Some of the real values of fundamental analysis

Ever notice how there’s always a new wonder diet promising to make you healthier? More times than not, though, it seems these things never work. Getting healthy comes back to the basics — a balanced diet and exercise.

The same goes with investing. Believe it or not, investing can be full of fads. There’s always a new investment pundit or economist with a novel way to pick winning stocks. And just as an hour on the treadmill will do you more good than a miracle diet, successfully choosing stocks often comes back to fundamental analysis.

Fundamental analysis is the classic way to examine companies and investments for a variety of reasons, including the fact it is:

• Based on fact, not opinion: It’s easy to get caught up in general enthusiasm about what a company is doing or the products it’s selling. Fundamental analysis blinds you to this investment hype and gets you focused on cold-hard business realities. It doesn’t matter if all the kids in your neighborhood are buying a company’s products if the company isn’t making any money at selling them.
• Good at pinpointing shifts in the business’s health: If a company’s success is starting to fade, you’ll see it show up in the fundamentals. No, there won’t be a giant sign saying “Sell this stock.” But there are clues if you know how to look, as you’ll discover in Chapter 18. Companies are required to disclose key aspects of their business, so if there’s a problem, a fundamental analyst will often be early at spotting some trouble.
• All about execution: Companies’ CEOs are usually good at getting investors focused on the future and how things are going to get better next quarter. But fundamentals are based in reality. Just think of children who say how hard they’re working at school. The report card is still the tangible evidence of how things are actually going. The numbers don’t lie — if you know where to look.
• A way to put price tags on companies: What’s a painting worth? What’s a used car worth? The price of an asset with a subjective value is generally what someone else is willing to pay for it. The stock market, an auction of buyers and sellers, does a good job putting price tags on companies. But fundamental analysis gives you another way to see just how much investors, by buying or selling stock, are paying for a stock.

Driving home an example

One of the best examples of how fundamental analysis can help you and your portfolio is General Motors. It’s one for the history books of capitalism. For decades, GM represented the might of U.S. industriousness, know-how, and creativity. GM commanded a massive market value of $3.5 billion in 1928, says Standard & Poor’s. I’ll step you through what market value means in more detail in Chapter 3, but for now, just know that GM was the most valuable company by far in 1928.

For decades, investors figured a dollar invested in GM was money in the bank. The company slugged through upturns and downturns and was a lasting power that helped drive the U.S. economy. The company kept paying fat dividends and kept powering profits higher. There was even an expression: “As GM goes, so goes the nation.”

But investors who blindly bet GM would remain a lasting force and ignored the fundamental signs of trouble suffered a brutal blow on June 1, 2009. On that day, which will forever remain one of the lowlights of capitalism, GM became the fourth-largest public company to seek bankruptcy protection, according to BankruptcyData.com. Shares of GM stock collapsed to just 75 cents a share, down 97 percent from their level just three years before.

Fundamental analysis may not have helped you predict just how shocking GM’s fate would be. But concrete elements from the company’s financial statements could have tipped you off to how challenged GM was well before it became a penny stock and was liquidated. GM was ultimately reborn when a new company was created and bought many of the old company’s assets, including the GM name. You can be sure that investors in the new GM paid much closer attention to the fundamentals.

Putting fundamental analysis to work

It’s easy to get consumed with the fast-money trading aspects of stocks. TV reports about stocks on the move and companies that have new products practically turn investing into a sporting event. If you listen to some traders talk, they rattle off companies’ ticker symbols in rapid-fire delivery just as sports fans talk about teams. Flashing arrows and rapid trading can become an addiction.

Fundamental analysis is trying to help you avoid this insanity. Stocks rise and fall each minute, day, and week based on a random flow of news. That’s mostly noise to a fundamental analyst. The constant ups and downs of stocks can sometimes confound logic and reason. Trying to profit from these short-term swings is a game for gamblers and speculators. It’s futile on a long-term basis.

But that’s not to say investing is gambling. When you buy a stock, you’re buying a piece of ownership in companies that make and sell products and services. You’re buying a claim to the companies’ future profits. Owning a piece of a real business over time isn’t gambling, it’s capitalism.

Fundamental analysis forces you to focus on investing in businesses, not stocks. You’re not buying a lottery ticket, but a piece of ownership in an actual company. Sometimes this gets lost by investors who pay more attention to stock charts than to financial statements.

