Picking stocks for fundamental reasons

Value investors are often drawn to the idea that they can get an edge on other investors by doing their homework and studying a company’s financial statements. These investors believe if they put in the time to understand a company’s business, accurately forecast its future, and pay the right price, they can achieve greater upside and less downside than the market as a whole.

There’s some truth to this. Academic studies have shown that stocks that are cheap, or value priced, tend to have strong long-term performance.

Need proof? Table 3-1 shows how so-called value-priced stocks have performed compared with so-called growth stocks. Value-priced stocks are those that are cheaper than the market based on fundamental metrics, like the ones you’ll be hearing about a great deal in this book. Growth stocks are those that are more expensive than the market. The numbers speak for themselves. Cheap stocks win over the long term. And it gets better: The edge of value stocks carries over to companies of all sizes — large or small.

Fundamental analysis can also help you protect yourself from your own speculative juices. By studying the cold, hard numbers of a company’s business, you can get a strong dose of reality while other investors get caught up in the hype surrounding a particular stock. Because fundamental analysis is based in the laws of business, it can give you a greater perspective on how much an investment is worth.

Fundamental analysis allows you to have a pretty good idea of what a company or stock is worth, even before you buy it. That’s critical in investing where the prices of stocks aren’t always the same as the value of the company. How can that be?

Value and price are determined by two very different things. A stock’s price is determined by an auction, very similar to how the price on a Pez dispenser is set on eBay. Investors frenetically buy and sell stocks every trading day, pushing the price up and down based on how optimistic or pessimistic they are about a company’s future potential that second or even nanosecond. Just as you can see a bidding war erupt over a Pez dispenser and push its value to extreme highs, the same can occur for a stock if many investors are willing to buy it.

A company’s value is very different — and quite disconnected from the noise on Wall Street. A company’s value is a mathematical measurement of what the company is worth based on how much profit it generates and how much growth it’s expected to generate. The value of a company doesn’t change second to second. Quite the opposite.

John Bogle, now deceased founder of the Vanguard investment company, separates the true value of companies from the market value determined by Wall Street noise. Bogle says the value of companies is determined by the slow creep upward of their dividends and earnings, which he calls the investment return. Then there’s the speculative return, which is the price that traders are willing to pay for shares of that company at the moment. Speculative returns aren’t rooted in anything other than how much traders are willing to pay. When you start paying more attention to the speculative gains, you’re setting yourself up for trouble. “In the short run, speculative returns are only tenuously linked with investment returns,” Bogle says. “But in the long run, both returns must be — and will be — identical.” In other words, the company’s market value will eventually match the fundamental value.

A great example of how fundamental analysis can help you spot a frenzy over a stock, causing its price to get out of line, occurred in March 2000. (Incidentally, the dot-com boom is still one of the best eras in recent memory for showing the danger of speculation.) Shares of Palm Computing, a maker of the Palm electronic organizer (remember those?), soared 150 percent in their first day of trading to more than $95 a share. At that price, investors put a total price tag of $54.3 billion on the company and its 23 million shares.

Just a little bit of fundamental sleuthing could have protected investors from the coming brutal collapse in the stock. Here’s how. Palm Computing was 95 percent owned by its parent company, 3Com, at the time. And the entire value of 3Com, including its 95 percent stock in Palm Computing, was just $28 billion. So why would investors be willing to pay nearly twice as much for a 5 percent piece of Palm than they would the entire parent company, 3Com? This kind of madness shows investors lose sight of fundamentals. It’s kind of like paying $20 for a slice of pie when you can buy the whole pie for $10. Fundamental analysts knew something was a little off. And they were right. The stock lost more than 70 percent of its value in just seven months. Ouch!

Dooming your portfolio by paying too much

No matter what type of investor you are, there are several absolutes. Here’s one of them: If you overpay for a stock, you’re accepting a sentence of poor long-term returns in the future. Your return on a stock is a function of how much you pay for it. By definition, the more you pay for an investment, the lower your return will be.

Imagine you have the opportunity to buy a Laundromat. The Laundromat has been open for 30 years, and in each of those years, it generates a profit of $100,000. Because the Laundromat is in a strip mall that will close in five years, you figure the business will generate $500,000 in profit over the years and then will be shut down.

To keep this example simple, forget about the role of inflation, or the decreasing value of money each year, at this point. Also assume that your estimate was correct, and the Laundromat generated $100,000 a year in profit.

Just imagine what would happen if you offered to buy this Laundromat for $200,000. Your gain would be 150 percent. You know this because your profit is $300,000 because that’s the difference between the Laundromat’s earnings ($500,000) and what you paid ($200,000). Your return is your profit of $300,000 divided by the price you paid, $200,000.

