When investors in the stock market choose stocks to buy or sell, they commonly apply some degree of fundamental analysis in making their decision. And, what is fundamental analysis? It is a way to determine the real and lasting value of a company and its stock. On one hand, investors look at factors such as the health of the economy, the jobs reports, interest rates, and whatever will tend to increase the value of stocks in general and their portfolio in particular. In regard to their own specific stock picks, fundamental or value investors calculate intrinsic stock value based on forward-looking cash flow. The point of this kind of analysis is to come to measurable and reliable assessment of stock value independent of the current market price.
How to Use Fundamental Analysis
The goals of an assessment of intrinsic stock value via fundamental analysis are two. For long term investors the point is to choose stocks that will grow in value and stock price over the years independent of the ebb and flow of the market. For both long term and short term investors the point is to decide if a stock is overpriced or underpriced in the current market. The concept of mean reversion says that the market price of a security will, over time, trend toward the intrinsic value of that security.
Investors use analysis of fundamentals like company cash flow, debt load, margin of safety with money in the bank and unencumbered assets, and strong brand name and market dominance. With this approach they arrive at an intrinsic value for the stock. Then they compare the intrinsic value to the market value. If the market value is higher than the intrinsic value the stock is overpriced and is sold or avoided. If the intrinsic value is higher than the market price the stock is one to hold or buy. Successful, rich, and famous investors like Warren Buffett use this approach and have been successful for decades. When an investor follows fundamentals over a period of time it is referred to as quality trend analysis.
As a practical matter, for many stocks it can be difficult to determine an accurate intrinsic stock value. Buffett has been quoted as saying that he and his company throw out nineteen out of twenty stocks they analyze as too difficult to determine an accurate intrinsic value.
Another bit of wisdom from Warren Buffett is that he only buys companies when he knows clearly what they do go make money and how that business plan will continue to make money into the long term future. Thus his portfolio is full of strong brand names like Coca Cola, Duracell, and Gillette as well as insurance companies like Geiko. He is a major shareholder in Coca Cola and Gillette. It owns Duracell and Geiko outright.
As a practical matter, investors who base their decisions on fundamental analysis are wary of tech stocks because of how fast changes happen and how quickly a brand new, cutting edge and profitable technology can by bypassed by a new discovery.
Qualitative Factors to Consider in Fundamental Analysis
Certainly we look at a company’s financials to determine much of worth fundamental analysis. But, there are also so-called qualitative issues that are important as well. Three that stand out are business model, competitive advantage, and quality of management.
What plan does a company have to make money and how do they carry it out? Investopedia provides a great example by comparing McDonalds and Boston Chicken. McDonalds sells fast food with a more recent emphasis on healthy and less fatty items. They make money on their real estate but the food business by itself is not only easy to understand but profitable as well. On the other hand, Boston Chicken was a stock market flash in the 1990s with spectacular growth. However, growth came at the expense of profits. The company made all of its money with franchise fees. And, when the franchises started to go out of business, Boston Chicken collapsed.
None other than Warren Buffett has said that he only invests in a company when he fully understands its business model and believes that the business model will provide continuing profits for years to come. And then he only buys their stock with its intrinsic value is greater than the current market price!
Companies that succeed over the long haul do so because they have one or more competitive advantages. Coca Cola comes to mind with its brand name and worldwide distribution network. Microsoft is a good example with its dominance of operating systems and workplace solutions for personal computers as well as cloud-based operations. Having a great idea and putting into operation is great for starters but then copycats show up and chip away at the business a company has built. When a company comes to a critical size it is in a “high cost of entry” business which gives it a competitive advantage versus upstarts.
Doing what your competitors are doing but doing it more efficiently is good for the short term but doing things that no one else has though of and continuing to do so is a better way to achieve a competitive advantage. Companies with strong R&D like the Johnson & Johnson’s and 3M’s of the world come to mind.
This area is of utmost importance as good management tends to make profitable and sustainable choices while bad management send companies off on the wrong track and wrecks even the best business model. Unfortunately, normal investors do not get to sit down with management of big companies for a chat. So, your information tends to be second hand and third hand. Useful ways to get to understand the management of a company are these.
Quarterly Conference Calls
Normally you can listen in one what the CEO and CFO of a company are saying in their quarterly conference calls. The initial part will be part of script but then comes the question and answer part which can be very revealing. Just listening to hear if they are answering directly or avoiding the issue is really important.
Discussion and analysis by manage should be available in every annual report. This may or may not be useful. What is really useful is to compare the discussions year by year. Did they do what they said they were going to do five years ago? How did it work out?
Does the Management Own Shares in the Company and Are They Keeping Them?
When the founder of the company is still in charge and is not selling his or her shares you know that management is focused on long term success. Watch out when you see SEC filings of upper management selling their shares while at the time talking about how well the company is doing!