Throughout this book you have learned how to analyze securities from an objective technical point of view. By carefully analyzing charts and other indications, you should now be able to make educated trading decisions regarding risk and reward based on the technicals and the psychology behind them. If you are a very active trader, technicals provide a framework to base most trading decisions. But when taking positions for a longer period of time—a few weeks to even months—it is helpful to research and understand basic fundamental information about the company.
While technical analysis is used to time when a particular price move will likely occur, fundamental analysis can be used to understand why price moves occur. But know that the understanding of why prices move cannot directly help you in making trading decisions about the future, because the fundamental information that is current is anticipated and already discounted through price. This we know, but indirectly, it can be useful, because other large-sized market participants place a significant emphasis on fundamentals when making trading and investment decisions. If a stock you are trading is appealing to other market participants both technically and fundamentally, it adds to the probability of being profitable. The large institutions that build positions based on fundamentals often look to buy pull-backs as stocks trend higher. Armed with the knowledge that the stock is appealing to institutional traders and that they will likely buy pullbacks, you can buy technical pullbacks as well and have the peace of mind that institutions are likely to support the stock. This should be evident technically as light volume pullbacks and high volume rallies. The active trader can use fundamental analysis to get into the minds of other market participants that can move the stock in the direction that makes you money.
Industry analysis and other factors that affect the individual company itself are the domain of the fundamentalist. The fundamentalist believes the market value of a stock is a function of how well the company is managed and measured through financial indicators such as earnings, financial ratios, the economy as a whole, and the performance of the company’s industry.
To ascertain a company’s ability to compete within its industry, analysts examine the company’s current and probable future market share. It seeks to measure whether it is a leader within its industry and introducing new product lines that might increase its market share. Fundamental analysts are concerned with the growth and stability of a company. They look at the quality of the firm’s management and historical earnings trends. They plot how its projected growth compares with that of its competitors, and whether its growth is stable or erratic. Analysts also examine a corporation’s capitalization and use of working capital. They try to pinpoint stocks that afford the investor maximum potential for growth, stability, and profits. The bottom line with a fundamental approach is that the price of a stock will move based on the profitability of the company. The fundamental approach leaves much room for corporate manipulation, trickery, and subjective analysis, as we have explored in Part I. This information can be so alluring and market-impacting that it requires a deeper understanding before we move into actionable trading and investing.
Basic fundamental information is the driving force behind many aspects of supply and demand in the market. As touched on in Chapter 1, the crash of the stock market in 1929 wreaked havoc on investors, causing them not only to lose money but to lose confidence in Wall Street. As a result, several laws were created to help squelch these feelings of mistrust. The Securities Act of 1933 was passed to regulate the securities industry. This required registration and disclosure. In 1934 the Securities Exchange Act was passed, which created the Securities and Exchange Commission (SEC), the primary federal regulatory agency for the securities industry. The SEC is made up of four basic divisions. The Division of Corporate Finance makes sure that publicly traded companies disclose the required financial information to investors. The Division of Market Regulation takes care of the legislation involving brokers and brokerage firms. The Division of Investment Management oversees mutual funds and investment advisors. The Division of Enforcement is charged with the investigation and enforcement of securities regulation.
The information that a publicly traded company must file to the SEC must also be made available to the public. This fundamental information includes information released by the company, such as earnings, annual reports, and quarterly reports.
Earnings are the primary focus of all analysts. Also known as net income, earnings are defined as the company’s revenues minus cost of sales, operating expenses, and taxes over a given period. Many investors value earnings information because they give an indication of the company’s expected future dividends to stockholders and its potential for growth. Earnings are stated in both quarterly and annual reports. Earnings are to the fundamentalist what price and volume are to the technician. Obviously, regardless of earnings and forecasts, current price is the market’s final word on the company’s perceived value. As we know, perception is reality in the markets.
Annual reports are audited documents required by the SEC. They are sent to a public company’s shareholders at the end of each fiscal year. The report includes a balance sheet that contains information about the company’s financial condition. The balance sheet can be analyzed to give you some idea of what would be paid to the shareholders if the corporation was liquidated. Annual reports also include an income statement that accounts for sales, expenses, and net profit for a given period. Each annual report contains a cash flow report that shows the cash receipts minus the cash payments for the fiscal year. Very similar to the annual report is the 10-K report that is filed to the SEC each year. The 10-K report contains more detailed information about the company than the annual report and is available for free from the SEC’s Web site.