Now, what if you got into a bidding war with another person interested in buying the Laundromat? In the heat of the moment, you offered to buy the business for $400,000 instead of $200,000. Your return will take a big hit, now equaling 25 percent. Nothing changed with the Laundromat. It will function the same whether you paid $400,000 or $200,000. But your return is now the profit of $100,000 divided by your purchase price of $400,000.

The same goes for investments, including stocks and bonds. If you increase the amount you pay for a share of stock, for instance, you eat into your return.

Overpaying for a stock is even more dangerous than increasing your offer for the Laundromat. If a company you invest in suffers a slowdown and its earnings are smaller than expected, you’ll find your return to be very small, or you may not get back what you invested.

Sitting through short-term volatility

Sometimes the excitement of daily market activity can get intoxicating. Ticker symbols scrolling at the bottom of the TV screen during financial programs can make you feel as if the markets are constantly moving and changing. And that’s true; markets are constantly moving as investors trade shares back and forth and push stock prices up and down. This is how the speculative return, as described previously, gets generated.

But a fundamental analysis can help you block out a great deal of this noise and be a better investor as a result. An example is perhaps with your house. Let’s say you’re living in a home you know is worth $400,000. You know that because you hired an appraiser to look at the condition of the roof, remodeled kitchen, and bath, as well as look at the prices of identical homes in the area. You have a pretty good idea of what the house is worth.

With this in mind, would you panic if you were sitting on the patio while a person walking by randomly offered you $200,000 for the home? Probably not. After all, you know the home is worth more than $200,000. Besides, you’re not in the market to sell anyway.

Still, that’s what stock investors commonly do when they pay too much attention to day-to-day movements in stock prices. They may have felt great about buying a stock for $10 a share, but if the stock falls to $8 a month later, they panic and wonder if they should sell. It doesn’t have to be that way.

One of the mantras of fundamental analysis comes from Benjamin Graham, the pioneer of the methods and mentor to Warren Buffett. Fundamental analysts will often say the market is a voting machine in the short term, but a weighing machine in the long run. In other words, stock prices can be kicked dramatically higher or lower in the short term. But over the longer term, the underlying value of a company will prevail, and its true heft will be recognized.

Fundamental analysis helps you focus on a investment’s true value, or weight, using Benjamin Graham’s analogy. If you know you correctly analyzed a company and assigned the correct value to it, then you don’t need to be as concerned about whether or not a company is popular or not in any given day, month, or year. Having a fundamental grasp of a company gives you the peace of mind to hold an investment for a long period of time and resist the urge to sell at the wrong time.

What is “the Warren Buffett Way”?

For many fundamental analysts, Warren Buffett is the ultimate role model. There’s no denying his success. Shares of Buffett’s Berkshire Hathaway rose from $65,500 a share to $417,700 in the 20 years ending June 2022 — an impressive 538 percent gain. That works out to about 9.7 percent a year on average. During that same time period, the Russell 3000 index, which measures the performance of the stock market in general, gained 9.2 percent in value including dividends, according to Russell Investments. Buffett’s longer-term record is strong, too. No wonder he’s called the Oracle of Omaha.

Trying to figure out Buffett’s secret is the investment world’s equivalent of the search for the Holy Grail. Scores of investors make the pilgrimage to Berkshire Hathaway shareholder meetings in Omaha each year, trying to figure out how Buffett does it. Hour-long lunches with Buffett auction off on eBay for hundreds of thousands of dollars. And there are countless books on Buffett, most notably The Warren Buffett Way (Wiley).

Interestingly, though, Buffett doesn’t make much of a secret of his techniques. Every year, in his letter to shareholders and also in Berkshire Hathaway’s “Owner’s Manual” he paints a picture of his approach. If you’re looking to up your fundamental analysis game, you’re wise to learn from the master. Much of Buffett’s approach is based in key elements of fundamental analysis, including:

• Invest as an owner, not a trader. Buffett is very clear that he looks at an investment not as a short-term trade, but a long-term relationship. Berkshire Hathaway will often invest in a company and hold it for a very long time, perhaps never selling the position. “Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns,” according to Berkshire’s Owner’s Manual.
• Consider carefully a company’s intrinsic value. Buffett repeatedly discusses intrinsic value, which is a measure of what a company is truly worth. Intrinsic value is how much cash a company is expected to generate over its lifetime, which is a good measure of what it’s worth. Buying a stock for less than its intrinsic value gives you a bit of a margin of safety. You’ll find out how to calculate a company’s intrinsic value in Chapter 11.
• Analyze management. Buffett routinely says even a seemingly ho-hum company can generate dazzling returns with a good management team at the helm. For that reason, Buffett will often leave the top officers and directors of a company in place, even after buying a company.
• Stick with businesses you understand. The better you grasp how a company makes its money and operates, the more informed you’ll be after reviewing its financial statements. You’ll also know better what to look for, because every industry and company has unique financial traits.
• Find businesses that have a real advantage. In capitalism, if a company has a good idea, other firms will try to copy it and steal away market share. Buffett combats that by investing in businesses with a strong brand or unique product, such as Coca-Cola.

