7. STOCK RESEARCH

7.1. What Are Stock Fundamentals?

We hear the word “fundamentals” on an almost-daily basis. Analysts, executives, and investors appear on CNBC daily to talk about the fundamentals of a stock. Fund managers are always talking about how this or that stock has strong fundamentals. There are also some traders who, in turn, proclaim that fundamentals don’t actually matter and investors should rely on a stock’s “technical” merits instead.

7.1.1. Fundamentals of Stock Fundamentals

In the broadest terms, fundamental analysis involves looking at any data, besides the trading patterns of the stock itself, which can be expected to impact the price or perceived value of a stock. As the name implies, it means getting down to basics.

Unlike its cousin, technical analysis, which focuses only on the trading and price history of a stock, fundamental analysis focuses on creating a portrait of a company, identifying the fundamental value of its shares, and buying or selling the stock based on that information.

Some of the indicators commonly used to assess company fundamentals include:

  • Cash flow
  • Return on assets
  • Conservative gearing
  • History of profit retention for funding future growth
  • Soundness of capital management for the maximization of shareholder earnings and returns

Think of the stock market as a shopping mall. Stocks are the items for sale in the retail outlets. Technical analysts will ignore the goods for sale. Instead, they will keep an eye on the crowds as a guide for what to buy. So, if a technical analystnotices shoppers congregating inside a computer shop, he or she will try to buy as many PCs as possible, betting that the growing demand will push PC prices higher.

7.1.2. The Fundamental Approach

Fundamental analysts have a more staid approach. Their sights are set solely on the products in the mall. Shoppers are dismissed as an unreliable, emotional herd with no inkling of the real value of the goods for sale. Fundamental analysts move slowly through the stores seeking the best deals. Once the crowd moves on from the PCs, they will take a closer look at the ones that were passed over.

Fundamental analysts might take a stab at determining the scrap value of the PC stripped down to its hard disk, memory cards, monitor, and keyboard. In the stock market, this is akin to calculating the book value, or liquidation price, of a company.

Fundamental analysts will also take a very close look at the quality of the PC. Is it going to last, or will it break down within a year? The fundamental analysts will pore over the specifications, scrutinize the manufacturer’s warranty, and consult consumer reports. Similarly, equity analysts check a company’s balance sheet for financial stability.

Then, the fundamental analysts might try to understand the performance of the PC in terms of, say, processing power, memory, or image resolution. These are like the forecast earnings and dividends identified from a company’s income statement.

Finally, the fundamental analysts will put together all the data and come up with an intrinsic value, or value independent of the current sale price. If the sale price is less than the calculated intrinsic value, the fundamentalists will buy PCs. If not, they will either sell the PCs they already own or wait for prices to fall before buying more.

7.1.3. Good Fundamentals Don’t Equal Profits

Performing fundamental analysis can be a lot of hard work. But that is, arguably, the source of its appeal. By taking the trouble to dig into a company’s financial statements and assessing its future prospects, investors can learn enough to know when the stock price is wrong. These conscientious investors are able to spot the market’s mistakes and make themselves money. At the same time, buying companies based on intrinsic, long-term value protects investors from the dangers of day-to-day market fluctuations.

However, the fact that fundamental analysis shows that a stock is undervalueddoes not guarantee that it will trade at its intrinsic value any time soon. Things are not so simple. In reality, real share price behavior relentlessly calls into question almost every stock holding, and even the most independently minded investor can start doubting the merits of fundamental analysis. There is no magic formula for figuring out intrinsic value.

When the stock market is booming, it is easy for investors to fool themselves into thinking they have a knack for picking winners. But when the market falls and the outlook is uncertain, investors cannot rely on luck. They actually need to know what they’re doing.

Bottom Line

There is much that the investor can do to learn about fundamentals. Investors who roll up their sleeves and tackle the terminology, tools, and techniques of fundamental analysis will enjoy greater confidence in using financial information and, at the same time, will probably become better stock pickers. At the very least, investors will have a better idea of what is meant when someone recommends a stock on strong fundamentals.

7.2. Five Essentials You Need To Know About Every Stock You Buy

Investing is easy, but investing successfully is tough. Statistics show that the majority of retail investors, those who aren’t investment professionals, lose money every year. There could be a variety of reasons why, but there is one that every investor with a career outside of the investment market understands: they don’t have time to research a large amount of stocks, and they don’t have a research team to help with that monumental task. (For related reading, check out The 4 Basic Elements Of Stock Value.)

