Chapter 20
IN THIS CHAPTER
Running through ten of the most basic things fundamental analysts should check for
Reinforcing some of the fundamental analysis techniques that matter most
Showing how several of the types of fundamental analysis may complement each other
Considering some signs that a company is beginning to lose its competitive edge
When you see that pile of dirty dishes in the sink, you might feel a tinge of guilt telling you that you really should wash them. But you just might not be in the mood.
That same sense of reluctant obligation might also apply to your portfolio. You might own some individual stocks and realize you should be analyzing their fundamentals, but other things just seem more interesting. So the annual reports and proxy statements just pile up.
Certainly, performing a complete financial analysis of a company takes time as you run through all the financial statements, calculate dozens of financial ratios, and study the industry, just to name a few things. Fundamental analysis can take a bit of effort, seeing that Wall Street analysts and credit rating experts get paid to do this kind of thing all day long.
Just because you might not have time to do a complete financial analysis doesn’t mean you should let your financial dishes sit in the sink. This chapter will tell you what ten types of fundamental analysis you should always make time for. You’ll find out which types of fundamental analysis you should prioritize when looking to dig into a company’s financials but have limited time. If you conduct these ten aspects of fundamental analysis, you will be well ahead of many investors who just blindly buy stocks on a whim.
If you’re not a full-time fundamental analyst, and you own more than a handful of stocks, it would be a full-time job to constantly monitor in real-time every bit of financial data you’ll want to be aware of.
So here it is. My suggestion on the one form of fundamental analysis you should never skip is the measurement of a company’s quality of earnings. As soon as you can get your hands on a company’s income statement and statement of cash flows, you want to make sure a company’s cash from operations is greater than or equal to its net income. When a company is generating cash flow, you have some proof the earnings are real, not just smoke and mirrors allowed by accounting. You can review how to conduct this analysis in Chapter 11.
It would be pretty rude to ask strangers you meet at a cocktail party how much money they have in their savings accounts. But you don’t have to worry about such etiquette when it comes to companies. Before you invest a dime in a company, you want to make sure you not only know how much companies have, but also what they owe. You should know:
Paying close attention to these three variables will help you avoid plunking your money down in a company that may not survive.
Investors are constantly surprised when they spend hours and hours analyzing a company’s fundamentals, only to buy a stock and still lose money.
There are countless forces at work to determine a stock’s price. Remember, stock prices are set by the constant tug of war between buyers and sellers trading shares back and forth until settling on a price everyone can agree upon. That’s why it’s critical for you to not only evaluate how solid a company is, but also how profitable it is and whether it has staying power. But above all: It’s imperative to not pay too much for the company.
As an investor in a company’s common stock, or the shares issued to the public representing standard ownership in the company, you’re at the mercy of the management team to make the correct decisions with your money. You’re counting on the board of directors to keep a watchful eye on the management team. If you can’t trust the management team and board of directors, you shouldn’t trust them with your investment.
Day traders used to scoff at investors who paid attention to dividends. During stock market booms, these small cash payments some companies pay to their shareholders seem almost insignificant.
But fundamental analysts know better. For one thing, dividend payments account for a big portion, roughly 30 percent, of the returns generated by stocks over time. Miss out on those payments, and you’re leaving quite a bit of cash on the table. Also, steady dividends can make sure you’re earning something on your money even if a stock is flat. Dividend payments can also be helpful in helping you decide how much a stock is worth, as described in Chapter 10.
Lastly, while companies can fudge or pad their earnings, dividends can’t be faked. Dividends are usually actual cash payments you can deposit in a bank account or spend. Companies paying dividends are at least showing you a tangible sign of their profitability.
It’s easy to simply take a company management’s word as gospel. Financial television is especially infamous for practically turning corporate CEOs into royalty and taking everything they say at face value.
That’s not to say you, as a fundamental analyst, need to treat CEOs as crooks or liars. But it is up to you to verify claims made by a CEO. If a company’s CEO says a new product is selling like crazy, take the time to look at its revenue growth and also the accounts receivable turnover in days to ensure customers are buying and actually paying for the goods. If a company claims to have posted record profits, it’s up to you to not only verify the claim, but also make sure it wasn’t the result of accounting puffery.
Fundamental analysis is powerful, but there is a great deal of emphasis placed on financial statements. The big weakness of financial statements — mentioned repeatedly in this book — is that they’re historical documents telling you how a company did, not how it will do.
Trend analysis, described in Chapter 17, is one way fundamental analysts look beyond historical numbers to assess the future. But you need to be especially mindful of game-changing technologies or new ways of doing things in business that can render a company’s way of making money, or business model, obsolete.
Eventually, for most companies, the early days of easy growth evaporate as the product and business matures. A product, which might have been so new that everyone had to buy one, eventually becomes so prevalent that growth slows. When a company expands rapidly, it becomes more difficult to grow further. These growing pains and maturity present great challenges to both management teams and fundamental analysts. Companies often struggle with the transition from a fast-growth company to a slower growth one, and sometimes need to change their entire strategies. Fundamental analysts, too, must change the way they evaluate a company and measure its valuation.
It’s often tempting to buy stock in a company you think is the best in a business, and assume that your work is done. But companies are constantly changing and evolving. Sometimes a company’s rival might rise up from near death with a killer product and pose a huge threat. Meanwhile, the valuations of so-called leading stocks are often driven up so high that its future returns are often disappointing.
Some athletes get themselves into trouble when they decide to showboat. The temptation to do that one extra and unnecessary back flip or victory dance sometimes lets a quiet competitor sneak up and steal the win.
Companies, too, can sometimes get full of themselves. Figuring that their fat days will never end, some companies build opulent headquarters, send employees on overly lavish business trips or even spend cash on vanity promotions.