Fundamental Analysis Strategies Review

When you buy a stock you are actually buying a proportional share in a business. There are therefore investors who believe that in order to figure out how much a stock is worth, one should determine how much the whole business is worth. This is done, for example, by examining the financials of the company in terms of per-share values; this in turn helps calculate how much the proportional share of the company is worth. This analyzing philosophy is the basis of fundamental analysis.

In addition, fundamental investors have to consider other aspects of the business, such as the quality and experience of the management, the competitive environment, future growth prospects and many other fundamentals issues which may affect the success of the business.

While the above analysis may seem reasonable and appropriate, there are other methods investors use, each with its strengths and weaknesses. These approaches have some issues in common, while they may differ in other aspects. Some investors therefore use a blend of approaches to achieve optimal valuation or growth.

In the following paragraphs we briefly summarize the most common types of fundamental analysis approaches, and explain the general description of each one of them.

Value investing

The foundation of value investing goes back to the 30’s, when Benjamin Graham first published his widely known book ‘Security Analysis’, which for the first time suggested quantitative measurements of valuing a business. The goal of a value investor is to buy shares of companies traded at a large discount to their intrinsic value. This means that while the company and therefore its shares may be worth more than the current price of the shares, for one reason or another the shares are sold cheaper than they “should”.

Valuing the intrinsic value of a company is not an easy task and there are many paths you can elect to do so. In general, value investors are using the financial sheets, such as the balance sheet and income and cash flow statements, in order to find those undervalued companies.

One way to value a company can be done by comparing the ratio between various financial parameters of the business to those shown in other companies from similar sectors or in the entire market in general (a ratio means to divide one parameter by another one). For example, a price to earning ratio (P/E - dividing the price of a stock by the company earnings of last 12 month) below a certain limit, or a book value at relatively low level, can give an indication of the company stock traded at a discount level.

Growth investing

As the name implies, growth investing deals with the potential of a company to grow relatively rapid in sales and earnings in the future. Investors choosing this method of analysis usually plan to hold their stocks for a long (and sometime even very long) period of time in order to “ride” on the increment in stock price as further into the future as possible.

As in value investing, there are many different ways to measure growth. Usually, growth investors are looking at the quality of the business and try to predict if measures such as sales and earnings growth rate will continue to be well above the industry or market average.

Growth method of investing is often considered as the opposite method of value investing, since the main interest is not the company’s current value, but its future growth potential. A better way to view these two strategies is may be to consider a quote by Warren Buffet: “growth and value investing are joined at the hip”. The confirmation for this statement is the commonly used hybrid GARP (Growth At Reasonable Price) method which combines the two strategies (see next paragraph).

GARP investing

GARP is the acronym for Growth At Reasonable Price. The world according to GARP investors combines the value and growth philosophies - looking for undervalued companies with high growth potential. Thus, GARPers do not just hold a portfolio of value stocks and growth stock; they select stocks which have both the characteristics of value and growth. For example, they are using the not well commonly known PEG (Price to Earning Growth) ratio, which compares a stock’s P/E ratio to its expected EPS growth rate (the P/E divided by the annual Earning Per Share growth).

A PEG below 1 implies that the stock’s present price is lower than it should be given its earnings growth. This stock could be interesting for GARPers, since the analysis may give an indication that the stock is undervalued compared to the company’s growth. Plainly put, the GARP investors are searching for companies that will be cheap tomorrow if the growth occurs as expected.

One of the biggest supporters of the GARP approach is Peter Lynch, who is considered to be the most successful fund manger of all times, due to his phenomenal average return of 29% in the 13 years he managed the Fidelity Magellan fund, turning 20 million to more than 14 billion dollars.

Although GARP might sound like the perfect strategy, combining growth and value investing is not as easy as it sounds, and success in the GARP strategy requires a thorough understanding of the involved strategies.

Income investing

One of the most straight forward strategies is income investing (called sometime dividend investing). Income investors concentrate on companies providing a steady stream of income. Don’t confuse steady income with fixed income securities, such as the interest you will get by investing in bonds. In income companies, the income is paid by dividends. A company’s excess net profit can be either reinvested in the business in order to expand it, or it can be distributed among shareholders in the form of dividends.

