Putting fundamental analysis to work
It’s easy to get consumed with the fast-money trading aspects of stocks. Exciting TV reports about stocks on the move and companies that have new products practically turn investing into a sporting event. In fact, if you listen to some traders talk, they rattle off companies’ ticker symbols in rapid-fire delivery just as sports fans talk about teams. Flashing arrows and rapid trading can become an addiction for people who get into it. And it’s exactly the headache and insanity fundamental analysis is trying to help you avoid. After all, stocks rise and fall each minute, day, and week based on a random flow of news. The constant ups and downs of stocks can sometimes confound logic and reason. Trying to profit from these short-term swings is a game for gamblers and speculators. It’s futile on a long-term basis. But that’s not to say investing is gambling. Remember that those stock symbols you see flashing red and green aren’t dice, horses, or cards. They’re more than just the two, three, or four letters of their ticker symbol. When you buy a stock, you’re buying a piece of ownership in companies that make and sell products and services. You’re buying a claim to the companies’ future profits. Owning a piece of a real business over time isn’t gambling, it’s capitalism. Fundamental analysis forces you to focus on investing in businesses, not stocks. You’re not buying a lottery ticket, but a piece of ownership in a company. If jumping in and out of stocks at the right time isn’t the way to riches, then what is the trick to successful investing? The answer is to stop thinking of stocks as just symbols that gyrate each day. The goal of fundamental analysis is to help you step away from the short-term trading and gambling of stocks. Instead, you approach investing as if you’re buying a business, not rolling the dice. Fundamental analysis ideally helps you identify businesses that sell goods and services for more than what they paid to produce them. Fundamental analysis is your tool to evaluate how good a company is at turning raw materials into profits. Certainly, famed investor Warren Buffett is one of the best-known users of fundamental analysis. No matter how you choose investments currently, you can likely apply fundamental analysis. Even if you’re the kind of investor who likes to buy diversified mutual funds and hold onto them forever, called a passive investor, it can be helpful to understand basic financial characteristics of the companies.
Knowing what fundamentals to look for
Knowing what makes a company tick isn’t as convoluted as it may sound. Companies are so regulated and scrutinized; all the things you need to pay attention to are usually listed and published for all to see. Generally, when you hear about a company’s fundamentals, the key elements to be concerned with fall into several categories including:
✓ Financial performance: Here you’re looking at how much a company collects from customers who buy its products or services, and how much it keeps in profit. Terms you probably hear quite a bit about, such as earnings and revenue, are examples of ways fundamental analysts evaluate a company’s financial performance.
✓ Financial resources: It’s not enough for a company to sell goods and services. It’s not even enough to turn a profit. Companies must also have the resources to invest themselves and keep their businesses going and growing. Aspects of a business, such as its assets and liabilities, are ways to measure a company’s resources.
✓ Management team: When you invest in a company, you’re entrusting your money with the CEO and other managers to put your cash to work. Fundamental analysis helps you separate the good managers from the bad.
✓ Valuation: It’s not enough to identify which companies are the best. What’s a “good” company anyway? Definitions of “good” can run the gamut. You also need to consider how much you’re paying to own a piece of a company. If you overpay for the best company on the planet, it’s still likely you’ll end up losing money on the investment.
✓ Macro trends: No company operates in a vacuum. A company’s performance is highly influenced by actions of competitors or the condition of the economy. These broad factors need to be incorporated into fundamental analysis,
Knowing what you need
One of the great things about running as a hobby is all you need is a pair of decent shoes. And basketball? Just grab a ball and find a hoop. No fancy equipment is required. The same goes with fundamental analysis. Much of the data you need is provided free by companies and can be accessed in seconds from any computer connected to the Internet. Fundamental analysis can get pretty involved. But at its most basic form, there are just a few basic ideas behind fundamental analysis, including:
✓ Awareness of the benefits of fundamental analysis: Since fundamental analysis takes some know-how and time spent learning a bit, you’ll want to know ahead of time why you’re going to the trouble. Even if you’re a passive investor, or one who simply buys a basket of stocks and holds on, there are reasons why fundamental analysis might be worth your while.
