THIS IS MY 59TH BLOG ON UNDERSTANDING MONEY TOOLS
In my last blog I wrote that I might write a blog on stock
and market analysis. Well, I got
bored, took my own suggestion to heart and this blog will cover very
fundamental analysis. Many of the roots of this go back for me to college and
business school in the 1960s. The basics remain the same. We’ll take a look at
fundamentals, and then some comments on how much of it is irrelevant in today’s
world of computers and trading in fractions of a second.
There are stock and market analysts, and economists trying
to figure out national and international issues all effecting the markets; lots
of variables. Bottom line there are only three things that can happen to the
stock market, it will go up, or it will go down, or stay the same. The
likelihood of the market staying exactly the same is zero. Traders for the big
companies can make money if the markets go up or down, but they can’t make
money with stagnant markets.
Before we start, let me make a statement that has usually
held true and that is that a monkey selecting stocks at random does just as
well as the educated and knowledgeable analyst.
Let’s take stocks to start with. Much of this I have covered
in previous blogs, and again nothing that I have personally created. To view
the financial situation of a corporation let’s start with their income
statement. What are their sales (gross revenues) and expenses? What does the
company’s cash flow look like? A company should definitely be up-trending for
you to show interest. Then, we need to look at the sector in general, how does
this company’s performance stack up to other companies in the “sector” or
industry? For how many months, years, etc? If you compare one company that has
only been in business three years to one that has been in business 30
years, that is not really a true
comparison. However, the younger company may have newer equipment, newer
technology, etc. Some industry people now refer to this as “weighted alpha”;
alpha being a particular industry sector.
Next, there are earnings per share (P/E) and projected
earnings per share (PP/E). Earnings per share is just the price per share of
the stock divided by the earnings, assuming earnings are positive! Compare this
number to their past history and other companies in the sector. The lower the
P/E the better. Projected earnings
or PEG projected earnings growth is more difficult and leaves more variables
with assumptions made by the company and analysts. You need to establish a
baseline to compare from, or to, an industry average.
Next, look at industry projections. In the long term, how
much need will there be for the products produced? Years ago we bought a stock
and held on for long periods, those days are gone. Look at the companies that
have left the DOW Jones Industrial Averages over the past 50 years and have
been replaced by new companies in different industries. Long term thinking is
pretty much gone. There are special situations that help companies short term.
Let’s take the lower price of oil. This should have a nice impact on
transportation companies including airlines, delivery companies like Fed Ex and
UPS where much of their expense is fuel. Companies buy fuel way ahead on the
commodities market and lock in price. The same holds true for the farming
industry and agriculture.
Now, we will take a look at a company’s balance sheet.
Again, in simplified form a balance sheet is assets minus liabilities and
stockholders equity. Liabilities may be divided into long term and short term.
This is really relevant when it comes to debt and bank debt. In 2008 it
crippled a ton of companies. Banks called in their loans made to companies for
operating loans, mainly loans under 5 years in length, and due and payable for
any reason the lender deemed appropriate. You should look at capital
expenditures, dividends, depreciation of equipment (accounting’s amortized
costs of equipment), when will equipment need replacing and how dated is that
equipment? One must look at an
individual company, and its history.
What is the price of the stock and capitalization of the
company in relation to its “book value”? There is book value that you can get
from company information and “break up” value, meaning the parts of a company
if everything falls apart. Break up values are to be noted more with “holding
companies” or “parent companies” that own several companies under them. A good
ratio of book value is 1.5.
“Debt to equity”. As we mentioned there is short term debt
and long term debt. Short term debt can be a problem to a company if they can’t
refinance, or there is a prolonged recession or downturn in the economy. There
are also contingent liabilities to look at. Did the company sign a promissory
note for payment under a special situation where they could be held liable for
payment of the note if the company holding the obligation or note defaulted? An
example would be the parent company signing a note so that a subsidiary company
could receive a bank loan.
In the balance sheet, look at receivables and payables.
Receivables are great if you can get paid. Many companies will “factor” their
receivables to a loan company to quicken cash flow. “Factoring receivables”
means selling the future income owed to you by other companies at a discounted
value. This amount is also weighted to expected loan defaults. “Payables” are
the amounts of money the company owes other companies, firms and individuals.
Something few people look at when reviewing a company is the
company pension plan. Has the company been borrowing from their pension plans
to operate the company? This is a legal obligation to fully fund a pension,
unless bankruptcy occurs. This amount can easily be in the millions of dollars.
