Fundamental Analysis – What we all know is completely wrong

What we all know about fundamental analysis from watching news channels is completely wrong. Understand the fundamentals of fundamental analysis

What we all know about fundamental analysis by watching TV and news channel is completely wrong. What we see on TV is more to do with market analysis and not fundamental analysis because the fundamental analysis is more about business analysis. TV Channels inject into us the theory of charts is technical analysis, and if anything, we talk about EPS and other such ratios as fundamental analysis.

If you want to know about real fundamental analysis, you have to unlearn those concepts of fundamental analysis that you know and start over.

I try to follow Warren Buffet’s way of investing when it comes to investing fundamentally, and you will see a lot of my fundamental analysis is based on the books I have read. One is Warren Buffet Way by Robert G Hagstrom, which I thought is very good at knowing a lot about Warren Buffet and his investments.

But before we begin about how I prefer analyzing business fundamentally, let me share with you the rules to fundamental analysis that I follow.

Fundamental analysis rules to follow

1. Time Rule

I follow a simple rule of investing fundamentally for at least five years (often more) in a company. I will share with you why in a moment.

Technical analysis is more about analyzing the chart patterns and investing in patterns that repeat themselves, but the fundamental analysis is more about studying the business.

If you look at the above statement, it will be clear why I prefer investing fundamentally for at least five years. It is because no business can turn things around overnight. So even if I invest in a company when things improve, it will need the time to turn things around and be profitable.

So if you are investing fundamentally, and it is for a year or two, you are being trapped by those TV channels where they inject – investing for a year or so is a long-term investor, and a lot of things can happen in a year.

Investing for one year to 5 years is more like a no man’s land. You are not investing technically because one year is a slightly longer-term for technical analysis, and it is the very short term for fundamental analysis.

In reality, one-year investors tend to buy a stock without any idea about either technical analysis or the company’s fundamentals. Then, once they are into the stock and it slides down, they tend to hold on to the stock for a time when they can get out of it for no profit, no loss kind of scenarios.

So I never tend to invest for a year or so and invest technically with a target and stop-loss or invest in the business for 5+ years.

2. Patience

No, I am not talking about the patience for your investment when the stock invested goes down. That goes without saying. What additional patience is needed is when you have cash ready to be deployed in the market. Still, then you are not able to deploy it because the companies are overvalued, and day in and day out, you see that your cash is remaining idle. Still, the company you want to invest in is really into the bull run and moving higher and higher.

So you not only need the patience to hold onto your investments but also need the patience to be investing in the stock when it is at the correct valuation as well.

It is not only technical analysis that needs investment to be done at the right time and at the right price, but it is also the case for fundamental analysis.

3. Rare opportunities

Fundamental investments are rare opportunities, and you have to accept and live by them. You will not be able to find too many companies that trade at prices you would find value in them fundamentally. On top of that, it is a very difficult process to find a fundamentally good company at a great price. If you can just find one, it is quite enough to be investing everything into it.

If you look at the portfolio of Warren Buffet and Berkshire Hathaway given in the book – The Warren Buffet Way, Roughly 50 Billion dollars are invested in 15 companies in 2012, and this portfolio is based on a period of 60 years. Roughly one company in 4 years. If Warren Buffet needed that much time to research and invest, you and I would need a lot more time. So if you think you can find a fundamentally good stock to invest in a day in and day out, you are on a completely wrong track to investing fundamentally.

What about Diversification, then?

As opportunities are rare, it also means you may not be able to diversify too much. Yet again, something that is being injected into us from Indian Media. Diversify.

So once you know that you are not able to find opportunities that easily, the next thing we may do is opt for someone who can find such opportunities for us. Isn’t it? If you think someone can help you find a stock of your lifetime, you need to think again.

Understanding Business Stages

Before jumping into the fundamental analysis, we need to understand the four stages of a business.

1. The development stage is when a company loses money as it develops the product or services. This is the time when business is in inception mode. Normally you don’t see the business going public in the development stages.
2. The growth stage is where the company has started moving, and the growth is such that it cannot support further growth from its finance and needs extra capital to keep growing. This is where the company will go for investments or can even go public for money.
3. In the matured business stage, where the growth rate slows but not the growth itself, the company begin to generate more cash than it needs for operations. Quite a critical stage to any business where the way the extra money is deployed decides the company’s fortune among shareholders and investors.
4. The decline stage is when a business cannot generate growth, and there is a decline in sales and earnings but continues to generate more cash than its needs, or it can manage to generate more cash by cost-cutting measures and other such things.

