FINDING STOCKS TO BUY AND SELL

PART THREE FINDING STOCKS TO BUY AND SELL 10381_Sincere_03.c 7/18/03 10:58 AM Page 87 Copyright © 2004 by The McGraw-Hill Companies, Inc. Click here for Terms of Use. This page intentionally left blank. 9 89 It’s Really Fundamental: Introduction to Fundamental Analysis The two main methods that people use to pick stocks are fundamental analysis and technical analysis. Fundamental analysis is the study of the underlying data that affect a corporation. Technical analysis, on the other hand, is the study of a stock’s price. Some of you may find that fundamental analysis is all you need in order to be a successful investor. After all, understanding and applying fundamental stock analysis helped make billionaire investor Warren Buffett a very rich man. In addition, successful mutual fund managers, such as Peter Lynch, Robert Rodriguez, and William Miller, to name a few, have also used fundamental analysis to find stocks in high-quality companies at bargain prices. If you want to learn about the stock mar- ket, you must have at least a basic understanding of fundamental analy- sis. It is worth your time to study it. CHAPTER 10381_Sincere_03.c 7/18/03 10:58 AM Page 89 Copyright © 2004 by The McGraw-Hill Companies, Inc. Click here for Terms of Use. Fundamental Analysis: An Overview When you buy a stock on the basis of fundamental analysis, you are not simply buying a piece of paper; rather, you are buying a piece of a cor- poration. If you’re going to buy a stock, you should find out as much as you can about the corporation. This is the essence of fundamental analysis: You study the corporation to decide whether it is a worthwhile investment. This includes looking at a number of factors, including the com- pany’s assets and liabilities, its earnings, the managers who are running the company, the competition, the kind of business the company is in, and the amount of debt it has. (You can find many of these items in the balance sheet, a brief financial report of the corporation that will be discussed shortly.) By using fundamental analysis, you should be able to pick out stocks that offer you the best chance for profits. You want to buy a stock whose price is reasonable when compared with its earn- ings—what fundamental analysts call “fair value.” You should know that fundamental analysis is one of the most popu- lar methods of determining whether a stock is a good bargain or is better left alone. If you have done your homework and closely studied all as- pects of a corporation, you should be rewarded with a higher stock price. Nevertheless, fundamental analysis is merely a tool to help you find and evaluate which stocks offer good value. Like anything related to the stock market, this method is more art than science. Just because you use fundamental analysis doesn’t mean that you’ll make a lot of money in the market. The more methods you learn, however, the better. This will also give you a chance to determine whether fundamental analysis is right for you. The Concepts behind Fundamental Analysis Learn Everything You Can about the Industry The first thing an investor has to determine when engaging in funda- mental analysis is what industry to look at. If we are in the middle of a recession, when jobs are scarce and people are struggling to stay out of 90 U NDERSTANDING S TOCKS 10381_Sincere_03.c 7/18/03 10:58 AM Page 90 debt, you might look at recession-proof industries like food, oil, and retail. Once the country is out of the doldrums and jobs are plentiful, you take a look at industries like technology that could take the market higher. Peter Lynch, a successful fund manager of the 1980s and 1990s, got many of his stock ideas by watching where his children shopped at the mall. If you go to the mall and The Gap, Starbucks, Hott Topic, or Victoria’s Secret is filled with shoppers, this is a clue that these stores are making money. This doesn’t mean that you should run out and buy stock in one of these companies—first you should use fundamental analysis to find out everything you can about the company. You should also take the time to read the annual report, call investor relations for an investment packet, and log on to the company Web site. You don’t want to invest a lot of money in a stock without finding out everything you can about the company’s business. Ideally, the business will be simple and understandable with good long-term prospects for the future. Identify the Leading Company Once you have identified the industry you want to invest in, you want to choose companies that are stronger and more profitable than their competition. Let’s say you want to invest in the retail sector because you believe (after careful research) that people will flock to discount stores that can save them money. What stores come to mind? Wal- Mart? Home Depot? Walgreen’s? Exactly. Choose the stores that