An example where the company could not fund its pension and hold to obligations
was the Pabst Brewery bankruptcy in the mid-1990s. The employees lost both
pensions and promises for health insurance.
“Liquid asset test”. This valuation standard has been around
for years. The calculation is assets of a company divided by total liabilities.
The old standard was a 2:1 ratio. You would want to protect yourself as an
owner of stock if there were problems with the company or a liquidation of
assets.
“Insider trading”.
This can be an indication of what the “boys” think of the company and
the future. Of course this is not just “boys” but girls, women and ladies. To date, I really haven’t found many “ladies” in this
grouping! Insiders are typically
the officers and board members of a given company. With these positions they
need to report the numbers of shares they are buying or selling. If there is a
lot of insider buying that is good. If there is significant insider selling,
watch out, those who know what is going on with the company want to get their
money out. Trading on “insider information” is illegal, monitoring if insiders
are buying or selling is not. The
government wanted to set an example several years back on trading given inside
information. Martha Stewart was tipped off by an officer in the drug company
Imclone that negative news was about to be released, therefore she sold her
stock position. Somehow she got
caught. The government came after her and she was found guilty. Martha spent a
little time in a minimum security prison practicing her sewing techniques. Yet
in reality, trading with insider information has always been a practice for the
wealthy and banking institutions. Do you not think that the employees of the
large banking/investment banking institutions did not have knowledge that our
mortgage derivatives were falsely rated between 2003 and 2008? The same
happened with mortgage derivatives taking down the Savings and Loans Industry
in the mid to late 1980s. Only a couple people have seen jail time for the
billons that were lost, over these debacles. Perhaps white collar crime pays
well!
Lastly, let’s take a brief look at the market evaluations,
and in what form they are
presented. Are the current US stock markets high? Yes, according to historical standards, however half the
analysts say it will go higher, half say lower, time will tell. Point being,
there are so many variables that enter into the equation. These days one
problem is world turmoil and big foreign money entering our markets because it
is a safe haven, or let’s say the lesser of the problematic world markets.
As mentioned in the last blog one top US investor draws
parallels between the capitalization of all stocks on the market and our gross
domestic product (GDP). They should move somewhat in concert with one
another. If the ratio is far from
a 1:1 ratio something is amiss, and that is where it is currently by about 27%.
So many things have an affect on the markets and they are mostly variables out
of our control like the price of oil, war in the Middle East, riots in the US
and world, weather disasters around the world disrupting trade, and many more.
When you look into the financial situation of a company, a
stock market, or a given market sector you are probably going to see it
presented in certain ways. Most of the time you will see charts. These charts
are normally presented within a 90 degree angle. On the horizontal line you will see time frames measured in
hours, days, weeks, months, or many years, increasing as you go left to right. On the vertical axis you will have
volumes of some measurement you are interested in, perhaps trading volume,
sales, revenues, expenses, etc; smaller numbers on the bottom and increasing as
you go upward.
Whether you are evaluating a particular stock or the markets
two key terms used are “resistance” and “support”. At the top of the market
there is a price point of resistance, where people or institutions will come in
and say this is the high and sell, a point that is difficult to rise above.
Contrary to this is the trough or bottom of the market and will receive
support. This is another key point
at which buyers enter as they figure the stock or market has hit the low. Over
a period of time a typical pattern is set of these highs and lows. Draw a line connecting the highs
together and lows together.
These charts may be shown like bars, different colors for
various examples, etc. and there may be “trend lines” drawn at the tops or
bottoms. These lows and highs can be important as they will show the historical
highs and the points of resistance at the lows for a stock. The old adage of
“buy low”, ”sell high” never fails, but is tougher than one might think. Rather than a trend line showing a
corporation’s statistics, it is also commonly used for the DOW, S&P and
NASDAQ averages.
There is always a disclaimer that I love and is all too
true, and that is “past performance does not indicate future results”.
Well, that is a pretty good and quick summary of stock and
market evaluations. What I have intended to do here is lay forth basics for
stock and market analysis for the common person. Stock selection these days is by computer paradigms with
buys, sells and hedges, trading in and out of a stock can be accomplished in
seconds. Once again, half the analysts will be correct and half will be wrong.
The correct ones will boast that they knew it would go their way, the ones that
got it wrong quietly slip away.
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