Part one: It’s all about the fundamentals
As financial markets teetered on the brink during the GFC, one thing was clear. The world economy was heading into uncharted waters. Each financial shock became daily front page news. Commentators the world over tried to outdo each other for the next big headline.
But as the dust started to settle, an old theme began to re-emerge. A theme used historically to place a financial value on any asset. Whether that be property, shares, or other types of business.
It all comes down to one simple thing: Allowing for risk, there is a relationship between the value of an asset and the cash flows (or the income) that it generates.
It seems logical, especially if you’re investing for income. You would most likely prefer to buy shares in a large and established company that pays a regular dividend, than one that might pay them in the future. You would be prepared to pay more for a stock that has a history of generating surplus cash.
In early 2009, this method of valuing shares started to put a floor under the share market. As the ‘Armageddon’ headlines started to recede, investors began to look again at a company’s fundamentals.
But it wasn’t an across the board recovery where all companies rose with the underlying trend. It was only companies with strong fundamentals that came roaring back.
What do we mean by fundamentals?
There are two broad methods that investors (or traders) use to analyse shares. Some use both, but people often get a feel for one of them and stick with it.
One way is to look at charts. You’ve probably looked at them yourself at times. Maybe you use them every day. Depending on your investment time frame, you might use daily, weekly, or monthly charts.
The purpose of charts is to use price data as a signal for your trading or investing decisions. You may recognise price clusters or patterns. It might be support or resistance levels, or it might be a simple moving average crossover point. You then use your interpretation of the data to trigger buy and sell signals as well as create stop loss levels.
The other method is to look at the fundamentals. Longer term (or ‘value’) investors will be more interested in the financial health of a business and its future prospects. They try to avoid the short term ‘noise’. Their aim is to buy shares in a company with a strong balance sheet, and one that has the ability to grow over time.
What to look for in a company’s fundamentals
When you are analysing fundamentals, in effect you are looking at the economic picture of a business. You might start off with the company’s balance sheet to see how strong it is. What are its debt levels like compared to similar companies in its sector? You could determine if it might hit trouble if interest rates were to rise. Breaking this down further, you might look at short term debt versus long term debt. Does the company have enough funds to cover its day to day operations?
Other key financial data is contained within the Profit and Loss Statements. Take a look at this extract from the recent interim result for Macquarie Radio Network [ASX: MRN]:
At a glance it all looks consistent from one period to the next. Revenue has gone up a bit. Expenses seem to be similar to the previous period.
But now look at Employee Benefits. These have blown out by close to $4 million! This just about eradicated all their profit. Unfortunately for shareholders, this lead to them cutting their dividend.
As obvious as it sounds, generating cash is key for any business. A company needs to be earning more than it is spending before it can make a profit and share this with its investors. If you remember the dotcom boom, the market eventually realised that the lofty share valuations were meaningless. Most of the companies were simply unable to generate sustainable cash flows. Only a few of them ever made a profit. The ‘bust’ happened quickly and sharply.
What else to look at
It is one thing to just focus on the financials, but fundamental analysis takes a broader sweep than that. Management are a further key to a company’s success. Look at the recent impact on Myer’s [ASX: MYR] share price when Bernie Brookes announced his departure. Whose management team would you favour between Virgin and Qantas? Or out of Wesfarmers or Woolworths?
One final thing to consider is the industry the company operates in, and where it fits into the overall economy. Value investors quite often avoid commodity type companies (like the bulk miners) because good management is often not enough to overcome the impact of depressed prices. Think how hard it is for the second tier iron ore companies to make a profit in the current environment.
Charting can be a good way to try and help time your way into the market. But fundamental analysis digs a bit deeper. It helps you see what the real picture is behind all the daily price moves.
More importantly, it defines your rationale for investing in a company in the first place. If the underlying fundamentals remain intact, you won’t be tempted to sell out of a stock in times of excess volatility.
Income Specialist, Daily Reckoning
PS: Keep your eye on your inbox for Part Two tomorrow: ‘The impact of inflation on your investments’