Quarterly reports are un-audited documents required by the SEC that report the financial results for the quarter and note significant changes that occurred during the quarter. The quarterly report includes a financial statement with an income statement, balance sheet, and many times a cash-flow statement on a per quarter basis. The quarterly report is also referred to as a Form 10-Q and is also available from the SEC Web site for free.
By utilizing this fundamental information, you can see how the company actually performed in the past and view predictions by the company for their future performance. From a fundamentalist’s point of view, if a company is growing and further growth and profits are expected, then the company’s stock should go higher. Most all market movement has some base in fundamentals, but remember it is not profitable to base your trading decisions off this fundamental information. As stated earlier, price discounts everything, meaning the current and anticipated fundamental information available is already factored in the stock price. This is basic human nature since participants know that in order to profit, others must buy the shares behind them. Acting on anticipated fundamentals drives prices ahead of actual fundamentals. The technician believes this is where practice trumps theory. In theory, fundamentals should reflect stock prices, however, in practice, perception reflects price (supply and demand).
In my opinion, the very nature of fundamental information makes it a conflict of interest between the entity that is releasing it and the public that is receiving it. The releaser wants to put out information that looks good to the public, in order to further attract investors. The SEC is charged with ensuring the quality of these reports but manipulation is possible. Let’s face it, in many cases (not all), publicly traded companies use the stock market like some people use dating services. Participants in dating services want to show themselves in the best light possible. If the dating service is analogous to the stock market, I argue why even use the dating service. If you can’t get a date on your own merits, something is wrong! In other words, the healthiest companies fundamentally are private companies, who are not interested in public scrutiny, nor need the hype often associated with the stock market.
If picking good stocks were as easy as researching a company’s financials and making trading and investment decisions based on this knowledge, anyone with this knowledge could be profitable. As you know this is not the case. It takes more than just an understanding of the company’s data since this information is subject to subjective interpretation, and yes, even manipulation.
The data a company releases passes through many hands. Any time information goes through human hands there are some bad apples that will manipulate the data to further their own ends. Manipulation is possible from a variety of places, but history shows most scandals involve those with the most to gain—high-level executives. It is an old cliché in politics that says, “if you want to find the corruption, follow the money.” If corruption is to be found, the path leads to the boardroom. For example, in 2002 WorldCom disclosed that it had hidden $3.8 billion in expenses from investors to inflate earnings. The Chief Financial Officer (CFO) and the Chief Executive Office (CEO) were blamed for the scandal. The manipulation at these high levels is truly alarming and brings to light the conflict of interest that occurs in company reports. The CFO is responsible for the financial planning and record keeping for a company. They also want the company and the stock itself to appeal to investors. When putting this information into a company report, the CFO has an opportunity to use tricky accounting to exaggerate earnings. If there is any manipulation by the CFO, in most cases they don’t work alone and others in high positions within the company take part in the deceit. Most executives in publicly traded companies own a considerable amount of stock in the company. They are hurt financially if the stock price moves lower.
The reason for these manipulations is because no company wants to report poor fundamental information to the public, since that would decrease stock price and tarnish the company’s image. Thereby, through tricky accounting these companies are able to hide expenses and make the company look more profitable than it is. This does not mean that all companies operate at this level of malice, but I do believe all publicly traded companies put their very best foot forward with a few inches to spare.
While there is regulation in place to prevent market-wide manipulation, it’s always there to one degree or another. Throughout the 1990s there was plenty of creative accounting taking place. One piece of trickery that companies used was reporting earnings on a pro forma basis. These earnings reports were released to the public in press releases. Some companies selectively excluded many expenses that would have reduced earnings in order to boost their stock price and company image. Later these companies filed a more complete and accurate set of numbers quietly to the SEC. The reports that were given to the SEC included expenses that were excluded in the pro forma earnings. The public rarely responds to the restated financials until it’s too late. There are many other tricks used by companies to boost earnings, and who better to explain them than one of the market’s best friends (as Warren Buffet put it), former SEC chairman Arthur Levitt. I highly suggest reading his tell-all book, Take on the Street.
