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5 tips on how to pick a stock a good stock

1. Look for consistent dividend paying stocks

Why? Well, if you are not getting a high rate of interest on your bank fixed deposit, you might as well invest in a stock that gives a decent dividend yield. But the keyword is 'consistency'; look for companies that consistently give dividends.

Matsushita Lakhanpal declared dividends for 10 years in a row before I picked it up in August 2004. In the years 2003 and 2004, it gave a dividend of Rs 3 per share. This means, at a price of Rs 50 per share, it was giving a 6% dividend yield (dividend yield = dividend amount per share / share price x 100).

Another good buy was Tata Chemicals, which I got a few years ago at Rs 50 per share. Again, what attracted me to this stock was the consistent dividend and high dividend yield. At a 50% dividend, I was getting an annual return of 10% pa.

My first call as an investor is to protect my capital (initial investment). Even if the Tata Chemicals stock had not appreciated, I could have assumed I had put money in a bank fixed deposit and was earning 10% as interest every year.

Most people were not impressed by Tata Chemicals then as fertilisers were out of favour and tech stocks were being wooed.

Eventually, the stock got 'discovered' by the market and now has a 'Strong Buy' recommendation from analysts and broking firms when it is at Rs 250.

Lesson to be learnt

The higher the dividend yield, the better.

In this current bull run, it will be difficult to find good, high dividend yield stocks but one can watch out for corrections (temporary dips) to buy such stocks.

• When stock market returns lie!

2. Check valuations

Valuation is a process by which the value of a company's stock is determined. This is based on a number of factors like earnings, the market value of the company's assets and the brands it owns.

Before the face value of ITC's shares was reduced from Rs 10 to Rs 1, and before the bonus was declared, I told some colleagues it would be a good buy. But they balked at the price which, then, was Rs 1,600.

But these very same set of investors were game to buy HLL at Rs 160 because they found it cheaper than Rs 1,600.

What they did not realise was that ITC, with a face value of Rs 10, was quoting at Rs 1,600 while HLL with a face value of Rs 1, was quoting at Rs 160.

ITC, due to its valuations, was considered at that price to be undervalued while HLL was overvalued.

In the past few weeks, HLL has surged on the back of FIIs buying the stock, surprising most people. But that is a different issue.

Lesson to be learnt

Don't just look at the price of the stock. Look at its valuations. There is a difference between a pricey stock and an expensive stock.

• Understanding IPO jargon

3. View prices over time

Don't look at just the yearly high/ low price of the stock. Investors make the mistake of assuming that, if a stock is quoting nearer to the year's bottom price, it has a lot of upside (potential to rise in price).

This can be most dangerous when bull markets give way to bear markets and the stocks begin falling like nine pins. Instead, look at a stock's three-to-five year price and its volume chart before investing. It may also be prudent to see what the all time high/ low of the stock is.

In certain cases, a company may begin to do really well and the stock's price keeps moving upward. In such a situation, the historical chart will not have any meaning.

Lesson to be learnt

In this current bull market, it will be rare for a small investor coming across a totally 'undiscovered' stock.

• Want to invest in stocks abroad?

4. Look at the promoter's stake

This refers to the number of shares held by the promoter out of the total number of shares available in the company. Generally, whenever promoters have a stake of 50% or more, it signals they have confidence in their business.

On the flip side, if the promoter's stake is too high, the stock tends to become illiquid as the amount available for trading is not huge. This results in the stock appreciating very slowly.

The best scenario, as far as I am concerned, is when the promoter's stake is between 50% to 65%.

Take the example of Pidilite.

Promoter stake: 71.8%

Institutional holding: 16%

General public: 11.84 %

Many midcaps of lesser quality have appreciated more than five to six times but this midcap blue chip rose from Rs 27.5 in September 2003 to just about Rs 53 or so five or six months ago (barring the short time frame when it went past Rs 90 when the stock split was announced).

Take a look at McDowell. The stake of General Public has fallen from 36% in October 2004 to 23% as of December 2005 and the stock price has gone up more than 10 times.

