. It is the investor's job as a
detective to provide him or herself with a clear picture of the company he or
she is buying. Furthermore, it is important to look at a number of different
factors and ratios that reveal important facts about the company's risk and its
potential because there is no indicator that will tell everything. Fundamental
analysis becomes a valuable tool when the investor begins to review trends,
each developed from tests of different ratios. It is also important to
understand that goals need to be set by the investor for him or herself in
terms of ratios. For example with the P/E ratios the investor may want to make
a goal to sell when the ratio hits a certain point because at that point the
company is not worth holding or could go down.
