As was described in the last article, fundamental analysis is used to find the earning potential of a company by looking at things such as its financial health, competition, market dynamics, and future growth potential. The most important information can be found in its financial statements, which are filed quarterly and yearly with the SEC in the 10-Q and 10-K. While laid-back investors will base their investment decisions upon the “Annual Report to Shareholders” which is mailed to their doorstep every year, the more serious investors should look at the more detailed 10-K. These documents can be found at finance.yahoo.com and under the tab “SEC filings”.
A Warren Buffett Analysis Approach
Buffett’s consistent long-term profit with his investment company Berkshire Hathaway is encouraging since it suggests that there is some kind of indicator for stocks that will increase in value. Last time, we saw how companies, whose profits continue to grow, would see their stocks increase in price as well. This is necessitated by the fact that increasing profits means more money in the hands of the stockholder at some point. People will bid for these profits, thus driving the price of the stock up.
Currently, with the fluctuating financial situation, many people are looking to turn a quick profit as they look forward to an eventual recovery. Many believe stocks to have taken a major blow (with a minor recovery) and since indexes must grow in the long run, if they buy now, they can get stocks at firesale prices. But these gungho investors should not be overly confident, because stocks can and have dropped lower. 10 years ago, the SPY, or commonly known as “spiders”, were trading at 150 and right now we are hovering at 101. The SPY is an ETF (stock that simply mimics an index) that is 1/10th the value of the S&P 500 index (so the S&P index can be seen as a representation of how 500 of
- continue losing money through operations rather than turning a profit, meaning they are slowly sucking away at shareholder value
- profits fail to grow or grow at such a slow rate that if the company had a large PE (Price to Earnings ratio) it will have to fall to bring the share price more in line with how much the company is making. This means that the share price falls with it since (earnings per share) * PE = Share Price
Instead, take a look at some of the companies that Warren Buffett currently has in his portfolio: KO (Coca-Cola), WFC (Wells Fargo), BNI (Burlington Northern), PG (Proctor and Gamble), KFT (Kraft Foods) and etc. The one thing that Buffett stresses when investing in stocks is a durable advantage. This can be translated into some type of competitive advantage that a company has over other companies in the industry. Coca-Cola’s competitive advantage lies in its brand name (or secret formula...depends on if you think it really tastes better), which leads to about 2.7 billion in revenues each year. Besides for brand name, other competitive advantages may be exclusive rights to an input (such as mining rights), political barriers to entry (laws that limit new companies from joining the industry), and economies of scale (certain industries take a lot of capital before it becomes profitable, such as a telecommunications company).
While many companies have advantages, not many will have a durable advantage. Durable advantages are advantages which can withstand booms and recessions, changes in taste/culture, and technological advance. We are essentially trying to pick up free money by picking a company whose future profits and earnings are so predictable that there is little to no risk inherent in putting our money into it. However, to make it profitable, it also has to be undervalued at the moment. Practically, one is looking for a company whose product will continue to be used long into the future, and whose customer base will continue expanding. Once again, as revenues increase, profits per shareholder increases and causes stock prices to increase.
Durable Advantages:
1. Booms and Recessions
To find something that’s resistant to changes in the economy, look at the company’s revenues for the past 10 years (or just as long as possible). If you see that revenues are constantly growing, and not swinging over the place, you most likely have a company who does well regardless of how the economy is doing. For example, no matter how poorly the economy is doing, people will most likely not vary how much Coke they drink. Obviously, financials and housing are industries that would suffer in a recession.
Look for:
Constant revenue growth- Look for revenue growth over the last 10 years, and no decrease in the gross profit margin. This means that they are making more and more sales and making the same amount of profit for every dollar of sales. All of this can be found at looking at historical data on yahoo or msn.
A strong financial position- Current ratio below 1 is ideal although not all companies which are strong financially are like this. Current ratio basically shows how easily a company can pay back its debt. Its short term debt is put over its short term cash like assets, meaning the lower the better. One is also looking for stock repurchases (meaning the company is strong enough financially to start repurchasing stock…ie paying out its investors) which also leads to higher earnings per share for the rest of the outstanding shares. A strong cash flow is also important, having cash available when debt is coming due and when opportunities for acquisitions and expansions comes up is very important.
2. Technological Advance
This is really important when looking for a low-risk, long-term winner. Tech companies make money by coming up with the next big product. If another company manages to develop the product first, their earning potential for the near future is crippled compared to what the shareholders had been expecting. Additionally, although the high risk inherent in tech-dependent industries may be paid out with high-rewards, one day, their patents will expire and they will fail to come up with new viable products. Therefore, these industries are susceptible to large short-term risk and cannot be left as a good long-term investment.
Look for:
1. Low R&D costs: means the company (and check industry as well) is not subjected to harsh competition in terms of new products that need to be created.
2. Low capital expenditures: means you don’t need to buy new plants or large amounts of equipment every few years due to depreciation. Think of auto-manufacturers for both R&D and cap-ex. Both costs are huge because tech advance is so fast in the industry and leads to low profit margins.
3. Brand name
This is almost assuredly the second most important trait that you are looking for, besides for the resistance to booms and recessions. Brand name will help a product to continue to bring in the dough even when knockoffs come onto the market. Something like Coke has a dominant market share despite sitting on aisles next to thousands of similar products.
Look for:
- Consistently high profit margins: Something with a brand name will be able to charge more for the same product due to the belief that it’s higher quality.
Hopefully this has been helpful. It’s mostly simple things, although it takes awhile to research. A suggestion would be filtering stocks by current ratios (<1.5),>5%), gross profit margins (>10%) and possibly current PE ratio. Above all just think, can I think of situations where my company and stock will tank and be unable to recover. If not, then think if the industry and the company itself will be able to expand and maintain its current (hopefully high) profit margins. Good luck! Next time on HOGS, and possibly a target value for this Chinese pork product manufacturer.
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