In Stage 3, companies should look at shareholders because they fueled the company’s future. So companies give dividends, and if the stock price is not what they value the business, they can look for a buyback. So yes, there is one more option for buying growth, like investing in some other business that can be part of the company’s portfolio.

Growth buying are of 2 types – first is buying a completely different business than the current one, and the second is buying a competitor or some supply chain within the operation of the same company. Later is always preferred as it provides a solid foundation for the current business.

Stage 4 is when I prefer avoiding the company.

Fundamental Analysis Avoidance Strategy

I have yet to find a complete solution to finding a fundamentally sound company at the right price point, but I have managed to find how to avoid bad companies. I have learned this over the years, and now I can quickly weed out companies that I will never invest in fundamentally, and once the company broils down through my touchstone of avoidance criteria, then only I get into the fundamentals of the company itself and so let me share with you every step that I use to decide on investing in a company or not.

1. Unique business

Fundamentally they should be a unique business or solution. So if you ask me to invest in a company, I would prefer to invest in only those companies that have unique business solutions and are not yet another player in providing a product or service. This helps businesses offer better profit margins which can help businesses in the bad times. If a company is yet another player in the industry, they will always have competitors around their nose to price their product line better and make it harder for the business to thrive.

When I prefer unique businesses, I can always weed out stocks that I will never invest in because there is a competitor offering the same product, and it is just that they are doing marketing well enough about the product to be the market leader or is into this business for a long time to be a market leader.

So if you ask about banks and other such stocks, they just don’t become part of my fundamental investing because Indian banks are just yet another bank offering similar kinds of products or services. I am yet to see any bank providing any unique solution to me as a customer. Similar things can be said about Indian aviation stocks or the telecom sector.

So if there is anything that the company can offer as a unique business or solution, I am looking at it further for fundamental investing or else I am just fine trading technically in it, if at all.

2. Not controlled by Government Policies

I don’t prefer investing fundamentally in stocks that are controlled by government policies. I don’t think it can be a profitable business in the long run as it is controlled by Governments for both profits and for losses.

So stocks in sectors of tobacco and alcohol go out of my investing equation. Apart from those, Oil as a sector also is what I avoid.

So anything that can have limited growth due to policies is something that I tend to avoid.

3. I can understand the business model

Once there is a unique business, and Government policies do not control it, the next thing that I look into is a business that is a rationale, and I can understand it.

I am not from a finance background, but I have basic knowledge about business and what a company does. Then there are certain companies where I could not understand what they do, and I avoid such companies.

For example, Jaypee Associates Ltd, where I am still not sure what the business is, has tons of companies they have a stake in and are partnered with, like power, health, hotels, and the list continues. But what Jaypee Associates do is not something I can understand so I tend to avoid it. If I have to invest in those companies that JayPee associates invest in, I will do that myself in sectors I prefer investing into and why should I go through them?

It is completely ok if you don’t understand the working of any sector or company.

Business Evaluations

Once the company passes the avoidance tests, I prefer to evaluate the business further. Also if I cannot understand the business of a company, I may not be able to evaluate the process further anyway.

4. Consistent operating history

There are multiple aspects to consistent operating history. First is a business operation for a consistent period of time but is also into the same business for many years and doing a turn around in not only good but also in bad times and second has consistent product or services being offered over a period of time.

If I see a company has changed operations like let’s say the company was making product A and now they are into product B and if there is no correlation of switching from product A to product B (Emphasize is on switching and not adding yet another product to the product line). So is product A initially planned not viable anymore? If yes then why and how management is accepting the failure to product A.

If there are IPO of companies that are not in the business for an elongated period of time, I tend to avoid those. In fact, there are very few IPOs that I have wasted a single minute in the last 3 or so years because either the companies don’t have a consistent operating history or if they have, they are overly priced.

So it is not about the history of the company but the history of the business in operation.

Many tend to follow another way round with operating history. If a company is moving to a new area, people start investing more and more into that company, assuming it is the right way forward, but I prefer to be knowing why the old was given up. The answer of why is if it goes down my throat well enough, then only I may invest or else I am out of it.