Profitable large companies, like Johnson & Johnson, which are not rapidly expanding, generally pay high yield dividends to their shareholders (calculated as the annual dividend per share divided by the stock price). Income investors are looking for those companies and enjoy their dividends stream as a part of their current income.



Qualitative investing

Qualitative investors are focused on the quality of the company- its financial quality as well as its human resources quality. The ROE (Return On Equity) or the ROA (Return On Assets), for example, are two commonly used measures determining the quality of the company, as they measure how much profit it generates using the money shareholders have invested in it or relative to the assets it holds.

Qualitative investors believe that behind every successful business there is great management. Thus, quality can also be measured by the excellence of the company’s executives. These people are the visionaries and leaders who make the strategic decisions regarding the company’s future and therefore determine the fate of the business. Therefore, it might be crucial to evaluate their “value” since ultimately it will affect the price of the stock.

Obviously, a person can not simply be valued quantitatively; but, you can try to figure it out by checking past and present performance, and the future plans of the management. Qualitative investors look for answers to questions such as who are the managers, where did they study and where did they work before joining the business and what is their track record in this or other companies.

For example, if the CEO (Chief Executive Officer) has worked in a successful oil company before joining the company, it could be good indication of his capability to run a company in the oil industry (whether drilling, equipment, distribution, etc). Additional questions, such as what is the management’s philosophy and what are their plans for the future, can give further insights of their chances to successfully grow the business.

Quantitative Analysis

Quantitative analysis is all about numbers. The underlying assumption behind this philosophy is that the conclusions based on different measures rather than the pure numbers, such as the quality of the management or the competitive environment, are based on subjective judgments. Quantitative investors believe that the numbers themselves are the only data that can be analyzed objectively.

Benjamin Graham, who is also known as the “father of value investing”, was the pioneer of quantitative methods. After the 1929 market crash, he developed a simple technique to analyze the numbers rising from the financial sheets of the company. He popularized the examination of well known ratios such as the price to earning (P/E) ratio, debt to equity ratio, book value, earning growth and others. Graham was focused on the objective numbers rather than other fundamental subjective data such as the quality of the management.

During the years, a significant amount of academic and actual research has been conducted in order to uncover the optimal method to crunch the numbers. The fast development in computers makes it easy today to analyze quickly the numbers of companies using a simple automatic tools or manual screeners. This has lead to variety of quantitative methods.

For example, there are investors who choose to trade companies by their size (their market capitalization - the stock price multiplied by the number of outstanding stocks); some investors choose small cap companies (companies with market cap between $100 million to $500 million), since history shows that small cap companies tend to have higher returns on average compared to larger ones. One reasonable explanation for this result is the fact that smaller companies have got much room to grow; thus, they could have much larger growth rate.

On the other hand, small companies usually reinvest most of their excess profits in the business itself, and don’t pay regular dividends as do some larger companies.

Most quantitative investors today use a set of screening criteria to screen for their winning stocks. There are various criteria used, from the simple P/E ratio to more complicated ratios.

The use of strategies to evaluate and pick stocks has become so popular today that most financial internet sites have their own designated screeners and ranking methods.

Among the variety of quantitative methods, there is the well known CANSLIM method, developed by William J. O’Neil, which is a hybrid of quantitative analysis and technical analysis (the analysis we will discuss next). Each letter in the acronym stands for a key factor to look for in a company. The “C” and the “A” stands for Current quarterly and Annual increment in earnings. The “N” stands for New things in the business such as new products, new management and so forth. “S” is the short for Small market cap with big demands for its stocks.

The next, “L”, tells you to verify if the company is a Leader or it is Laggard compared to other companies in its industry. The “I” symbolizes the Institutional sponsorship (meaning which financial institutions hold a significant percentage of the company’s stock) and the “M” stands for the direction of the Market.

As previously mentioned, this strategy also includes various components of technical analysis such as cutting all losses at no more than 7% or 8% below the buy point (i.e. if the price of a stock you hold falls more than 7-8% from the original buy price it should be sold).

Source: http://blog.yalicoo.com/2008/06/26/fundamental-analysis/

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