have name brand recognition and that advertise heavily. These companies are called industry leaders. If people are buying the company’s prod- ucts, the company’s earnings will go up, which should cause the stock price to rise. To find industry leaders, you want to look for companies that have superior sales and earnings with little or no debt. The financial newspaper Investor’s Business Daily rates the relative strength of stocks in leading industries, giving them a score between 1 and 99. A relative strength rating higher than 90 is considered excellent. You can also find information about industry leaders in the Value Line Investment Survey, which can be found at the public library. (The Value Line Investment Survey has loads of information about individual stocks condensed on one page. Nearly all of the fundamental information you need to know about a stock can be found in this periodical.) IT ’ S REALLY FUNDAMENTAL : INTRODUCTION TO FUNDAMENTAL ANALYSIS 91 10381_Sincere_03.c 7/18/03 10:58 AM Page 91 Talk to the Managers Many investors who use fundamental analysis believe in talking to the CEO and company managers to get a feel for how the corporation is being run. Ideally, when you speak to management, you can ask how the business is doing, where it will be spending its money, and who its competitors are; you can also get insights about the corporation. Ques- tioning managers is something that many professional fund managers do. They want to invest in companies with experienced, innovative managers who have a vision for the future. They try to avoid companies that have too much debt, are losing business to competitors, and have other liabilities (like lawsuits) that can affect earnings. As an individual investor, it is highly unlikely that you will be able to sit down with the CEO or upper management to share a drink and a game of golf and to try to find out exactly what is going on in the cor- poration. And even if you could, it is doubtful that the CEO would say anything negative about the corporation. That is why management interviews are somewhat controversial and why some professional investors would rather study the balance sheet than talk with managers. Company Insiders: Watch Them Closely According to the SEC, officers and directors of a corporation who have access to proprietary information and people who own more than 10 percent of the corporation’s stock are considered corporate insiders. You can get clues to how a stock will do by looking at whether insid- ers are buying or selling the stock. To find what insiders are doing, log onto Yahoo! Finance (finance.yahoo.com), CBS Marketwatch (www. marketwatch.com), or Bloomberg (www.bloomberg.com). In addition, the SEC’s Web site, www.sec.gov, manages the EDGAR (Electronic Data Gathering Analysis and Retrieval) database, which contains many fascinating financial documents about the actions of insiders. Some investors have created strategies that involve copying insid- ers. After all, insiders are more knowledgeable about the future prospects of the company than others are. On the other hand, there are problems with tracking insider transactions. Sometimes insiders buy or sell for reasons that have nothing to do with what is happening at the 92 U NDERSTANDING S TOCKS 10381_Sincere_03.c 7/18/03 10:58 AM Page 92 company. In addition, because of the way insider transactions are reported, you may not find out what insiders are doing until it is too late. For example, while the CEOs of Enron and WorldCom dumped millions of shares of stock in their companies, their action wasn’t made public until the stocks were trading for pennies a share (insider reports are sometimes delayed by up to 3 months). The Balance Sheet: Uncovering the Truth about a Company’s Finances A balance sheet is a report of the financial condition of a business, including items that only an accountant could love. And yet, to really understand the company you have invested in, you should study its bal- ance sheet. Unfortunately, most people buy stocks without taking the time to read the balance sheet. Just remember this: You shouldn’t waste thou- sands of dollars investing in a company unless you know a few facts about it, like how much the company earns, how much it spends, and how much it owes. When you have found out the truth about a com- pany’s earnings, expenses, and debt, you’ll have a better idea of whether you should buy its stock. The balance sheet is found at the back of a company’s annual report. You can also find any company’s balance sheet by registering free at www.businessweek.com. Type in the stock symbol and select SEC filings. You can also log on to Edgar Online, a subscription-based service that allows you access to all SEC filings, including the quar- terly 10-Q filing and the annual 10-K filing. Let’s take a quick look at some of the items on a balance sheet (which by