Lesson to be learnt

When the stake of 'General Public; falls over time, it is an indicator that the promoters, high networth individuals and FIIs are buying it and it would not be long before the stock appreciates.

• Are you a smart investor?

5. Check who the promoter is

There are many promoters whose companies show losses or very low profits in the bear markets. The moment a bull market begins, they suddenly start turning around. The turnaround lasts only as long as the bull market is alive and kicking. Then they fade back into oblivion. Some disappear.

Some companies themselves do pretty well but they always lend money to group companies/ subsidiaries and the loans are then written off. This is one of the ways for promoters to siphon off funds.

If the group company or subsidiary starts doing very well, it is de-linked/ spun off from the main company and the promoters take full control.

The best example is Indian Organic Chemicals.

This company used to be part of the Sensex in 1990. It had a wholly owned subsidiary called Sonata Software, which was de-merged (spinned off into a separate company) in 1992. The promoters themselves bought 100% stake at a paltry Rs 9 crore.

In the next few years, the tech boom took place and Sonata Software went public (listed on the stock exchange).

None of the shareholders of Indian Organic Chemicals were offered any preferential shares (shares at a discount to the market rate).

Profitable divisions of the company continued to be spun off and whatever remains of the original Indian Organic Chemicals is now called Futura Polyester.

What is Technical Analysis for Stock Market?

What is Technical Analysis?

Technical Analysis is the forecasting of future financial price movements based on an examination of past price movements. Like weather forecasting, technical analysis does not result in absolute predictions about the future. Instead, technical analysis can help investors anticipate what is “likely” to happen to prices over time. Technical analysis uses a wide variety of charts that show price over time.

Technical analysis is applicable to stocks, indices, commodities, futures or any tradable instrument where the price is influenced by the forces of supply and demand. Price refers to any combination of the open, high, low, or close for a given security over a specific time frame. The time frame can be based on intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly or monthly price data and last a few hours or many years. In addition, some technical analysts include volume or open interest figures with their study of price action.

The Basis of Technical Analysis

At the turn of the century, the Dow Theory laid the foundations for what was later to become modern technical analysis. Dow Theory was not presented as one complete amalgamation, but rather pieced together from the writings of Charles Dow over several years. Of the many theorems put forth by Dow, three stand out:

• Price Discounts Everything
• Price Movements Are Not Totally Random
• “What” Is More Important than “Why”

Price Discounts Everything

This theorem is similar to the strong and semi-strong forms of market efficiency. Technical analysts believe that the current price fully reflects all information. Because all information is already reflected in the price, it represents the fair value, and should form the basis for analysis. After all, the market price reflects the sum knowledge of all participants, including traders, investors, portfolio managers, buy-side analysts, sell-side analysts, market strategist, technical analysts, fundamental analysts and many others. It would be folly to disagree with the price set by such an impressive array of people with impeccable credentials. Technical analysis utilizes the information captured by the price to interpret what the market is saying with the purpose of forming a view on the future.

Prices Movements are not Totally Random

Most technicians agree that prices trend. However, most technicians also acknowledge that there are periods when prices do not trend. If prices were always random, it would be extremely difficult to make money using technical analysis. In his book, Schwager on Futures: Technical Analysis, Jack Schwager states:

“One way of viewing it is that markets may witness extended periods of random fluctuation, interspersed with shorter periods of nonrandom behavior. The goal of the chartist is to identify those periods (i.e. major trends).”

A technician believes that it is possible to identify a trend, invest or trade based on the trend and make money as the trend unfolds. Because technical analysis can be applied to many different time frames, it is possible to spot both short-term and long-term trends. The IBM chart illustrates Schwager's view on the nature of the trend. The broad trend is up, but it is also interspersed with trading ranges. In between the trading ranges are smaller uptrends within the larger uptrend. The uptrend is renewed when the stock breaks above the trading range. A downtrend begins when the stock breaks below the low of the previous trading range.