Many an investor hopes to profit like Buffett without actually learning fundamental analysis. There are plenty of ways to do that. Investors who want to ride Buffett’s coattails could just invest in Berkshire Hathaway’s shares. Others try to mimic what Buffett does. Some investors try to figure out what Buffett is investing in by reading Berkshire Hathaway’s annual report, a document that discloses all the firm’s large holdings.

It’s never a good idea to blindly buy stocks just because another investor did. Still, reviewing the stocks that pass Buffett’s fundamental analysis might be a good place to start. The list of Berkshire Hathaway’s holdings in publicly traded companies can be found in the company’s annual reports, available here: www.berkshirehathaway.com/reports.html. Table 3-3 shows you what some of Berkshire’s biggest positions were at the end of 2021.

Blindly following moves of top investors isn’t an instant route to riches. That’s especially the case when trying to take cues from Buffett. Buffett constantly reminds his shareholders that he plans to hold investments for a long time. And his holdings can also suffer large losses in the short term. For instance, had you bought Apple at the beginning of 2021 after seeing it was a top holding at the end of 2020, you would have suffered a 22 percent loss by June. And he unloaded all his airline stocks in May 2020, missing out on a rally just three months later. Buffett is a good investor, but he’s not perfect.

Checking in on Graham and Dodd

As much as Buffett is revered and admired, he, too was a student of fundamental analysis. Buffett has utilized and perfected the tools of professors Benjamin Graham and David Dodd, who are discussed at more length in the following sections. Graham and Dodd, whose names are synonymous with a method of investing called value investing, trace their roots to Columbia University, which Buffett attended.

Looking beyond the per-share price

Many investors get obsessed with the per-share price of a stock. It’s easy to understand why. When you buy a slice of pizza, for instance, you might not think to calculate how much, based on the per-slice price, you’re paying for the entire pie.

But one of the basic premises of fundamental investing is just that. You want to know how much you’re paying for your slice of a company, and how that compares to what it’s really worth. And if there’s one aspect of fundamental analysis you can use immediately from this chapter, it’s that the per-share price of a stock, by itself, doesn’t tell you much.

Just looking at a company’s per-share price can lead you to make incorrect judgments. Some investors, for instance, have puzzled over how shares of Visa could trade for only about $200 a share while rival MasterCard commands a price of upwards of $300 a share, because Visa processes more credit card transactions than MasterCard does. You might assume Visa is a better value than MasterCard because the per-share stock price is lower. But that’s not necessarily the case, and you need to take the analysis beyond the stock price.

Fundamental analysis, though, will show you that Visa’s lower per-share price doesn’t mean it’s a screaming buy. Remember market value mentioned earlier? Well, it’s back again. Market value tells you how much investors are paying for an entire company based on the price of the single share of stock. Using the pizza metaphor, market value tells you what the price of the whole pizza is, based on the price of one slice. You can apply this information immediately to stocks by using this formula:

Market value = share price × number of shares outstanding

The key parts of market value are:

• Share price: How much investors are willing to pay for a slice of ownership in a company. You can get a company’s share price from many sources, ranging from your online brokerage firm or investing websites.
• Number of shares outstanding: The number of slices, or shares, a company’s value is cut into. The number of shares outstanding is available in a company’s balance sheet, as described more fully in Chapter 6.

I’ll do the work for you and grab the stock prices of both Visa and MasterCard, as well as each company’s total number of shares outstanding. Applying market value to Visa and MasterCard reveals much more than simply looking at their share prices does. The analysis shows that despite its lower per-share price, Visa is actually the company with the bigger total value. You figure this out by:

• Calculating market value of Visa:
• 199.18 a share price × 2,083.2 million shares = $414.9 billion
• Calculating market value of MasterCard:
• 318.24 a share price × 972.6 million shares = $309.5 billion

You can see that investors are in fact paying 30 percent more for Visa than MasterCard. Whether or not they’re paying too much is another question and something you can explore in more detail in Chapter 8. But at this point, it’s important to understand how fundamental analysis goes well beyond just taking a look at a company’s share price.

