Fundamental Analysis basics 2

How to do a sample fundamental analysis

Even though there is no one clear-cut method to fundamental analysis, here is one suggestion by Stock Charts, which I like very much. It is methodical, standard, and accounts for most of the variables that we need to know. At the same time, it is important to try to develop some system that works for you, and also, it is good to keep in mind that we may want to see how Warren Buffett does his approach as well, to gather more perspectives on investment and how to make money.

This fundamental analysis method (it is only a suggestion of how you could possibly do this analysis) employs a methodical, top-down approach that starts with the overall economy, and then works down to specific industry groups, and finally to specific companies. Industry groups are compared against other industry groups and companies against other companies to ensure a fair comparison, and usually, companies are compared with others in the same group.

First and of highest importance in a top-down approach would be an overall evaluation of the general economy. Basically, it is common knowledge that when the economy expands and grows, most industry groups and companies will also benefit and grow accordingly. Correspondingly, when the economy declines, most sectors and companies usually suffer accordingly as well. A rising tide lifts all boats and a tide that is going down brings down those boats as well. Many economists link economic expansion and contraction to the level of interest rates, where interest rates are seen as a leading indicator for the stock market as well. A correlation between stock prices and interest rates thus seems to exist, so you might want to take note of that here. Once a feel for the overall economy has been made, an investor can then start to divide the economy into its various industry groups.

If the prognosis is for an expanding economy, then certain industrial groups are likely to benefit more than others. This is important. An investor can narrow the field to those groups that are best-suited to benefit from current or future economic environments. If most companies are expected to benefit from an expansion in the economy, then risk in equities would be relatively low and an aggressive growth-oriented strategy (i.e. a portfolio full of stocks) might be advisable. A growth strategy here might involve the heavy purchase of technology, biotech, and even cyclical stocks. That is the best strategy to make money.

If, however, the economy is forecasted to contract, an investor may opt for a more conservative strategy and seek out stable income-oriented companies. A defensive strategy might involve the purchase of companies that give out dividends instead of focusing on growth, consumer staples, utilities and energy-related stocks, for instance.

To assess an industry group's potential, an investor would want to consider the overall growth rate, market size, and importance of this particular group to the economy. While the individual company is important, its industry group is likely to exert as much, or more, influence on the stock price. When stocks move, apparently they usually move as groups. Many times, it is more important to be in the right industry than in the right stock if you want to make a lot of money!

Once the industry group is chosen, an investor would need to narrow the list of companies before proceeding to a more detailed analysis. Investors are usually interested in finding the leaders and the innovators in a group. The first task is to identify the current business and competitive environment in a group as well as future trends. One needs to look at market share, product position and competitive advantage? What are the barriers to entry? Who is the current leader and how will changes within the sector affect the current balance of power? Success depends on an edge, be it marketing, market share, technology or innovation. A analysis of the competition within a sector will help identify companies with a key competitive edge and most likely to keep it. An investor might analyze the resources and capabilities within each company to identify those companies that are capable of creating and maintaining a competitive advantage. The analysis could focus on selecting companies with a sensible business plan, solid management and sound financials (which we will look at in the next post on financial reports).

The business plan forms the basis for analysis. If the plan, model or concepts are poor, there is little hope here for the business. For a new business, the questions may be these here: Does its business make sense? Is there a market? Can a profit be made? Or more obviously, can the company make a lot of money or not? For an established business, the questions may be: Is the company's direction clearly defined? Is the company a leader in the market? Can the company maintain leadership?

In order to execute a business plan, again here a company requires top-quality management. Investors might look at management to assess their capabilities, strengths and weaknesses here. Even the best ideas and plans in the most dynamic industries can go to waste with bad management. Alternatively, even strong management can make for extraordinary success in a mature industry. Again, here some of the questions to ask might include: How talented is the management team? Do they have a track record? Can management deliver on its promises? If management is a problem, here it is best not to buy such stocks.

The final step to this analysis process would be to take apart the financial statements and come up with a means of valuation. In another section, in this blog, I will try to discuss and give ideas on how to read and analyse annual reports.

After all is said and done, again an investor will be left with a handful of companies that stand out from the pack. Over the course of the fundamental analysis, some companies will definitely stand out as potential leaders and innovators here. In addition, other companies would be considered laggards, poor companies, and very unpredictable. The final step of the fundamental analysis process is to synthesize all the available data, analysis and understanding into actual stock picks, and buy accordingly.

It is important to note that fundamental analysis is very valuable, but it should be approached with caution. We all have personal biases, and every analyst who writes reports on companies has some sort of bias. There is nothing wrong with this, and the research can still be of great value, but it is something that you should be aware of. Learn what the ratings actually mean and the track record of an analyst before investing your hard-earned money. Remember the ultimate goal is to make money. Corporate statements and press releases offer good information, but they should be read with a healthy degree of skepticism to separate the facts from the spin. Press releases don't happen by accident; they are an important PR tool for companies. Reading press releases, annual reports, investment books are all important! Investors should become skilled readers to weed out the important information and ignore the hype. In other posts on this blog, we will examine the basics on how to read and analyse annual reports, as they are integral to investment. Stay tuned for further posts!