"What" is More Important than "Why"

In his book, The Psychology of Technical Analysis, Tony Plummer paraphrases Oscar Wilde by stating, “A technical analyst knows the price of everything, but the value of nothing”. Technicians, as technical analysts are called, are only concerned with two things:

1. What is the current price?
2. What is the history of the price movement?

The price is the end result of the battle between the forces of supply and demand for the company's stock. The objective of analysis is to forecast the direction of the future price. By focusing on price and only price, technical analysis represents a direct approach. Fundamentalists are concerned with why the price is what it is. For technicians, the why portion of the equation is too broad and many times the fundamental reasons given are highly suspect. Technicians believe it is best to concentrate on what and never mind why. Why did the price go up? It is simple, more buyers (demand) than sellers (supply). After all, the value of any asset is only what someone is willing to pay for it. Who needs to know why?

General Steps to Technical Evaluation

Many technicians employ a top-down approach that begins with broad-based macro analysis. The larger parts are then broken down to base the final step on a more focused/micro perspective. Such an analysis might involve three steps:

1. Broad market analysis through the major indices such as the S&P 500, Dow Industrials, NASDAQ and NYSE Composite.
2. Sector analysis to identify the strongest and weakest groups within the broader market.
3. Individual stock analysis to identify the strongest and weakest stocks within select groups.

The beauty of technical analysis lies in its versatility. Because the principles of technical analysis are universally applicable, each of the analysis steps above can be performed using the same theoretical background. You don't need an economics degree to analyze a market index chart. You don't need to be a CPA to analyze a stock chart. Charts are charts. It does not matter if the time frame is 2 days or 2 years. It does not matter if it is a stock, market index or commodity. The technical principles of support, resistance, trend, trading range and other aspects can be applied to any chart. While this may sound easy, technical analysis is by no means easy. Success requires serious study, dedication and an open mind.

Chart Analysis

Technical analysis can be as complex or as simple as you want it. The example below represents a simplified version. Since we are interested in buying stocks, the focus will be on spotting bullish situations.

Overall Trend: The first step is to identify the overall trend. This can be accomplished with trend lines, moving averages or peak/trough analysis. As long as the price remains above its uptrend linezxZxZX Resistance: Areas of congestion and previous highs above the current price mark the resistance levels. A break above resistance would be considered bullish.

Momentum: Momentum is usually measured with an oscillator such as MACD. If MACD is above its 9-day EMA (exponential moving average) or positive, then momentum will be considered bullish, or at least improving.

Buying/Selling Pressure: For stocks and indices with volume figures available, an indicator that uses volume is used to measure buying or selling pressure. When Chaikin Money Flow is above zero, buying pressure is dominant. Selling pressure is dominant when it is below zero.

Relative Strength: The price relative is a line formed by dividing the security by a benchmark. For stocks it is usually the price of the stock divided by the S&P 500. The plot of this line over a period of time will tell us if the stock is outperforming (rising) or under performing (falling) the major index.

The final step is to synthesize the above analysis to ascertain the following:

• Strength of the current trend.
• Maturity or stage of current trend.
• Reward to risk ratio of a new position.
• Potential entry levels for new long position.

Top-Down Technical Analysis

For each segment (market, sector and stock), an investor would analyze long-term and short-term charts to find those that meet specific criteria. Analysis will first consider the market in general, perhaps the S&P 500. If the broader market were considered to be in bullish mode, analysis would proceed to a selection of sector charts. Those sectors that show the most promise would be singled out for individual stock analysis. Once the sector list is narrowed to 3-4 industry groups, individual stock selection can begin. With a selection of 10-20 stock charts from each industry, a selection of 3-4 of the most promising stocks in each group can be made. How many stocks or industry groups make the final cut will depend on the strictness of the criteria set forth. Under this scenario, we would be left with 9-12 stocks from which to choose. These stocks could even be broken down further to find the 3-4 of the strongest of the strong.

Strengths of Technical Analysis

Focus on Price

If the objective is to predict the future price, then it makes sense to focus on price movements. Price movements usually precede fundamental developments. By focusing on price action, technicians are automatically focusing on the future. The market is thought of as a leading indicator and generally leads the economy by 6 to 9 months. To keep pace with the market, it makes sense to look directly at the price movements. More often than not, change is a subtle beast. Even though the market is prone to sudden knee-jerk reactions, hints usually develop before significant moves. A technician will refer to periods of accumulation as evidence of an impending advance and periods of distribution as evidence of an impending decline.