The point to all of this is that the only annual reports filed to the SEC have to be independently audited. The astute researcher could have discovered things weren’t quite right if they went through the annual 10-K report and not the press releases handed out by the company. The difficulty is that 10-K reports can be long and complex, while the press releases are flashy and easier to read. It comes down to the need to get your hands dirty and dig through the quarterly and annual reports filed to the SEC. Most investors simply do not want to work that hard. This contributes to our advantage as hard-working self-analysts.
The market analyst’s job is to give objective advice about companies and make buy and sell recommendations to investors to help them make investment decisions. Throughout the 1990s the analysts developed unique relationships with the companies they covered. As companies perform creative accounting to boost earnings, they often leaked the earnings information to the analysts. The analysts are paid to do objective research on the companies that they are covering. Instead of being objective, they fed off the scraps of information thrown to them by the company’s CFOs. In the previous WorldCom example, the company was rated as a buy just days before the company announced its accounting scandal. Where does that put the investor on the market food chain? This is just one of many examples. History has plenty more examples of manipulation at both the corporate and institutional level.
As these types of situations escalated, some analysts began to upgrade and downgrade securities based on information leaked to them. Even if the analysts uncovered creative accounting and rated the company a sell, the brokerage that they worked for would be punished by a loss of investment banking business from the company. It worked the other way around as well. Analysts would pressure CEOs and CFOs to leak fundamental data to them. If the company was small they had a tough decision to make since if they didn’t pre-release data to analysts, they would be threatened indirectly with a sell rating. This was the leverage the analyst used to get information. They are in a position of power, and like most politicians, they use it. This shouldn’t be any real surprise; this is also the nature of people who are influenced by greed. Not all people operate this way, but remember what we said. If you want to find corruption, follow the money. Put another way, a famous bank robber was asked why he robbed the banks, and he said, “Because that’s where the money is.” Wall Street is also where the money is, and to quote Don Henley of the Eagles, “a man with a briefcase can steal more money than a man with a gun.”
In the late 90s, analysts began to release the numbers that companies leaked to them and then the company preceded to beat these analysts’ estimates. It was a circle of corruption that left the investor without a leg to stand on when the market entered into a decline. As companies filed for bankruptcy protection, a closer view of their financial statements took place and the deceptions started to emerge.
Whether the Republicans or Democrats are in office, every administration in office (the administration on the out seems to want the opposite during election years) wants to see the economy in an expansion phase along with a healthy stock market. This makes the public believe that they are doing a good job. In fact, the Government is like a very large company. The fundamental numbers released by the Government are on the economy of the entire nation. Much like the annual and quarterly reports that companies release to show how well they are doing as a company, the Government releases numbers on how well the economy of the country is doing. Politicians are notorious for trying to take credit for the economic prosperity of the nation. When election time comes around, they look back and show a track record of what the economy did while they were in office. The downside to this is that the Government is permanently biased toward trying to show an improving economy.
The Government releases many economic numbers to the public on a regular basis. Every Thursday, the initial jobless claims number is released. Every month employment numbers are released. Every quarter GDP numbers are released. Every administration wants to stay in office, and political forces play a part in public perception of economic data.
One example of an economic number that has been suspected of being manipulated is the Consumer Price Index (CPI). The CPI is an inflationary indicator that measures the change in the cost of a basket of products and services that remains fixed. As prices of goods in the basket move higher, the buying power of the dollar falls since people can’t buy as much as they previously could with the same dollar. The board that oversees the Federal Reserve Banks (Fed) pays close attention to the CPI. The Fed adjusts money flow through interest rates to keep inflation around 2 to 3 percent. As long as inflation is under control interest rates can remain low. By lowering short-term interest rates, the Fed makes money less expensive to borrow (loosening the money supply), which in turn stimulates economic growth.
The Fed is an independent committee that sets the monetary policy of the nation but gets their data from the Government. The Government, on the other hand, dictates fiscal policy, which sets the federal tax and spending policies influenced by Congress and the President. If the CPI were to indicate that inflation were rising, the Fed would likely step in and raise interest rates to reduce the money supply, helping to support the value of the dollar (supply and demand). Though the Fed makes its own decision, based on information from the Government, there exists the real possibility that political interest interferes with the checks and balances system described.