If jumping in and out of stocks at the right time isn’t the way to riches, then what is the trick to successful investing? The answer is to stop thinking of stocks as just symbols that gyrate each day. The goal of fundamental analysis is to help you step away from the short-term trading and gambling of stocks. Instead, you approach investing as if you’re buying a business, not rolling the dice.

Fundamental analysis ideally helps you identify businesses that sell goods and services for more than what they paid to produce them. Fundamental analysis is your tool to evaluate how good a company is at turning raw materials into profits. If there’s an investor who best personifies fundamental analysis over speculation, it’s famed investor Warren Buffett of Berkshire Hathaway. Buffett is one of the best-known users of fundamental analysis — in fact, he’s so confident in his analysis of a business he’ll often buy very large stakes and hold on to it for decades. You will read more about how Buffett applies fundamental analysis to investing in Chapter 3.

No matter how you choose investments currently, you can likely apply fundamental analysis. Even if you’re the kind of investor who likes to buy diversified mutual funds and hold onto them forever, called a passive investor, it can be helpful to understand basic financial characteristics of the companies.

Knowing what fundamentals to look for

Knowing what makes a company tick isn’t as convoluted as it may sound. Companies are so regulated and scrutinized, all the things you need to pay attention to are usually listed and published for all to see. Generally, when you hear about a company’s fundamentals, the key elements to be concerned will fall into several categories including:

• Financial performance: Here you’re looking at how much a company collects from customers who buy its products or services, and how much it keeps in profit. Terms you probably hear quite a bit about, such as earnings and revenue, are examples of ways fundamental analysts evaluate a company’s financial performance.
• Financial resources: Companies don’t succeed long term simply selling goods and services. It’s not even enough to turn a profit. Companies must also have the financial firepower to invest in themselves and keep their businesses going and growing. Aspects of a business, such as its assets and liabilities, are ways to measure a company’s resources.
• Management team: When you invest in a company, you’re entrusting your money to the CEO and other managers to put your cash to work. Fundamental analysis helps you separate the good managers from the bad.
• Valuation: It’s not enough to identify which companies are the best. What’s a “good” company anyway? Definitions of “good” can run the gamut. You also need to consider how much you’re paying to own a piece of a company. If you overpay for the best company on the planet, it’s still likely you’ll end up losing money on the investment. You’ll read more about valuation in Chapter 10 and Chapter 11.
• Macro trends: No company operates in a vacuum. A company’s performance is highly influenced by actions of competitors or the condition of the economy. These broad factors need to be incorporated into fundamental analysis, as you’ll discover in Chapter 15 and Chapter 16.

Knowing what you need

One of the great things about running as a hobby is all you need is a pair of decent shoes. And basketball? Just grab a ball and find a hoop. No fancy equipment is required. The same goes with fundamental analysis. Much of the data you need is provided free by companies and can be accessed in seconds from any device connected to the Internet.

Fundamental analysis can get pretty involved. But in its most basic form, fundamental analysis has just a few basic ideas behind it, including:

• Awareness of the benefits: Because fundamental analysis takes some know-how and time spent learning a bit, you’ll want to know ahead of time why you’re going to the trouble. Chapter 2 and Chapter 3 highlight the payoff of fundamental analysis. Even if you’re a passive investor, or one who simply buys a basket of stocks and holds on, there are reasons why fundamental analysis might be worth your while.
• Retrieval of financial data: Getting all the key data you need to apply fundamental analysis is easy, if you know where to look. Chapter 4 gives you quick tips on how to round up all the company financial data you’ll need.
• Basic math: There it is: The M word. There’s no way around the fact there will be some number crunching involved in some aspects of fundamental analysis. Don’t worry, I’ll guide you to help keep the math as painless as possible.

Staying focused on the bottom line

If there’s one thing investors may agree is of upmost importance, it’s the company’s profitability. When it comes down to it, when you invest in a stock you’re buying a piece of the company’s earnings. Knowing how to read and understand how much profit a company is making is very important when it comes to knowing whether or not to invest.

The income statement, described in full detail in Chapter 5, will be your guide when you’re trying to determine how profitable a company is. What might also surprise you is that the income statement can tell you a great deal about a company, in addition to just how much income it brings in.

Sizing up what a company has to its name

During times of intense financial stress, investors often make a very important mental shift. They’re not so concerned about making money as they are about just getting their money back. Similarly, when things get tough in the economy, investors are less interested in how profitable a company is and are more mindful of whether a company will survive the economic downturn.