Supply, Demand, and Price Action

Many technicians use the open, high, low and close when analyzing the price action of a security. There is information to be gleaned from each bit of information. Separately, these will not be able to tell much. However, taken together, the open, high, low and close reflect forces of supply and demand.

The annotated example above shows a stock that opened with a gap up. Before the open, the number of buy orders exceeded the number of sell orders and the price was raised to attract more sellers. Demand was brisk from the start. The intraday high reflects the strength of demand (buyers). The intraday low reflects the availability of supply (sellers). The close represents the final price agreed upon by the buyers and the sellers. In this case, the close is well below the high and much closer to the low. This tells us that even though demand (buyers) was strong during the day, supply (sellers) ultimately prevailed and forced the price back down. Even after this selling pressure, the close remained above the open. By looking at price action over an extended period of time, we can see the battle between supply and demand unfold. In its most basic form, higher prices reflect increased demand and lower prices reflect increased supply.

Support/Resistance

Simple chart analysis can help identify support and resistance levels. These are usually marked by periods of congestion (trading range) where the prices move within a confined range for an extended period, telling us that the forces of supply and demand are deadlocked. When prices move out of the trading range, it signals that either supply or demand has started to get the upper hand. If prices move above the upper band of the trading range, then demand is winning. If prices move below the lower band, then supply is winning.

Pictorial Price History

Even if you are a tried and true fundamental analyst, a price chart can offer plenty of valuable information. The price chart is an easy to read historical account of a security's price movement over a period of time. Charts are much easier to read than a table of numbers. On most stock charts, volume bars are displayed at the bottom. With this historical picture, it is easy to identify the following:

• Reactions prior to and after important events.
• Past and present volatility.
• Historical volume or trading levels.
• Relative strength of a stock versus the overall market.

Assist with Entry Point

Technical analysis can help with timing a proper entry point. Some analysts use fundamental analysis to decide what to buy and technical analysis to decide when to buy. It is no secret that timing can play an important role in performance. Technical analysis can help spot demand (support) and supply (resistance) levels as well as breakouts. Simply waiting for a breakout above resistance or buying near support levels can improve returns.

It is also important to know a stock's price history. If a stock you thought was great for the last 2 years has traded flat for those two years, it would appear that Wall Street has a different opinion. If a stock has already advanced significantly, it may be prudent to wait for a pullback. Or, if the stock is trending lower, it might pay to wait for buying interest and a trend reversal.

Weaknesses of Technical Analysis

Analyst Bias

Just as with fundamental analysis, technical analysis is subjective and our personal biases can be reflected in the analysis. It is important to be aware of these biases when analyzing a chart. If the analyst is a perpetual bull, then a bullish bias will overshadow the analysis. On the other hand, if the analyst is a disgruntled eternal bear, then the analysis will probably have a bearish tilt.

Open to Interpretation

Furthering the bias argument is the fact that technical analysis is open to interpretation. Even though there are standards, many times two technicians will look at the same chart and paint two different scenarios or see different patterns. Both will be able to come up with logical support and resistance levels as well as key breaks to justify their position. While this can be frustrating, it should be pointed out that technical analysis is more like an art than a science, somewhat like economics. Is the cup half-empty or half-full? It is in the eye of the beholder.

Too Late

Technical analysis has been criticized for being too late. By the time the trend is identified, a substantial portion of the move has already taken place. After such a large move, the reward to risk ratio is not great. Lateness is a particular criticism of Dow Theory.

Always Another Level

Even after a new trend has been identified, there is always another “important” level close at hand. Technicians have been accused of sitting on the fence and never taking an unqualified stance. Even if they are bullish, there is always some indicator or some level that will qualify their opinion.

Trader's Remorse

Not all technical signals and patterns work. When you begin to study technical analysis, you will come across an array of patterns and indicators with rules to match. For instance: A sell signal is given when the neckline of a head and shoulders pattern is broken. Even though this is a rule, it is not steadfast and can be subject to other factors such as volume and momentum. In that same vein, what works for one particular stock may not work for another. A 50-day moving average may work great to identify support and resistance for IBM, but a 70-day moving average may work better for Yahoo. Even though many principles of technical analysis are universal, each security will have its own idiosyncrasies.