The administration in office would like to have interest rates low to help boost the economy and show what a good job they are doing running the country. If the Fed were to raise interest rates, it’s like putting the brakes on the economy, which no administration wants to happen. Presidencies associated with runaway inflation are tarnished in the eyes of history, Jimmy Carter being a prime example. Therefore, modern politicians are even more influenced by the position the Fed takes. In a world of global economics and exponential complexity, government officials are more influenced by fiscal policy than at any other time in history.
Since the Government is much like a large company, the politicians, like the CEO, also have an incentive to “put their best foot forward” and show economic numbers that will help the economy and allow the administration to continue to run the country.
This overview of fundamental analysis as applied to our capitalistic system explains procedurally how information is disseminated to the public. Even in a perfect world, the system itself puts the investor at the bottom of the food chain. The hierarchy of the system identifies why other sources of market food must be sought. Technical analysis quenches the appetite, but because present fundamentals are already priced in, there are trends within a company’s financial information that can be useful, especially when entering the market for longer periods of time. Traders and investors alike should use this information with caution since it is easy to become emotionally attached to your analysis and opinions especially when a company has good fundamentals. Trading decisions should not be based on fundamentals—only to add confirmation to decisions that are made through technical analysis.
The study of fundamental data encompasses a very large area. There are several trends that you can look at to get a quick idea about the fundamentals of the company. A review of the basic fundamentals of a company that you want to buy should be that it is making money or on the way to earnings. There are many sources for fundamental data, but the best source comes from 10-K reports. The 10-K report and the 10-Q report are the logical places to start from when beginning the journey into fundamental analysis. Remember that the 10-K report is subject to less manipulation (not immune to) since it must be certified by an independent auditor before going to the SEC.
When looking for long candidates, you want to find securities that are good technically, but if you are planning to be in the trade for a longer period of time, you want to know that the fundamentals are also sound and therefore appealing to institutional clients. By checking the trend of net revenues, net income (earnings), and the earnings per share, you can get a good idea of whether a company looks good from a fundamental standpoint. Many times buying a stock that is breaking out of a stage 1 accumulation to a stage 2 markup will have lagging fundamentals that do not yet look stellar. The important aspect to look for is the fundamental trend of improvement in revenue, earnings, and EPS. In other words, we need to be fishing where others are not, but where the fish are likely to be.
You are only limited by the amount of time you have available when delving into fundamental research. But, there are several important things to look at on a company’s 10-K statement. The first thing is to note whether the net revenues are increasing or decreasing year to year.
In Figure 11-1, the highlighted revenues have increased every year for the last four years. This is a quick way to check to see if the company is making money before any expenses. If this number is increasing then the company is doing more business and pulling in profits. Revenues minus expenses and taxes is the net income—the same as net earnings. When looking to go long, make sure these numbers are increasing year over year and quarter over quarter. Institutional participants that trade in large size are looking at the same data, yet most average participants are not. Additionally, fund managers typically don’t want to hold positions they cannot justify to their investors, hence the term “window dressing” the portfolio. Many times, funds will move into fundamentally strong issues as their fiscal year ends in order to report quality companies in the portfolio. During the year when they are outside the 10-K spotlight, funds tend to take more risk in issues with less desirable fundamentals but more potential for explosive upside. This desperate method of trading allows fund managers lagging the S&P 500 an opportunity to catch up. Then as the end of the fiscal year approaches, they clean up their act with more fundamentally sound companies—window dressing.
FIGURE 11 - 1 This shows the net revenues, net income, and the net income per share highlighted in a 10-K statement from the SEC Web site.
Another component of fundamental data is the price-to-earnings ratio. The P/E ratio is a common measure of how expensive a stock is. The P/E ratio is the stock’s price divided by the after-tax earnings over a 12-month period. The higher the P/E ratio, the higher the participant will pay for each dollar of annual earnings. One reason the P/E ratio is important is because it is part technical and part fundamental. The stock price component is at least in part derived from technicals, while the earnings component is purely fundamental. By tying a technically based piece of information in with the earnings, you remove some of the subjectivity from the equation, making it less subject to manipulation. The price is what it is. The P/E is a barometer used to measure the price of the stock by comparison to earnings per share.
