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 fundamental analysis is more about business analysis. TV Channels injects into us the theory of charts is technical analysis and if anything we talk about EPS and other such ratios, it is fundamental analysis.

If you want to know about real fundamental analysis you have to unlearn those concept 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 lot of my fundamental analysis is based from the books I have read. One of them is Warren Buffet Way by Robert G Hagstrom that I thought is very good at knowing lot about Warren Buffet and his way of 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 5 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 repeats itself but fundamental analysis is more about analyzing the business.

If you look at the above statement, it will be clear as to why I prefer investing fundamentally for at least 5 years. It is because no business can turn things around overnight. Even if I invest in business when things are on the 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 lot of things can happen in a year time.

Actually investing for 1 year to 5 year is more like a no mans land. You are not investing technically because one year is slightly longer term for technical analysis and it is very short term for fundamental analysis.

The reality is 1 year investor are those who tend to buy a stock without any idea about either technical analysis or fundamentals of the company and 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 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 needed is when you have cash ready to be deployed in market but then you are not able to deploy it because the companies are over valued and day in and day out you see that your cash is remaining idle but the company you want to invest into is really into the bull run and moving higher and higher.

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

3. Rare opportunities

Fundamental investments are rare opportunities and you have to accept and live by it. 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 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 over a period of 60 years. Roughly 1 company in 4 years. If Warren Buffet needed that much time to research and invest, you and me will need lot more time. So if you think you can find fundamentally good stock to invest into 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 fundamental analysis we need to understand the 4 stages of a business

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

In Stage 3, companies should be looking at shareholders because it is they who fueled the companies future. So companies give dividends and also if the stock price is not what they value the business at, they can look for a buy back. Yes there is one more option to go for buying growth like investing in some other business which can be part of the companies portfolio.

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

Stage 4 is when I prefer avoiding the company.

Fundamental Analysis Avoidance Strategy

I am yet to find a complete solution to finding a fundamentally good company at the right price point but what I have managed to find is how to avoid bad companies. I have learned this over the years and now I can easily weed out companies that I will never invest into 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 each and 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 solution and are not yet another player to provide a product or service. This helps business to offer better profit margins which can help business in the bad times. If a business is yet another player in the business, they will always have competitors around their nose to price their product line better and make it harder for business to thrive.

When I prefer unique businesses, I can always weed out stocks that I will never invest into 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 kind of product or services. I am yet to see any bank providing any unique solution to me as customer. Similar things can be said about Indian aviation stocks or telecom sector.

So if there is anything that the company can offer as 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 the 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 goes out of my investing equation. Apart from those Oil as a sector also is what I avoid.

So any thing 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 it is not controlled by Government policies, the next thing that I look into is a business that is rationale and I can understand it.

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

As an example JayPee Associates Ltd where I am still not sure what is the business, they have tons of companies where they have a stake into and are partnered with like power, health, hotels and the list continues. But what does JayPee Associates do is not something I can understand so I tend to avoid it. If I have to invest in those companies where JayPee associates invests into, 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 2 aspect to consistent operating history. First is business operation for 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 lets say 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 the 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 into the business for an elongated period of time, I tend to avoid those. In fact there are very few IPO’s that I have wasted a single minute in 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 history of the business in operation.

Many tend to follow other way round with operating history. If a company is moving to 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 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 share holders, it does not make much sense to me. Yes I understand there are different stages of a business and not every stages can yield dividend but then 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 business but you invest in people.

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

Did they opted for a buy back when the share price was not doing right and do they value the stock price being low?

Reliance Industries has piles of cash but they are neither going for a buyback not announcing any extra dividend. So the management is not able to generate much value for shareholders and is not returning the money to the shareholders either. So anybody asks me about Reliance Industries for investment, I tell them to avoid it.

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 loose sight of the companies objectives and still generate value for shareholders.

Now if we look at a 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 an 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 for debt. If a company can have a profit margins better than what they are offered money for, it is highly likely that most business will opt for debt.

Equity to debt ratio is something that needs to be checked and if there is a company with higher debt, they will have their 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 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 company that had lot of debt but is on the process of reducing it.

8. Higher sales and not higher profit

Always focus on one key aspect of companies operation and it is that sales should always go higher year on year. There is no exception to this. Profit can be subdued for 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.

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

So profit in absolute numbers is 10.

At the end of 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 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, they should be able to generate better than 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 Business are not same

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

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 value of a business and not those stupid ratios.

10. Value and not price

Its not about the price but about the value of a business.

Lets 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 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 a 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 builder of property A is reputed (management criteria) and there is no reason for it to be at 20% discount but there are some problem with papers of the builder.

Will you still purchase it?

I am sure you will not because the price of the 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 those companies that have a unique product or solution that can withstand the profit margins and can dominate the segment they operate in for an elongated period of time. It is better to pay a premium for a great company with great management and business than get a great price for a averagely good company and business.

Share your thoughts in comments below.