Do you want to make your portfolio grow by leaps and bounds? Do you want this growth with the minimum level of risk? If so, you have come to the right place to learn!
In the financial article Smart Investors Know the Sectors, we touched upon Portfolio Management and the benefits of holding two types of portfolios: a Core Portfolio, also called an Investment Portfolio, and an Explore Portfolio, which we refer to as a Trading Portfolio.
Now it is time to talk about the Explore portion of our portfolios, or what we might call our speculative investments. This chapter will provide you with a solid foundation on how to develop the Explore portfolio. You will see why it is judicious to apply a little more rigor in the selection process as the risk on speculative investments is higher, though the returns are also expected to be higher.
There are three main types of analysis that will allow us to select better trades: Trend Analysis, Fundamental Analysis, and Technical Analysis. This article explains Trend Analysis and Fundamental Analysis. We will cover Technical Analysis in the next article.
What is Trend Analysis and How to Use It
When we use Trend Analysis, also called Top-Down Analysis using Charts, we attempt to determine the trends of the markets, what’s current, what is the direction of the market, and what unique offerings, such as new products or services, will be marketed to consumers. We try to pick winners, and of course, to size our investment according to our risk tolerance in case we are not successful.
There are three trends: up, down, and sideways. Up is called “Bullish.” Down is called “Bearish.” Sideways is called “Neutral.”
Bullish Market is a financial market in which prices are rising or are expected to rise (when Bulls attack they thrust their horns up, thus the name Bull Market to describe an uptrend). Bull markets are characterized by investor optimism and the perception that strong results will continue. A typical chart for an uptrend would have higher highs and higher lows:
Bearish Market occurs when prices of securities are falling (when Bears attack they swipe their paws downward, thus the name Bear Market to describe a downtrend). Investors are pessimistic and have a negative outlook that it will continue for some time. A downtrend is known by lower highs and lower lows. This is what the chart will look like:
Sideways Market occurs when the price trend is neither an uptrend nor a downtrend, but rather, it trades horizontally. A sideways chart is known by equal highs and equal lows:
By charting performance, we can determine the trends that markets and stocks are taking. We can apply these graphic measurements of trends to Countries, to Markets, to Sectors, to Industries, and to Individual Stocks.
We can also determine long, intermediate, and short-term trends of the global markets; which areas of the globe are outperforming others; analyze the overall risk, or portfolio heat; and then review which sectors and industry groups we can use to find stocks of companies within those Industries.
We should seek to gain a fundamental understanding of the general market trends prior to performing more detailed Fundamental Analysis.
The Benefits and Rationale of Fundamental Analysis
Fundamental Analysis involves analyzing a company’s financial statements, business plans, corporate health, its management and competitive advantages, and its competitors and markets.
Do you remember the Goal Setting and Budgeting exercises we performed at the beginning of this project? We made goals, time lines, and budgets. We made a Business Plan individually and collectively, for the whole family and for all the members. This same process can be applied to a corporation, and this is what we call the “Fundamentals” for that company.
Fundamental Analysis is performed on historical and present data, with the goal of making financial forecasts which will guide our trading decisions. Fundamental Analysis provides several possible objectives:
- to conduct a company stock valuation and predict its probable price evolution,
- to make a projection on its future business performance,
- to evaluate its management and make internal business decisions,
- to calculate its credit risk.
The intrinsic value of a company is determined on the basis of three aspects of Fundamental Analysis: Economic Analysis, Industry Analysis and Company Analysis. These three types of analysis will determine the true value, or equity, of the company, so we need to become proficient in how to use them.
With the knowledge of the true value of the equity of the company, we can divide that amount by the number of shares of outstanding stock, or shares of ownership in the company. That will explain the true value or the price per share.
To determine the underlying health of a company, we must examine its core numbers: its Balance Sheet, its Income Statement, its earnings releases, and other indicators of economic health.
Shares of companies with strong fundamentals will tend to go up over time, while fundamentally weak companies will see their stock prices fall.
We must also keep in mind that the purpose and objective of a business is to not only create a profit for the owners and shareholders, but to also add value to society and its customers in a certain way by providing specific goods or services. In this light, prior to making trading investments, we should understand:
- What are those specific areas in which the company will satisfy a need of the society?
- What does it do to work towards the betterment of people in society?
- Is it a dharmic enterprise?
- Is it an immoral enterprise?
- Does it provide a real value to society?
- Does it provide a transient value to society?
Ultimately, we will only want to invest in those companies whose value system is aligned with our own. Each of us must use our discrimination.
Interpreting Financial Statements
To gain insights into a company’s financial health, we must analyze its financial statements. There are three primary financial statements that give us information about the company’s performance: the Balance Sheet as of a given date, an Income Statement for a given period of time, and a Cash flow Statement for the same time period.
A “balance sheet” presents a picture of how the company’s assets, the value of what a company owns, “balance” against its liabilities, what the company owes. It is a snapshot of the financial condition of a company.