Seeing how a company’s fundamentals and its price may get out of alignment

You don’t need a long memory to remember how fundamental analysis could have helped your investing. During the tech-stock boom of the late 1990s, investors were so enamored with dot-coms they were willing to pay boundless amounts for them. Just a few years later, in the mid-2000s, investors repeated their mistakes by creating a housing boom that drove up shares of homebuilders’ stocks. What’s remarkable is there were at least two massive stock market bubbles in just one decade. And it happened yet again. New investors piled into speculative “meme stocks” like GameStop in early 2021. Fundamental analysis could have helped you sidestep the intense pain after all these bubbles inevitably burst.

Let’s put one of these bubbles into context, using our new tool: market value. GameStop, a mall-based seller of video games, was at the epicenter of the meme stock craze. Back in early 2021, investors awarded the company with a total market value of $12.6 billion. Fast-forward to the middle of 2022 — long after the mania over Reddit stock tips soured. GameStop’s market value was pricked to $9.4 billion. Where did the missing $3.2 billion in market value go? Out of the pockets of speculators. GameStop’s market value collapsed a remarkable 65 percent, erasing billions in market value.

Academics argue over why bubbles and manias occur with investing. And you can leave that heady discussion to them. Just know that sometimes, overenthusiasm for stocks can drive prices, albeit temporarily, to levels that aren’t justified by their underlying businesses. Fundamental analysis is one way to try to see when a bubble is forming and try to profit from it.

Even masters of fundamental analysis have difficulty timing bubbles just right. Many analysts had warned that tech stocks were overvalued in 1998, for instance. And they were right … eventually. These investors had to bear being wrong and missing out on huge gains as tech stocks continued to soar in 1999 and early 2000, even though they proved to be wildly overvalued.

Investors who pay attention to company fundamentals are often able to at least recognize when a bubble is forming. Weak fundamentals, for instance, were the tip-off for the dot-com bubble. More than a third of the 109 Internet companies that failed had business models that didn’t bring in enough revenue or had costs too high to ever make a profit, according to Boston Consulting.

Avoiding overhyped “story stocks”

Fundamental analysis can help you recognize when stocks are rising too much, well beyond what’s justified by their businesses. It’s a great way to resist the story stocks trance, or overinfatuation with companies that seem to have boundless potential and grab the attention of the masses. Like clockwork, investors go gung-ho over a type of company — usually in a seemingly promising industry. Investors have had temporary insanity over biotech firms, 3-D printing companies, social media stocks, for-profit colleges, satellite radio operators, and even retailers. Most of these spells eventually end badly.

Alternative energy stocks, including solar companies, are a recent example of stocks that lured investors with an irresistible premise but have struggled to deliver the fundamentals to support the optimism. Take the example of SolarCity. The company, which builds and leases back residential solar installations, seemed like a total winner in 2014. The company is also linked to famed inventor of Tesla Motors, Elon Musk, as chairman. What’s not to like?

SolarCity saw its stock soar 634 percent in early 2014, racing to the point where it had a market value of $7 billion in February 2014. While the company was losing money in 2012, 2013, and 2014, it told investors that customers were signing up at a rapid clip and profits would eventually roll in. Investors continued to buy in. It took some time, but investors who made the effort to actually read the company’s financial statements with horror were proven right. Fundamental analysts spotted two signs they routinely look for, including:

• Lack of profit: Even as SolarCity grew, the losses continued to mount. SolarCity lost money in five of the six years between 2009 and 2014. Just in 2014 alone, the company posted a net loss of $66.5 million.
• Large debt burden: The company continued to pile on more and more debt as it grew. As of September 2015, SolarCity was carrying $2.1 billion in long-term debt, or debt that’s due in a year or longer. That debt load was up 50 percent from 2013.

Despite the glowing promises of the company, investors ended up suffering as those plans never panned out. The company’s stock price had fallen by 65 percent from the high in February 2014 as of November 2015. Once again, fundamental analysis proved correct. Finally, Tesla bought SolarCity for just $2.6 billion in 2016. That’s more than 60 percent less than it was “worth” in 2014. Investors paying attention to fundamental analysis clearly knew the hype wasn’t justified at the high — avoiding a massive loss.

Pairing buy-and-hold strategies with fundamental analysis

Buying and holding stocks over the long term can be a great way to make money. Just ask Warren Buffett. Fundamental analysis can help give you the insights in companies to have the faith to hold on.