✓ Retrieval of financial data: Getting all the key data you need to apply fundamental analysis is easy, if you know where to look. You can quickly round up all the data you need.
✓ Basic math: There it is: The M word. There’s no way around the fact there will be some number crunching involved in some aspects of fundamental analysis. Don’t worry, I’ll guide you to help keep the math as painless as possible. One of the key tools you’ll need is for trend analysis.
Knowing the Tools of the Fundamental Analysis Trade
You can read all sorts of books on home repair and even take a trip to your hardware store and buy lots of screws, nails and glue. But none of that effort will benefit you unless you have a tool-belt of hammers and the knowledge of how to get started and put your plan into reality. The same importance of execution is part of fundamental analysis. You may appreciate the importance of fundamental analysis and may even be able to download fundamental data from Web sites or from a company’s annual report. But you need to have the tools to analyze the fundamentals to get any real value from them.
Staying focused on the bottom line
If there’s one thing investors may agree is of upmost importance, it’s the company’s profitability. When it comes down to it, when you invest in a stock you’re buying a piece of the company’s profitability. Knowing how to read and understand how much profit a company is making is very important when it comes to knowing whether or not to invest. The income statement, when you’re trying to determine how profitable a company is. What might also surprise you is that the income statement can tell you a great deal about a company, in addition to just how much income it brings in.
Sizing up what a company has to its name
During times of intense financial stress, investors often make a very important mental shift. They’re not so concerned about making money as they are about just getting their money back. Similarly, when things get tough in the economy, investors are less interested in how profitable a company is and are more mindful of whether a company will survive. When you’re trying to understand the lasting power of a company, fundamental analysis is of great value. By reading the company’s balance sheet, you can get a rundown of what a company has — its assets — and what is owes — its liabilities. Monitoring these items give you a very good picture of how much dry powder a company has to endure a tough period.
Financial ratios: Your friend in making sense of a company
As you flip through the book and jump around to different topics that interest you, you might be a bit bewildered by just how many pieces of data fundamental analysts must deal with. You’ve got the financial statements that measure just about every aspect of the company. It can be intimidating to decide what numbers matter most and which ones can be ignored. Financial ratios will be a great help here. These ratios draw all sorts of fundamental data from different sources and put them into perspective. Financial ratios are also important because they form the vocabulary of fundamental analysts. If you’re ever at a cocktail party where analysts are talking about gross margins and accounts receivable turnover, I want you to be prepared. By the way, that sounds like a pretty boring party. Financial ratios are the favorites used by many fundamental analysts. You’ll soon be using seemingly unrelated pieces of financial data about a company to glean some very important conclusions about the company.
Making Fundamental Analysis Work for You
Imagine a young child who memorized an entire dictionary, but can’t use a single word in a sentence. That’s a basic analogy of some investors’ fundamental analysis knowledge. You might, too, know some things about the income statement and balance sheet and have a great knowledge of what’s contained in the statements. But when it comes to applying your know-how, which can be a bit trickier. Putting fundamental analysis in action requires taking everything you know about a company and mixing in some estimates and best guesses about the future to arrive at a decent expectation of whether or not to invest in a company.
Using fundamentals as signals to buy or sell
Buying a stock at the right time is very difficult. But knowing when to sell it is even tougher. And while fundamental analysis won’t tell you the exact best time and day to buy or sell, it can at least give you a better understanding of things to look out for when it comes to making decisions. If you’re a passive investor and buy large diversified baskets of dozens of stocks, you can afford to buy and hold stocks. Even if one company runs into big-time trouble, it’s just one holding in a large basket of stocks. However, if you choose to invest in individual stocks, monitoring the fundamentals is critical. If you start noticing a company’s trend deteriorating, you don’t want to be the last investor to get out.
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