For that reason, investments made after little research often result in losses. That’s the bad news. The good news is that, although the ideal way to purchase a stock is after a large amount of research, an investor can cut down on the amount of research by looking at these select items: TUTORIAL: Bond & Debt Basics

7.2.1. What They Do

Jim Cramer, in his book “Real Money,” advises investors to never purchase a stock unless they have an exhaustive knowledge of how they make money. What do they manufacture? What kind of service do they offer? In what countries do they operate? What is their flagship product and how is it selling? Are they known as the leader in their field? Think of this as a first date. You probably wouldn’t go on date with somebody if you had no idea who they were. If you do, you’re asking for trouble.

This information is very easy to find. Using the search engine of your choice, go to their company website and read about them. Then, as Cramer advises, go to a family member and educate them on your potential investment. If you can answer all of their questions, you know enough.

7.2.2. Price/Earnings Ratio

Imagine for a moment you were in the market for somebody who could help you with your investments. You interview two people. One person has a long history of making people a lot of money. Your friends have seen a big return from this person, and you can’t find any reason why you shouldn’t trust him with your investment dollars. He tells you that for every dollar he makes for you, he’s going to keep 40 cents, leaving you with 60 cents. The other guy is just getting started in the business. He has very little experience and, although he seems promising, he doesn’t have much of a track record of success. The advantage to this guy is that he’s cheaper. He only wants to keep 20 cents for every dollar he makes you - but what if he doesn’t make you as many dollars as the first guy?

If you understand this example, you understand the P/E or price/earnings ratio. If you notice that a company has a P/E of 20, this means that investors are willing to pay $20 for every $1 per earnings. That might seem expensive but not if the company is growing fast.

The P/E can be found by comparing the current market price to the cumulative earnings of the last four quarters. Compare this number to other companies similar to the one you’re researching. If your company has a higher P/E than other similar companies, there had better be a reason. If it has a lower P/E but is growing fast, that’s an investment worth watching. (If these numbers have you in the dark, these easy calculations should help light the way, see How To Find P/E And PEG Ratios.)

7.2.3. Beta

Beta seems like something difficult to understand, but it’s not. In fact, it can be found on the same page as the P/E Ratio on a major stock data provider, such as Yahoo or Google. Beta measures volatility or how moody your company’s stock has acted over the last five years. Think of the S&P 500 as the pillar of mental stability. If your company drops or rises in value more than the S&P over a five-year period, it has a higher beta. With beta, anything higher than 1 is high beta (meaning higher risk) and anything lower than 1 is low beta (lower risk). (Beta says something about price risk, but how much does it say about fundamental risk factors?)

You have to watch high beta stocks closely because, although they have the potential to make you a lot of money, they also have the potential to take your money. A lower beta means that a stock doesn’t react to the S&P 500 movements as much as others. This is known as a defensive stock because your money is much safer. You won’t make as much in a short amount of time, but you also don’t have to watch it every day.

7.2.4. Dividend

If you don’t have time watch the market every day, and you want your stocks to make money without that kind of attention, look for dividends. Dividends are like interest in a savings account. You get paid regardless of the stock price. Dividends of 6% or more are not unheard of in high quality stocks. Before purchasing a stock, look for the dividend rate. If you simply want to park money in the market, invest in stocks with a high dividend. (For more, see Why Dividends Matter.)

7.2.5. The Chart

Learning to read a chart is a skill that takes time, but basic chart reading takes very little skill. If an investment’s chart starts at the lower left and ends at the upper right, that’s a good thing. If the chart is heading down, stay away and don’t try to figure out why. There are thousands of stocks to choose from without picking one that is losing money. If you really believe in this stock, put it on your watch list and come back to it at a later time. There are many people who believe in investing in stocks that have scary looking charts, but they have research time and resources that you probably don’t.

The Bottom Line

Nothing takes the place of exhaustive research. However, one key way to protect your assets is to invest for the longer term by taking advantage of dividends and finding stocks with a proven record of success. Unless you have the time, risky and aggressive trading strategies should be avoided or minimized.

7.3. Sector Breakdown

7.3.1. What Is a Sector Breakdown?

A sector breakdown is the mix of sectors within a fund or portfolio, typically expressed as a portfolio percentage. Sector designations can vary depending on the fund’s investment criteria and overall objective.