Fundamental analysis doesn’t require you to constantly buy and sell stocks. In fact, many investors tend to do their homework, buy a stock, and hold on. They realize that constantly buying and selling stocks can be hazardous for your portfolio because it may hurt you with:

• Mounting trading costs: Every time you buy or sell a stock, it costs you something. Certainly, you can reduce commissions by opening an account with a deep-discount online brokerage, as described in Investing Online For Dummies (Wiley). But the costs are still a factor, including ones you might not notice.

  There are two prices for stocks, the bid price and the ask price. The ask is the price you must pay when you buy a stock. The bid is the price you get when you sell. The ask is always higher than the bid, just like the price you get for trading in a car to a dealer, the bid, is less than the price the dealer will resell the car for, or the ask. When you buy a stock, you’re paying a hidden fee, which is the difference between the bid and ask, or the spread.

• Unnecessary taxes: Flipping in and out of stocks can end up making Uncle Sam rich. If you sell a stock for a profit before you’ve owned it at least a year, it’s a short-term capital gain. Short-term capital gains are taxed at your ordinary income-tax rates, which can be up to 37 percent. On the other hand, if you hold onto a stock for more than a year and sell it, the highest tax rate you’ll likely pay is 15 percent. By just holding on a little longer, you can save a bundle on taxes.
• Mistakes: It’s tempting to think that you’re never wrong. And after reading this book and applying fundamental analysis, you’ll be more informed than many other investors. Still, it’s easy to make a mistake if you sell too early.

Looking to the long term

While it’s not always the case, investors who rely on fundamental analysis are often resigned to being patient and working for the rest of the world to see how great the company you own is. After all, when you’re counting on the fact that the stock market and its scores of traders, portfolio managers, and other investors are wrong, you can’t expect them to arrive at your way of thinking overnight.

Fundamental analysis often works best when paired with a passive investing strategy. With passive investing, you do all your homework, pick your stock, and then wait. The stock might fall further. But it’s up to you to have the courage to trust your research and wait until other investors see what attracted you to the stock.

And because making money with fundamental analysis requires you to go against the crowd, you’ll often need to buy the stock when you think others are wrong. A few of the times where stock prices might, temporarily, undervalue a company include:

• The wake of an accounting scandal: When investors can no longer trust a management team because the financial statements have been falsified, they might sell the stock indiscriminately. If the stock is adequately beaten down to a point where you feel the company’s not being properly appreciated, there could be opportunity.

  Trying to buy a stock after the company has been “cooking the books” is extremely difficult. Because fundamental analysis is based on accurate financial accounting, making a decision based on false information is complicated and beyond the scope of this book.

• Amid pending litigation or liability claims: Stocks will often trade at discounts, or below their true value, when investors are worried a company might face massive claims. This has happened with companies involved in tobacco and asbestos.
• Slowing growth: When a company or its industry matures, it may see the rate of increase in revenue and earnings slow. When that happens, growth investors, who buy growth stocks, may dump the stock so they can move on to the new darling.
• Industry shifts: When there’s a major disruption to an industry, the stocks in the group might get seriously punished. Following the credit crunch, for instance, stocks in the financial sector lost 58 percent of their value as a group in 2008. Certainly, not all banks and financial firms deserved to be punished that badly. Fundamentals analysts who bought the surviving bank stocks at the end of 2012 enjoyed a 56 percent rally through late 2015 — which beat the market’s gain.

Being willing to step up and invest in a company others want nothing to do with can be lucrative. Beaten-down stocks that get rediscovered by investors can rally strongly.

Patience isn’t always a virtue

According to classic value investing, if you’ve done your fundamental analysis, you can buy stocks, forget about them, and wait a few years to count your riches. Unless there’s a major change that warrants changing your opinion, which you can find out about in Chapter 10, value investors hang on and wait for the market to wake up.

Don’t let the fact you’ve done your fundamental research blind you to the fact that sometimes a cheap stock can get cheaper, and stay that way. Overconfidence in fundamental analysis can turn a bad decision into a devastating one. The brutal decline suffered by Lucent shareholders is a classic example. Lucent was born out of the technology arm of AT&T, which was known for innovative patents for telecommunication and computing. Lucent, considered a blue chip by many investors, routinely showed up on lists of the most popular stocks with individual investors.

The stock’s downfall remains an example of the dangers of hanging on too long. The stock hit its all-time high of $85 a share in 1999 amid the technology boom. Many investors looking at the stock’s falling market value figured the company would come back. They kept thinking that as the stock fell to $75, $65, and $55. But it didn’t come back. The stock collapsed to $2.34, the price at which rival Alcatel offered to buy it in 2006. Remember that even when you’re using fundamental analysis, you’re making a bet that the market is mispricing a company. If you’re wrong, you need to be prepared to either be very patient or protect yourself against extreme downside by selling before losses become devastating.