5. Dividends

I am a fan of dividends, and if you already follow my blog you expected dividends somewhere. If a company cannot generate some cash for their shareholders, it does not make much sense to me. Yes I understand there are different stages of a business and not every stage can yield dividends but then a public limited company should always be operational and want to be scaling up and if they cannot provide once a year dividend to their shareholders, I think it is something that I don’t take it very highly.

6. Honest and capable management

You don’t invest in the business but you invest in people.

How a business communicates in bad times is what gives confidence to its shareholders about the team. Are they honest in letting their shareholders know about the bad things or are just trumpeting good things in bad times and telling about future growth only? See how they communicated in the past when the time was not right for the company?

Did they opt for a buyback when the share price was not doing right and do they value the stock price being low?

Buybacks and dividend is something that helps assess the management.

No matter how good a business is, you cannot succeed with average people working for you and they should not lose sight of the company’s objectives and still generate value for shareholders.

Now if we look at very good management, it should not be the only reason why you should be investing in a business because it is not that a good manager can save a drowning ship and so it is also important that you drill to management once you are sure it is a good business and that this management can turn things around in few years down the line.

Financial Aspects

7. Debt and Interest

If you analyze companies, most of them will have a very big expense of debt and it is quite normal in the initial stages of the business to be going into debt. If a company can have profit margins better than what they are offered money for, it is highly likely that most businesses will opt for debt.

The equity to debt ratio is something that needs to be checked and if there is a company with higher debt, it will have its profits eroded. So company with higher debt but working on reducing the debt with profits, is something to be investing into. If you can invest at the right time when they have managed to work on reducing the debt, you will see the profit roaring and soon the company will have better EPS and other such ratios and ultimately will have a sudden rise in the stock price in Indian stock market because that is how the so-called fundamental investors invest.

So ideally you should be investing in a company that had a lot of debt but is in the process of reducing it.

8. Higher sales and not higher profit

Always focus on one key aspect of the company operation and it is that sales should always go higher year on year. There is no exception to this. Profit can be subdued by various factors like debt, interest or other unit setups but then sales cannot be.

Profit can go higher for companies because they are always keeping the profit of the previous year as working capital. Let me share with you an example to explain what I mean.

Let’s say you invest 100 Rs at 10% return annually for calculation’s sake. So at the end of the first year, you are should have 110 Rs. You gained 10 Rs on your 100 Rs as an investment.

So the profit in absolute numbers is 10.

At the end of the second year at the same return annually, you will have 121 and so you gained 11 Rs.

So your profit increased from 10 Rs to 11 Rs and that is an increase in 10% from 10 to 11% but actually, there is no growth because you made at the same rate of 10% only but because you retained the profit into the business to make it grow, it is bound to make more profit in the absolute terms.

So in absolute terms, for each rupee a company keep with them, it should be able to generate better than the bond rate else it would make much more sense for the company to put the cash into the bond market anyway and shareholder will do the same.

So look for companies that are able to grow their cash at a rate better than the best option available.

9. All Businesses are not the same

There are many types of businesses like production, manufacturing, mining, services and the list can go on and on. There are businesses which are cash-heavy and there are certain businesses which do not need a large amount of operating cash. Like infrastructure projects need a long time to execute and need huge cash up front compared to IT services-based businesses.

So if we try to judge every business based on certain rules and ratios, it may not be ideal. So you should always focus on the value of a business and not those stupid ratios.

10. Value and not price

It’s not about the price but about the value of a business.

Let’s say you want to invest in a property (Investment in properties is what we Indians understand ins and out) that should be of value 10Lakh but property A is offered at 8Lakh (20% discount) and property B is offered at 12lakh (20% premium).

Which one will you purchase assuming you have the budget for both?

I am sure you will get into the best possible lawyer to find out if there is anything that is bad about property A or not but let me add why it is being offered at a discount to property B.

There are very few people who want to be buying property A as of now and so it is offered at a discount to property B.

Will you still purchase it?

Now you found that the builder of property A is reputed (management criteria) and there is no reason for it to be at 20% discount but there are some problems with the papers of the builder.

Will you still purchase it?

I am sure you will not because the price of property A is lower, but there is not much value in that property.

Conclusion

Fundamental investment is not about investing in mid-cap companies operating like large-cap companies but in companies with a unique product or solution that can withstand the profit margins and dominate the segment they operate in for an elongated period. It is better to pay a premium for a great company with great management and business than get an excellent price for an averagely good company and business.

Share your thoughts in the comments below.