7.3.2. Understanding Sector Breakdown

A sector breakdown is provided for fund analysis and can help an investor to observe the investment allocations of a fund. Sector investing can be a significant factor influencing investments in the fund. A fund may target a specific sector, seek to diversify among sectors or generally have sector variance that results from investing from a broad universe. A sector fund would have an allocation of 100% to a specified sector.

Some funds may have restraints on sector investments. Therefore sector analysis is used by fund managers to exclude specific investments. This often occurs with environmental, social and governance focused funds. These funds seek to exclude micro sectors like tobacco.

Fund companies regularly provide sector reporting in their marketing materials. Sector breakdowns provide a representation of the sector allocations of the fund’s assets, often on a monthly or quarterly basis. Some funds may even report sector breakdowns daily on the fund’s website.

7.3.3. GICS Sectors

Sectors are typically considered to be a broad classification. Within each sector numerous sub-sectors and industries can also be further delineated. The Global Industry Classification Standard also known as GICS is the primary financial industry standard for defining sector classifications.

The Global Industry Classification Standard was developed by index providers MSCI and Standard and Poor’s. Its hierarchy begins with 11 sectors which can be further delineated to 24 industry groups, 68 industries and 157 sub-industries. It follows a coding system which assigns a code from each grouping to every company publicly traded in the market. The GICS coding system is integrated throughout the industry allowing for detailed reporting and stock screening through financial technology.

The 11 broad GICS sectors commonly used for sector breakdown reporting include the following:

  • Energy
  • Materials
  • Industrials
  • Consumer Discretionary
  • Consumer Staples
  • Health Care
  • Financials
  • Information Technology
  • Telecommunication Services
  • Utilities
  • Real Estate

7.3.4. Diversification and Sectors

A diversified stock portfolio will hold stocks across most, if not all, GICS sectors. Diversification across stock sectors helps to mitigate idiosyncratic or unsystematic risks caused by factors affecting specific industries or companies within an industry.

Sector indexes can also be used by investors seeking to invest in the growth prospects of a single sector. Investment companies offer passive index funds that seek to replicate each of the eleven GICS sectors. The Vanguard Information Technology Index Fund is one example of a passively managed mutual fund that seeks to replicate the holdings of the MSCI U.S. Investable Market Information Technology Index. The strategy is also available to investors through an exchange-traded fund, the Vanguard Information Technology ETF.

7.4. How to Analyze a Company’s Financial Position

To understand and value a company, investors have to look at its financial position. Fortunately, it is not as difficult as it sounds to perform a financial analysis of a company by examining its financial statements.

If you borrow money from a bank, you have to list the value of all of your significant assets, as well as all of your significant liabilities. Your bank uses this information to assess the strength of your financial position; it looks at the quality of the assets, such as your car and your house, and places a conservative valuation upon them. The bank also ensures that all liabilities, such as mortgage and credit card debt, are appropriately disclosed and fully valued. The total value of all assets less the total value of all liabilities gives your net worth or equity.

Evaluating the financial position of a listed company is quite similar, except investors need to take another step and consider that financial position in relation to market value. Let’s take a look.

7.4.1. Start with the Balance Sheet

Like your own financial position, a company’s financial situation is defined by its assets and liabilities. A company’s financial position also includes shareholder equity. All of this information is presented to shareholders in the balance sheet.

Let’s suppose that we are examining the financial statements of the fictitious publicly listed retailer The Outlet to evaluate its financial position. To do this, we review the company’s annual report, which can often be downloaded from a company’s website. The standard format for the balance sheet is assets, followed by liabilities, then shareholder equity.

7.4.2. Current Assets and Liabilities

Assets and liabilities are broken into current and non-current items. Current assets or current liabilities are those with an expected life of fewer than 12 months. For example, suppose that the inventories that The Outlet reported as of December 31, 2018, are expected to be sold within the following year, at which point the level of inventory will fall, and the amount of cash will rise.

Like most other retailers, The Outlet’s inventory represents a significant proportion of its current assets, and so should be carefully examined. Since inventory requires a real investment of precious capital, companies will try to minimize the value of a stock for a given level of sales, or maximize the level of sales for a given level of inventory. So, if The Outlet sees a 20% fall in inventory value together with a 23% jump in sales over the prior year, this is a sign they are managing their inventory relatively well. This reduction makes a positive contribution to the company’s operating cash flows.

Current liabilities are the obligations the company has to pay within the coming year, and include existing (or accrued) obligations to suppliers, employees, the tax office and providers of short-term finance. Companies try to manage cash flow to ensure that funds are available to meet these short-term liabilities as they come due.