Conclusions

Technical analysts consider the market to be 80% psychological and 20% logical. Fundamental analysts consider the market to be 20% psychological and 80% logical. Psychological or logical may be open for debate, but there is no questioning the current price of a security. After all, it is available for all to see and nobody doubts its legitimacy. The price set by the market reflects the sum knowledge of all participants, and we are not dealing with lightweights here. These participants have considered (discounted) everything under the sun and settled on a price to buy or sell. These are the forces of supply and demand at work. By examining price action to determine which force is prevailing, technical analysis focuses directly on the bottom line: What is the price? Where has it been? Where is it going?

Even though there are some universal principles and rules that can be applied, it must be remembered that technical analysis is more an art form than a science. As an art form, it is subject to interpretation. However, it is also flexible in its approach and each investor should use only that which suits his or her style. Developing a style takes time, effort and dedication, but the rewards can be significant.

What is Fundamental Analysis for a Stock Market?

What is Fundamental Analysis?

Fundamental analysis is the examination of the underlying forces that affect the well being of the economy, industry groups, and companies. As with most analysis, the goal is to derive a forecast and profit from future price movements. At the company level, fundamental analysis may involve examination of financial data, management, business concept and competition. At the industry level, there might be an examination of supply and demand forces for the products offered. For the national economy, fundamental analysis might focus on economic data to assess the present and future growth of the economy. To forecast future stock prices, fundamental analysis combines economic, industry, and company analysis to derive a stock's current fair value and forecast future value. If fair value is not equal to the current stock price, fundamental analysts believe that the stock is either over or under valued and the market price will ultimately gravitate towards fair value. Fundamentalists do not heed the advice of the random walkers and believe that markets are weak-form efficient. By believing that prices do not accurately reflect all available information, fundamental analysts look to capitalize on perceived price discrepancies.

General Steps to Fundamental Evaluation

Even though there is no one clear-cut method, a breakdown is presented below in the order an investor might proceed. This method employs a top-down approach that starts with the overall economy and then works down from industry groups to specific companies. As part of the analysis process, it is important to remember that all information is relative. Industry groups are compared against other industry groups and companies against other companies. Usually, companies are compared with others in the same group. For example, a telecom operator (Verizon) would be compared to another telecom operator (SBC Corp), not to an oil company (ChevronTexaco).

Economic Forecast

First and foremost in a top-down approach would be an overall evaluation of the general economy. The economy is like the tide and the various industry groups and individual companies are like boats. When the economy expands, most industry groups and companies benefit and grow. When the economy declines, most sectors and companies usually suffer. Many economists link economic expansion and contraction to the level of interest rates. Interest rates are seen as a leading indicator for the stock market as well. Below is a chart of the S&P 500 and the yield on the 10-year note over the last 30 years. Although not exact, a correlation between stock prices and interest rates can be seen. Once a scenario for the overall economy has been developed, an investor can break down the economy into its various industry groups.

Group Selection

If the prognosis is for an expanding economy, then certain groups are likely to benefit more than others. An investor can narrow the field to those groups that are best suited to benefit from the current or future economic environment. If most companies are expected to benefit from an expansion, then risk in equities would be relatively low and an aggressive growth-oriented strategy might be advisable. A growth strategy might involve the purchase of technology, biotech, semiconductor and cyclical stocks. If the economy is forecast 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 consumer staples, utilities and energy-related stocks.

To assess a industry group's potential, an investor would want to consider the overall growth rate, market size, and importance to the economy. While the individual company is still important, its industry group is likely to exert just as much, or more, influence on the stock price. When stocks move, they usually move as groups; there are very few lone guns out there. Many times it is more important to be in the right industry than in the right stock! The chart below shows that relative performance of 5 sectors over a 7-month time frame. As the chart illustrates, being in the right sector can make all the difference.