When you’re trying to understand the lasting power of a company, fundamental analysis is of great value. By reading the company’s balance sheet, you can get a rundown of what a company has — its assets — and what is owes — its liabilities. Monitoring these items gives you a very good picture of how much financial dry powder a company has to endure a tough period. Chapter 6 explores the balance sheet in more detail.

Burn baby burn: Cash burn

One of the biggest killers of companies, especially smaller firms just starting out, is poor cash flow. While a company might have a great product concept, excellent management, and even dedicated financial backers, timing is everything. If a company is using up cash to pay its bills and employees but not bringing in enough cold, hard cash from customers, it can run into a giant financial headache very quickly and not have enough cash to reach its potential.

If there’s one thing I hope you pick up from this book, it’s how fundamental analysis helps you keep a close eye on how much cash is coming into and out of a company. Monitoring cash flow is critical to know if a company is running perilously empty on cash, which you’ll dig into in more detail in Chapter 7. Tracking a company’s cash flow is also a very important way fundamental analysis helps you put a price tag on that company, as you will find out about in Chapter 11.

Financial ratios: Your friend in making sense of a company

As you flip through this book and jump around to different topics that interest you, you might be a bit bewildered by just how many pieces of financial data fundamental analysts must deal with. You’ve got the financial statements that measure just about every aspect of the company. It can be intimidating to decide what numbers matter most and which ones can be ignored.

Financial ratios will be a great help here, as you’ll see in Chapter 8. These ratios draw all sorts of fundamental data from different sources and put them into perspective.

Financial ratios are also important because they form the vocabulary of fundamental analysts. If you’re ever at a cocktail party where analysts are talking about gross margins and accounts receivable turnover, I want you to be prepared. By the way, that sounds like a pretty boring party.

I’ll show you a whole host of financial ratios in Chapter 8 that are the favorites used by many fundamental analysts. You’ll soon be using seemingly unrelated pieces of financial data about a company to glean some very important conclusions about the company.

Using fundamentals as signals to buy or sell

Buying a stock at the right time is very difficult. But knowing when to sell it is even tougher. And while fundamental analysis won’t tell you the exact best time and day to buy or sell a stock, it can at least give you a better understanding of things to look out for when it comes to making decisions.

If you’re a passive investor and buy large baskets of stocks, such as those in the Standard & Poor’s 500 Index, you can afford to buy and hold the stocks as a group. Even if one company runs into big-time trouble, it’s just one holding in a large basket of stocks and not all that catastrophic. However, if you choose to invest in individual stocks, trying to pick companies you think will beat the market, monitoring the fundamentals is critical. If you start noticing a company’s trend deteriorating, you don’t want to be the last investor to get out.

The perils of ignoring the fundamentals

Blindly following a company and investing in the stock can be very dangerous — if you pick the wrong one. The dot-com bubble and subsequent financial crisis of 2008 and 2009 are still the best and most dramatic examples of how ugly things can get for investors who buy what’s popular and ignore the fundamentals. Table 1-1 shows a list of a few major U.S. stocks that were worth $100 a share or more at the beginning of 2000, but saw their share prices fall to below $10 a share by the start of 2009. Time will tell if the 2022 wipeout in meme stocks will end the same. Ouch!

Avoiding stock disasters like those in Table 1-1 is one thing that makes fundamental analysis so powerful. Losses that large are nearly impossible to recover from in a single person’s lifetime. You can read more about why avoiding investment disasters is so critical in Chapter 18.

Using fundamental analysis as your guide

As Table 1-1 shows, investing in individual stocks is very risky. That’s why if you’re going to buy individual stocks, you want to invest with your eyes wide open. Just as you probably wouldn’t dare fire a loaded weapon or jump out of an airplane without proper training, the same goes with investing in individual stocks. And it’s not just ancient history. Take GameStop, an online retailer whose shares investors pushed up to nearly $350 a share in early 2021. By mid-2022, GameStop shares lost half their value, falling to roughly $120 per share.

Luckily, fundamental analysis provides investors with a host of very specific tools to help them protect themselves. And while the tools of fundamental analysts aren’t foolproof, they give investors guidance of when a stock might be getting a little dangerous or the underlying trends might be changing.

Hopefully, by reading this chapter you’ll see why fundamental analysis is so important and be eager to see how the rest of the book can help you. You’ll find complete explanations of some of the most powerful tools used by fundamental analysts in this book. Chapter 11, for instance, will be very valuable to you because it shows you how to use a company’s cash flow as a way to measure its value. And in Chapter 12, you’ll discover how the pros spin through the annual reports they receive from companies.