7.4.3. The Current Ratio

The current ratio – which is total current assets divided by total current liabilities – is commonly used by analysts to assess the ability of a company to meet its short-term obligations. An acceptable current ratio varies across industries, but should not be so low that it suggests impending insolvency, or so high that it indicates an unnecessary build-up in cash, receivables or inventory. Like any form of ratio analysis, the evaluation of a company’s current ratio should take place in relation to the past.

7.4.4. Non-Current Assets and Liabilities

Non-current assets or liabilities are those with lives expected to extend beyond the next year. For a company like The Outlet, its biggest non-current asset is likely to be the property, plant and equipment the company needs to run its business.

Long-term liabilities might be related to obligations under property, plant and equipment leasing contracts, along with other borrowings.

7.4.5. Financial Position: Book Value

If we subtract total liabilities from assets, we are left with shareholder equity. Essentially, this is the book value, or accounting value, of the shareholders’ stake in the company. It is principally made up of the capital contributed by shareholders over time and profits earned and retained by the company, including that portion of any profit not paid to shareholders as a dividend.

7.4.6. Market-to-Book Multiple

By comparing the company’s market value to its book value, investors can in part determine whether a stock is under- or over-priced. The market-to-book multiple, while it does have shortcomings, remains a crucial tool for value investors. Extensive academic evidence shows that companies with low market-to-book stocks perform better than those with high multiples. This makes sense since a low market-to-book multiple shows that the company has a strong financial position in relation to its price tag.

Determining what can be defined as a high or low market-to-book ratio also depends on comparisons. To get a sense of whether The Outlet’s book-to-market multiple is high or low, you need to compare it to the multiples of other publicly listed retailers.

The Bottom Line

A company’s financial position tells investors about its general well-being. A financial analysis of a company’s financial statements - along with the footnotes in the annual report - is essential for any serious investor wanting to understand and value a company properly.

7.5. Technical Analysis Definition

7.5.1. What is Technical Analysis?

Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume. Unlike fundamental analysts, who attempt to evaluate a security’s intrinsic value, technical analysts focus on patterns of price movements, trading signals and various other analytical charting tools to evaluate a security’s strength or weakness.

Technical analysis can be used on any security with historical trading data. This includes stocks, futures, commodities, fixed-income, currencies, and other securities. In this tutorial, we’ll usually analyze stocks in our examples, but keep in mind that these concepts can be applied to any type of security. In fact, technical analysis is far more prevalent in commodities and forex markets where traders focus on short-term price movements.

KEY TAKEAWAYS

  • Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities in price trends and patterns seen on charts.
  • Technical analysts believe past trading activity and price changes of a security can be valuable indicators of the security’s future price movements.
  • Technical analysis may be contrasted with fundamental analysis, which focuses on a company’s financials rather than historical price patterns or stock trends.

7.5.2. The Basics Of Technical Analysis

Technical analysis as we know it today was first introduced by Charles Dow and the Dow Theory in the late 1800s. Several noteworthy researchers including William P. Hamilton, Robert Rhea, Edson Gould and John Magee further contributed to Dow Theory concepts helping to form its basis. In modern day, technical analysis has evolved to included hundreds of patterns and signals developed through years of research.

Technical analysts believe past trading activity and price changes of a securitycan be valuable indicators of the security’s future price movements. They may use technical analysis independent of other research efforts or in combination with some concepts of intrinsic value considerations but most often their convictions are based solely on the statistical charts of a security. The Market Technicians Association (MTA) is one of the most popular groups supporting technical analysts in their investments with the Chartered Market Technicians (CMT) designation a popular certification for many advanced technical analysts.

7.5.3. The Underlying Assumptions of Technical Analysis

There are two primary methods used to analyze securities and make investment decisions: fundamental analysis and technical analysis. Fundamental analysis involves analyzing a company’s financial statements to determine the fair value of the business, while technical analysis assumes that a security’s price already reflects all publicly-available information and instead focuses on the statistical analysis of price movements. Technical analysis attempts to understand the market sentiment behind price trends by looking for patterns and trends rather than analyzing a security’s fundamental attributes.

Charles Dow released a series of editorials discussing technical analysis theory. His writings included two basic assumptions that have continued to form the framework for technical analysis trading.