The Balance Sheet has three major sections: assets, liabilities, and equities:
Assets are the business resources of the company. What does the company own?
An Asset is any kind of resource, which helps to empower a company to perform its business.
Generally we speak of things, which have value, for example: land, buildings, machinery and equipment, money, and brand name recognition.
Liabilities, which are often referred to as Creditor Claims, are obligations the company has made to outside parties who have provided resources.
These outside parties may have lent money or sold supplies on credit to the company, and therefore are owed repayment. Remember, these outside parties do not have ownership in the company, but they are creditors.
For example, if we made a down-payment on the purchase of our land and buildings, and make regular payments secured by a mortgage on the property, this would be regarded as a liability.
Anything we purchase with credit constitutes a liability and we have to pay it back. It is similar to how a mortgage on a home would be considered a liability.
Equity, which is sometimes called Owner’s Claims, is simply the difference between Assets and Liabilities. If the Assets are greater than the Liabilities, then the owners of the company have Equity, a stake of ownership, which has positive value. If on the other hand, the Liabilities are greater than the Assets, then the owners of the company owe money to their creditors and are said to have Negative Equity.
This is much the same way that a home owner has positive equity in a home when the market value is greater than the mortgage. But, if the market value is less than what is owed, they are “underwater,” which means they have negative equity.
Let’s look at a sample balance sheet for Apple Co. on March 29th, 2014:
Notice that the Total Assets of Apple equal the Total Claims (liabilities + shareholder’s equity) against the company. This is the “balance” in the Balance Sheet. Here is the equation:
Assets = Liabilities + Shareholders’ Equity
$205,989 M = $85,810 M + $120,179 M
In a fundamentally healthy company, Assets will outweigh the Liabilities, creating a positive equity for the shareholders. Similarly, a company having troubles, or even a start-up company, may have negative shareholder equity.
This is how the Balance Sheet works. Now it’s time to do some calculations. Pull out your calculator and follow along!
Income Statement (Earnings Statement)
The Income Statement presents the flow of Revenues and Expenses in a given year. Compared to the Balance Sheet, the Income Statement gives a more detailed answer to a critical question for any investor: is the company making money?
The well-known expression “the bottom line” comes from Income Statements. Specifically, it matches the Revenues in a given period to the Expenses in that period to calculate profitability, or Net Income (Revenue – Expenses).
While the bottom line Net Income is obviously an important figure, a good analyst will review an income statement line-by-line. There may be little bits of good news or red flags revealed along the way to calculating that final profitability figure that can give an indication of a company’s financial health.
Let’s look at the Annual Income Statement for Apple, ending March 29, 2014:
We can see that Apple had Total Revenues of $176.0 B, Costs of Revenue of $109.3 B, Taxes of $13.4 B, Other Expenses (net of Other Income) of $15.6 B, and a Net Profit Applicable to Common Shares of $37.7 B.
Time to pull out your calculators and have fun with some calculations and ratios! Please follow along:
Cash Flow Statement
The Cash Flow Statement helps investors answer questions like: Is the company generating enough cash needed to fund growth? Or is growth outpacing cash generation, requiring additional financing? Is the company generating enough cash to cover its short-term needs? Can the company generate sufficient revenues to cover its immediate obligations?
The Cash Flow Statement is slightly different from the Income Statement and, though the preponderance of investment analysis focuses on the Income Statement (profitability), we should not overlook the Cash Flow Statement. There are several profitable companies that have gone out of business because they were unable to pay their obligations.
The key difference between the Cash Flow Statement and the Income Statement is in the concept of “matching” expenses to the time of usage.
The Cash Flow Statement measures the cash inflows and cash outflows much the same way that you balance a checkbook. You get a paycheck — that’s a cash inflow. You pay your bills — that’s a cash outflow. This is very straightforward.
The Income Statement applies accounting policies and procedures to try to best “match” the expenses to the usage of the equipment that is used to manufacture product. In this way, it is a good measure of profitability.
For example, let’s say you make a large purchase in cash, such as a $40,000 Nissan automobile, and you are expecting to be able to drive it for ten years.
On the Cash Flow Statement, this would be a negative cash outflow of $40,000.
On the Income Statement, this would show as a $4000 annual depreciation expense for the next ten years (using a very simplistic depreciation method). Do you see how the Income Statement is “matching” the expense to the time period that the asset is expected to be used?
Let’s see how Apple is doing on cash flow. Refer to Apple’s Cash Flow Statement (below) and notice that there are three key sections: Operating Activities, Investing Activities and Financing Activities. In each of these sections, we measure the cash inflows and the cash outflows.
In the Operating section, the Depreciation, Depletion, and Amortization is a non-tangible expense. Meaning, these costs impact the company’s reportable profitability (net income), but are accounting functions, rather than cash flows out of the company. These can be called paper losses.