no means includes everything): 1. Assets (what the company owns, such as cash, property, equip- ment, real estate, and accounts receivable) 2. Liabilities (what the company owes, such as declared and unpaid dividends and accounts payable) 3. Shareholders’ equity, or net worth (assets minus liabilities) Let’s take a look at Bright Light’s consolidated balance sheet, shown in Figure 9-1. IT ’ S REALLY FUNDAMENTAL : INTRODUCTION TO FUNDAMENTAL ANALYSIS 93 10381_Sincere_03.c 7/18/03 10:58 AM Page 93 Simply put, a balance sheet is a list of everything a company owns and everything it owes. This gives shareholders a snapshot of the com- pany’s finances. The best way to study a balance sheet is to compare it to the balance sheets of other companies in the same industry. In addi- tion, you should look at the balance sheet for previous years to get a better idea of where the company has been and where it might be going. 94 U NDERSTANDING S TOCKS Bright Light Balance Sheet (in thousands) December 31, December 31, 2002 2001 ASSETS Current Assets Cash and cash equivalents 1,196 1,098 Accounts receivables 1,637 1,367 Inventories 528 530 Deferred income taxes 158 120 Property and equipment 978 877 Other assets 325 103 —————— —————— Total Current Assets: 4,822 4,095 LIABILITIES AND STOCKHOLDER’S EQUITY Current Liabilities Accounts Payable 879 525 Accrued Expenses 578 502 Income taxes payable 186 179 Current Portion of Long-Term Debt 98 75 —————— —————— Total current liabilities: 1,741 1,281 Stockholder’s Equity Common stock 1,567 1,567 Retained earnings 1,514 1,247 —————— —————— Total stockholder’s equity: 3,081 2,814 Total liabilities and stockholder’s equity: 4,822 4,095 Figure 9-1 10381_Sincere_03.c 7/18/03 10:58 AM Page 94 As long as the company is not hiding debt or liabilities, the balance sheet gives you a glimpse of its financial condition. However, reading a balance sheet takes skill because some companies are clever at hiding their expenses and debt while exaggerating their earnings. For example, only a handful of knowledgeable investors figured out that the balance sheets of companies like Enron and WorldCom didn’t add up. As it turned out, upper management at these two compa- nies gave an extremely distorted view of the true financial picture. It would have been difficult, if not impossible, for investors to uncover the truth. Nevertheless, before Enron’s collapse, financial expert War- ren Buffett reminded investors he never invested in a company in which he didn’t understand how they made money. The lesson: If you’re still confused after reading the balance sheet, invest your money elsewhere. The Annual Report For many people, there isn’t anything more boring than reading the annual report, a financial report of large, publicly owned cor- porations. These reports are often long, generally 30 or more pages containing important financial statements such as the bal- ance sheet and income statement. In addition, there might be a letter from the CEO about the steps he or she is taking to make the business more profitable, how the company has performed, and business strategies. Unless you are an accountant or lawyer, it could easily take you all day to wade through the entire report, which often contains public relations fluff. Many pros have learned to focus only on the information in the report they believe is important and ignore the rest. To cover themselves, many companies will mention all of the risks you’ll take if you invest in the company. They also tend to highlight the positive aspects of their business while minimizing the negative. As mentioned before, a few companies purposely deceived investors into believing they were more profitable than they were, although a careful read of the annual report could pro- vide clues that the company was not entirely truthful. Some of the most fascinating tidbits can be found in the footnotes. This is per- IT ’ S REALLY FUNDAMENTAL : INTRODUCTION TO FUNDAMENTAL ANALYSIS 95 10381_Sincere_03.c 7/18/03 10:58 AM Page 95 haps where you’ll learn about perceived risks, ongoing legal issues, and other unforeseen problems. Although it might be painful to read the entire annual report, it’s worth your while to understand where you are putting your hard-earned money. If you are a long-term investor, you want to learn whether or not the company is making money, whether its debt is rising or falling, and if management has a successful busi- ness plan. In the next chapter, you will learn the tools and tactics that funda- mental analysts use to value stocks. 96 U NDERSTANDING S TOCKS 10381_Sincere_03.c 7/18/03 10:58 AM Page 96 . PART THREE FINDING STOCKS TO BUY AND SELL 10381_Sincere_03.c 7/18/03 10:58 AM Page 87 Copyright © 2004. higher stock price. Nevertheless, fundamental analysis is merely a tool to help you find and evaluate which stocks offer good value. Like anything related to