  1. Markets are efficient with values representing factors that influence a security’s price, but
  2. Market price movements are not purely random but move in identifiable patterns and trends that tend to repeat over time

The efficient market hypothesis (EMH) essentially means the market price of a security at any given point in time accurately reflects all available information, and therefore represents the true fair value of the security. This assumption is based on the idea that the market price reflects the sum total knowledge of all market participants. While this assumption is generally believed to be true, it can be affected by news or announcements about a security that may have varied short-term or long-term influence on a security’s price.Technical analysis only works if markets are weakly efficient.

The second basic assumption underlying technical analysis, the notion that price changes are not random, leads to the belief of technical analysts that market trends, both short-term and long-term, can be identified, enabling market traders to profit from investing based on trend analysis.

Today, technical analysis is based on three main assumptions:

1: The market discounts everything.
Many experts criticize technical analysis because it only considers price movements and ignores fundamental factors. Technical analysts believe that everything from a company’s fundamentals to broad market factors to market psychology are already priced into the stock. This removes the need to consider the factors separately before making an investment decision. The only thing remaining is the analysis of price movements, which technical analysts view as the product of supply and demand for a particular stock in the market.
2: Price moves in trends.
Technical analysts believe that prices move in short-, medium-, and long-term trend. In other words, a stock price is more likely to continue a past trend than move erratically. Most technical trading strategies are based on this assumption.
3: History tends to repeat itself.
Technical analysts believe that history tends to repeat itself. The repetitive nature of price movements is often attributed to market psychology, which tends to be very predictable based on emotions like fear or excitement. Technical analysis uses chart patterns to analyze these emotions and subsequent market movements to understand trends. While many form of technical analysis have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.

7.5.4. How Technical Analysis Is Used

Technical analysis attempts to forecast the price movement of virtually any tradable instrument that is generally subject to forces of supply and demand, including stocks, bonds, futures and currency pairs. In fact, some view technical analysis as simply the study of supply and demand forces as reflected in the market price movements of a security. Technical analysis most commonly applies to price changes, but some analysts track numbers other than just price, such as trading volume or open interest figures.

Across the industry there are hundreds of patterns and signals that have been developed by researchers to support technical analysis trading. Technical analysts have also developed numerous types of trading systems to help them forecast and trade on price movements. Some indicators are focused primarily on identifying the current market trend, including support and resistance areas, while others are focused on determining the strength of a trend and the likelihood of its continuation. Commonly used technical indicators and charting patterns include trendlines, channels, moving averages and momentum indicators.

In general, technical analysts look at the following broad types of indicators:

  • price trends
  • chart patterns
  • volume and momentum indicators
  • oscillators
  • moving averages
  • support and resistance levels

7.5.5. The Difference Between Technical Analysis And Fundamental Analysis

Fundamental analysis and technical analysis, the major schools of thought when it comes to approaching the markets, are at opposite ends of the spectrum. Both methods are used for researching and forecasting future trends in stock prices, and like any investment strategy or philosophy, both have their advocates and adversaries.

Fundamental analysis is a method of evaluating securities by attempting to measure the intrinsic value of a stock. Fundamental analysts study everything from the overall economy and industry conditions to the financial condition and management of companies. Earnings, expenses, assets and liabilities are all important characteristics to fundamental analysts.

Technical analysis differs from fundamental analysis in that the stock’s price and volume are the only inputs. The core assumption is that all known fundamentals are factored into price; thus, there is no need to pay close attention to them. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use stock charts to identify patterns and trends that suggest what a stock will do in the future.

7.5.6. Limitations Of Technical Analysis

The major hurdle to the legitimacy of technical analysis is the economic principle of the efficient markets hypothesis. According to the EMH, market prices reflect all current and past information already and so there is no way to take advantage of patterns or mispricings to earn extra profits, or alpha. Economists and fundamental analysts who believe in efficient markets do not believe that any actionable information is contained in historical price and volume data, and furthermore that history does not repeat itself; rather, prices move as a random walk.

A second criticism of technical analysis is that it works in some cases but only because it constitutes a self-fulfilling prophesy. For example, many technical traders will place a stop-loss order below the 200-day moving average of a certain company. If a large number of traders have done so and the stock reaches this price, there will be a large number of sell orders, which will push the stock down, confirming the movement traders anticipated. Then, other traders will see the price decrease and also sell their positions, reinforcing the strength of the trend. This short-term selling pressure can be considered self-fulfilling, but it will have little bearing on where the asset’s price will be weeks or months from now. In sum, if enough people use the same signals, they could cause the movement foretold by the signal, but over the long run this sole group of traders cannot drive price.