Narrow Within the Group

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 within a group. The first task is to identify the current business and competitive environment within a group as well as the future trends. How do the companies rank according to market share, product position and competitive advantage? Who is the current leader and how will changes within the sector affect the current balance of power? What are the barriers to entry? Success depends on an edge, be it marketing, technology, market share or innovation. A comparative analysis of the competition within a sector will help identify those companies with an edge, and those most likely to keep it.

Company Analysis

With a shortlist of companies, 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.

Business Plan

The business plan, model or concept forms the bedrock upon which all else is built. If the plan, model or concepts stink, there is little hope for the business. For a new business, the questions may be these: Does its business make sense? Is it feasible? Is there a market? Can a profit be made? 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?

Management

In order to execute a business plan, a company requires top-quality management. Investors might look at management to assess their capabilities, strengths and weaknesses. Even the best-laid plans in the most dynamic industries can go to waste with bad management (AMD in semiconductors). Alternatively, even strong management can make for extraordinary success in a mature industry (Alcoa in aluminum). Some of the questions to ask might include: How talented is the management team? Do they have a track record? How long have they worked together? Can management deliver on its promises? If management is a problem, it is sometimes best to move on.

Financial Analysis

The final step to this analysis process would be to take apart the financial statements and come up with a means of valuation. Below is a list of potential inputs into a financial analysis.

Accounts Payable Accounts Receivable Acid Ratio Amortization Assets - Current Assets - Fixed Book Value Brand Business Cycle Business Idea Business Model Business Plan Capital Expenses Cash Flow Cash on hand Current Ratio Customer Relationships Days Payable Days Receivable Debt Debt Structure Debt:Equity Ratio Depreciation Derivatives-Hedging Discounted Cash Flow Dividend Dividend Cover Earnings EBITDA  Economic Growth Equity Equity Risk Premium Expenses

Good Will Gross Profit Margin Growth  Industry Interest Cover International Investment Liabilities - Current Liabilities - Long-term Management Market Growth Market Share Net Profit Margin Pageview Growth Pageviews Patents Price/Book Value Price/Earnings PEG Price/Sales Product Product Placement Regulations R & D Revenues Sector Stock Options Strategy Subscriber Growth Subscribers Supplier Relationships Taxes Trademarks Weighted Average Cost of Capital

The list can seem quite long and intimidating. However, after a while, an investor will learn what works best and develop a set of preferred analysis techniques. There are many different valuation metrics and much depends on the industry and stage of the economic cycle. A complete financial model can be built to forecast future revenues, expenses and profits or an investor can rely on the forecast of other analysts and apply various multiples to arrive at a valuation. Some of the more popular ratios are found by dividing the stock price by a key value driver.

Ratio Price/Book Value Price/Earnings  Price/Earnings/Growth  Price/Sales  Price/Subscribers  Price/Lines  Price/Page views  Price/Promises

Company Type Oil Retail  Networking B2B ISP or cable company Telecom Web site Biotech

This methodology assumes that a company will sell at a specific multiple of its earnings, revenues or growth. An investor may rank companies based on these valuation ratios. Those at the high end may be considered overvalued, while those at the low end may constitute relatively good value.

Putting it All Together

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

Strengths of Fundamental Analysis

Long-term Trends

Fundamental analysis is good for long-term investments based on very long-term trends. The ability to identify and predict long-term economic, demographic, technological or consumer trends can benefit patient investors who pick the right industry groups or companies.

Value Spotting

Sound fundamental analysis will help identify companies that represent a good value. Some of the most legendary investors think long-term and value. Graham and Dodd, Warren Buffett and John Neff are seen as the champions of value investing. Fundamental analysis can help uncover companies with valuable assets, a strong balance sheet, stable earnings, and staying power.

Business Acumen

One of the most obvious, but less tangible, rewards of fundamental analysis is the development of a thorough understanding of the business. After such painstaking research and analysis, an investor will be familiar with the key revenue and profit drivers behind a company. Earnings and earnings expectations can be potent drivers of equity prices. Even some technicians will agree to that. A good understanding can help investors avoid companies that are prone to shortfalls and identify those that continue to deliver. In addition to understanding the business, fundamental analysis allows investors to develop an understanding of the key value drivers and companies within an industry. A stock's price is heavily influenced by its industry group. By studying these groups, investors can better position themselves to identify opportunities that are high-risk (tech), low-risk (utilities), growth oriented (computer), value driven (oil), non-cyclical (consumer staples), cyclical (transportation) or income-oriented (high yield).