Investing Activities consist primarily of capital programs, where a company may purchase new fixed assets such as equipment or additional plants. This capital cost is a cash outflow. The investing section of a cash flow statement may also include new assets acquired during a merger, or disposal of fixed assets that were previously on the books, and other items.
These Investing Cash flows are typically depreciated on the Income Statement (much the same way as the car purchase example we talked about previously) to reflect an annual expense which matches the year of usage.
Financing Activities primarily include dividends, change in debt levels, and sale/purchase of stock.
A quick glance at Apple’s Cash Flow Statement shows that they generated ~$53.9 B (cash inflow) and spent ~$9.3 B for new investments, paid $11 B of dividends, and bought back stock of ~25.9 B. They generated $6.9 B of cashflow in excess of their expenses!
Let’s look at some analysis — pull out your calculator and follow along:
One more statistic I find particularly relevant is Float. To an investor, float generally refers to the total number of shares available for trading. Float is calculated by subtracting closely held shares and restricted shares from the total number of outstanding shares. That way we get an accurate account of how many shares are actually available for trading.
Key Statistics Are at Our Fingertips
We have covered the basics of how to interpret Financial Statements. Now, I’ve got some great news for you. You don’t have to calculate all of those ratios and metrics yourself!
Though we need a solid understanding of the basics, the heavy lifting of analyzing and normalizing each company’s financial statements can be found through multiple online sources.
Our goal is to efficiently utilize this data and convert it into profit through making smart investment decisions.
For example, here is a table of Key Statistics for Apple from a free online source that I commonly refer to:
There are many resources from which we can find the Key Statistics by which we can analyze stocks: Google Finance, Yahoo Finance, all of the online brokerages.
This table is an example from Yahoo Finance, and it includes Valuation Measures, Financial Highlights, and Trading Information.
In this table, you will see that there are many ratios which we have not discussed, but that other investors may use to help influence their decisions.
Every trader will have his or her own favorites, such as Price/Sales, Price/Book, Profit Margins, Operating Margins, Return of Assets, Return on Equity, and various others.
As you gain familiarity with financial statements and become adept at trading, you too will develop a short list of key metrics and a disciplined process to help you make judicious decisions. You will develop your own personal investment strategy that fits your purposes.
Fundamental Analysis: An Approach to Investment Selection
Fundamental Analysis is important because it helps to identify stocks with key growth and stability characteristics. By conducting a fundamental analysis on a company, investors can reduce or limit the emotion that comes with an investment decision; a stock either passes a fundamental screening or it doesn’t.
Fundamentals tell the history of a company, the good and bad about financial stability and strength, about budgeting and risk-taking, all of which will help to reduce risk by predicting the company’s capacity to perform in the present and in the future. Good fundamentals provide a solid foundation on which companies can build.
Some Brokerage Houses recommend making a Report Card for every intended purchase.
In the pursuit of this objective, they have devised scoring systems by which investors can quantify all of the data which is included in a Fundamental Analysis.
While you can use one of their scorecards, or develop your own, this sample Report Card and the following discussion defines the criteria for a grading system. It is meant to show you an approach such that you are better empowered to develop and customize a method that fits your needs.
This particular Report Card is broken into two Phases. Phase 1 is used for preliminary screening based on financial strength using 13 key ratios as a criteria. Phase 2, which we will discuss next, is a more detailed review of a short-list of those companies that passed the Phase 1 scoring criteria.
Phase 1 Report Card
Using the Phase 1 Report Card (above), the 13 ratios are calculated and scored with either an Up Green Arrow (strong performance), Down Red Arrow (weak performance), or no arrow (middle of the road).
Good stock choices will have at least five strong performing green arrows and not more than two weak performing red arrows. When those are identified, we put them on a watch list for further review in Phase 2.
Though these ratios are calculated using online resources or brokerage services, we are responsible for understanding what they mean and why they are significant. These ratios serve as our foundation, our stepping stones, to move viable stocks to the next phase of analysis.
Phase 2 Report Card
The Phase 2 Report Card assesses future estimates by analysts about the company’s ability to promote and increase its sales and earnings. It is a more detailed review that we should perform on those companies that pass the Phase 1 screen.
The Phase 2 Report Card consists of four key areas to review: A) Financials, B) Analyst Estimates, C) Price Pattern, and D) Volatility. The F/E Score on the report card is the average of the Financial and Estimates scores. In addition to these four areas, we will also include E) Current News in our scoring as well.
These are the key ingredients to Fundamental Analysis, following which we are sure to find strong companies with good prospects for the future.
Many investors spend more time researching a new handbag or a pair of shoes, then they do researching their investments. But if we are prudent, and invest the time in research and analysis, we have a much more substantial chance to capitalize on investment opportunities.
Remember, we do not have to be right all the time. We only need to be right more times then we are wrong, and then investments will yield a profit.
Now that we are familiar with the Fundamental Analysis of investing, our next article will look at the Technical Analysis.