P/E is calculated by using the following equation:
$10 current market value per share (CMV)/$1 EPS = 10:1 P/E Ratio
In this example, this stock is trading at 10 times the earnings per share. This is often an acceptable ratio for many stocks to trade at and still not be considered overvalued.
However, many growth stocks will trade higher than 10:1 because of the anticipation that future returns will be explosive. For example, if a company earns $1 per share, keeps the money, and then invests it back in the company as opposed to paying it out in dividends, the company should grow by more than $1 next year. If the company earns $2 per share next year, and the average P/E for similar companies is 10:1, then the stock should be valued at $20 for the next year as well ($2 × 10). Instead of the shareholder getting the $2-per-share dividend, the benefit comes in the form of market appreciation. This is one of today’s most important valuation techniques used by fundamentalists and other market players. Most mutual fund managers use this tool to help make investment decisions regarding growth companies.
The P/E ratio is also a lagging indicator because it is calculated over the past year on a quarter-by-quarter basis. The P/E is actually akin to a moving average as a forecasting tool since it calculates the current quarter with the data of the prior three quarters. As time advances, the newest quarter’s data is added and the oldest quarter is dropped off. Therefore, based on the price discounting mechanism of the market, many companies are not profitable during stage 1 accumulation. Like the moving average, the P/E will lag the market since a company with negative earnings will have no P/E. As prices rise into stage 2 markup, the market is telling you to expect improving fundamentals. As the stock price moves higher and company earns a profit, the P/E will start to rise. Remember, the market often anticipates itself, therefore the trader cannot wait for the P/E ratio to come alive anymore than a moving average before acting.
Conversely, because fundamental information and P/Es are closely watched by institutional investors and mutual funds, healthy P/E ratios do not always mean strength. These participants usually enter the market with large-sized positions and cannot enter and exit these positions quickly without impacting the market. Therefore, their large size forces them to be more reliant on eroding fundamentals. If a company has declining revenues and earnings, the risk is higher to institutions since the company could release news that is negative such as lower guidance. In this case, the risk of investment is higher even if the technicals look good.
In the introduction, Bernoulli’s insight regarding the logic behind taking risk stated that if the satisfaction of each new increase in wealth is smaller than the last, then the “disutility” of the loss (risk) will always exceed the positive utility of the gain of equal size.1 This timeless insight applies to the logic of avoiding high-risk situations such as buying a stock on good technicals and eroding fundamentals. Clearly the satisfaction gained in a winning trade (wealth) does not justify the disutility of the loss (risk), since the risk factors are disproportionately higher. This is the lesson regarding fundamentals. If they are to be considered in your trading and investing decisions, they must support the technicals and vise versa.
Doing your own research is the key—especially when you trust your own judgment over the advice of others. This does not mean that all fundamental information is untrustworthy, no more so than it means that all fundamental information is trustworthy. The lesson here is to be your own filter and not let any one piece of fundamental data disproportionately influence your trading decisions. It is the confluence of several independent sources of data, and your analysis of this information that will lead to the lowest risk, highest reward trades.
Remember, the amateur blindly follows the advice of the other people with no filters to determine if the information is nutritional or poison, and even if you don’t actually manage your own money, you must research what is handed to you. If your broker recommends a stock to you, you can take an objective look at the technicals and fundamentals of the stock and have a reasonable process for filtering the stock’s information and then make your own informed decision. If you have money in mutual funds, you can look at the overall market on a technical basis and move your money between mutual funds depending on what stage the market is in and the direction of the trend. The amateur believes there is not much he can do about the market; he is at its mercy. Smart money puts some time and effort into research and takes responsibility. Now that you have a general idea of the two major forms of analysis, it is time to pull it all together, with the greatest emphasis on technical analysis.
Technical analysis, the business cycle, stage analysis, support and resistance, consensus, moving averages, continuation/reversal patterns, and oscillators/indicators can be used to paint a picture of the psychology behind the market. Now it’s time for action. In Chapter 12 we pull together the top-down approach using multiple timeframes to form decisions. The trend alignment of these timeframes is vital before acting on the analysis.
1 Bernstein, Peter L., Against the Gods (New York: John Wiley and Sons, 1996), 112.