Knowing Who's Who

Stocks move as a group. By understanding a company's business, investors can better position themselves to categorize stocks within their relevant industry group. Business can change rapidly and with it the revenue mix of a company. This happened to many of the pure Internet retailers, which were not really Internet companies, but plain retailers. Knowing a company's business and being able to place it in a group can make a huge difference in relative valuations.

Weaknesses of Fundamental Analysis

Time Constraints

Fundamental analysis may offer excellent insights, but it can be extraordinarily time-consuming. Time-consuming models often produce valuations that are contradictory to the current price prevailing on Wall Street. When this happens, the analyst basically claims that the whole street has got it wrong. This is not to say that there are not misunderstood companies out there, but it is quite brash to imply that the market price, and hence Wall Street, is wrong.

Industry/Company Specific

Valuation techniques vary depending on the industry group and specifics of each company. For this reason, a different technique and model is required for different industries and different companies. This can get quite time-consuming, which can limit the amount of research that can be performed. A subscription-based model may work great for an Internet Service Provider (ISP), but is not likely to be the best model to value an oil company.

Subjectivity

Fair value is based on assumptions. Any changes to growth or multiplier assumptions can greatly alter the ultimate valuation. Fundamental analysts are generally aware of this and use sensitivity analysis to present a base-case valuation, an average-case valuation and a worst-case valuation. However, even on a worst-case valuation, most models are almost always bullish, the only question is how much so. The chart below shows how stubbornly bullish many fundamental analysts can be.

Analyst Bias

The majority of the information that goes into the analysis comes from the company itself. Companies employ investor relations managers specifically to handle the analyst community and release information. As Mark Twain said, “there are lies, damn lies, and statistics.” When it comes to massaging the data or spinning the announcement, CFOs and investor relations managers are professionals. Only buy-side analysts tend to venture past the company statistics. Buy-side analysts work for mutual funds and money managers. They read the reports written by the sell-side analysts who work for the big brokers (CIBC, Merrill Lynch, Robertson Stephens, CS First Boston, Paine Weber, DLJ to name a few). These brokers are also involved in underwriting and investment banking for the companies. Even though there are restrictions in place to prevent a conflict of interest, brokers have an ongoing relationship with the company under analysis. When reading these reports, it is important to take into consideration any biases a sell-side analyst may have. The buy-side analyst, on the other hand, is analyzing the company purely from an investment standpoint for a portfolio manager. If there is a relationship with the company, it is usually on different terms. In some cases this may be as a large shareholder.

Definition of Fair Value

When market valuations extend beyond historical norms, there is pressure to adjust growth and multiplier assumptions to compensate. If Wall Street values a stock at 50 times earnings and the current assumption is 30 times, the analyst would be pressured to revise this assumption higher. There is an old Wall Street adage: the value of any asset (stock) is only what someone is willing to pay for it (current price). Just as stock prices fluctuate, so too do growth and multiplier assumptions. Are we to believe Wall Street and the stock price or the analyst and market assumptions?

It used to be that free cash flow or earnings were used with a multiplier to arrive at a fair value. In 1999, the S&P 500 typically sold for 28 times free cash flow. However, because so many companies were and are losing money, it has become popular to value a business as a multiple of its revenues. This would seem to be OK, except that the multiple was higher than the PE of many stocks! Some companies were considered bargains at 30 times revenues.

Conclusions

Fundamental analysis can be valuable, but it should be approached with caution. If you are reading research written by a sell-side analyst, it is important to be familiar with the analyst behind the report. We all have personal biases, and every analyst has some sort of bias. There is nothing wrong with this, and the research can still be of great value. Learn what the ratings mean and the track record of an analyst before jumping off the deep end. 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. Investors should become skilled readers to weed out the important information and ignore the hype.