Investing - Part I

Fundamental Analysis

Before reading any further, please be sure that you have read and understand my disclaimer which essentially states that this information is educational in nature and is not to be construed as investment advice.

OK, I've basically decided to break this into four main sections: fundamental analysis, technical analysis, options, and an overview of how the economy and the market interact.

First a little background as to why I believe that I'm qualified to discuss these matters.

I've worked for two different brokerage firms, one was a small regional firm, and the other was one of the biggest on Wall Street. During my first year and a half I worked almost exclusively with smaller and relatively inactive clients. Later I worked with some of the largest accounts in the major firm. In order to talk to the group I was in required a minimum net worth of $1 million or you had to be a very, very active trader. At the end of my career, I was working exclusively with the hyperactive traders and was also involved in specialized knowledge groups for both fundamental and technical analysis.

So now you know a little about me. Before we really jump into breaking down fundamentals let me let you in on the secret that Wall Street will never tell you.

If you take the time to learn the basics, chances are, you will know more than your broker. I was consistently amazed at the number of call transfers I would get from brokers who didn't know their basic order types or who couldn't tell a PE ratio from a moving average. It was consistently amazing to me.

When I was taking calls for the fundamental analysis group I used to love the calls that I'd get from brokers that had gotten themselves into discussion way over their heads. They'd get me on the phone and start asking how a declining price to sales ratio in light of an increasing inventory that is apparently being financed through increased long-term debt might affect the share price of a competitor in the next three to five years.

At that point, I'd stop the broker and take over the conversation. Fundamental analysis should be just that - fundamental.

The first, most obvious - and most overlooked - step is to identify the company you want to analyze. If you're interested in XYZ Company, it doesn't make much sense to be digging into the financial reports of ABC instead (I'll explain why in a few minutes).

The next step is to determine what the company does. It is amazing how many people would call up and say, "Buy 5000 XYZ." When the trade was done they would then ask, "What do they do?"

It is amazing what you can determine about the future prospects of a company simply from figuring out what they do. Why are they in business? Do they produce buggy whips or rotary dial telephones? Are they a biotech company? It will also give you a general idea as to how much of their business might be international. Identifying the business of the company will also usually give you a basic understanding of who the major competitors might be.

Next we get into the actual fundamental analysis. I would always start with a simple question: why is this company in business? The answer with every single company is the same: to make money. So the question becomes whether the company is really making money or not.

Most people would immediately reach for the balance sheet to look for an increase in the shareholder equity. Others would immediately grab for the income statement. Almost no one would actually go and look at the statement of cash flows. So why would I?

Neither the balance sheet nor the income statement provides a true picture of a company's financial situation. Too often they are easy to manipulate. How is the balance sheet computed? Has the company changed their inventory accounting method (not unusual in companies that are struggling)? Are they moving debt off the balance sheet through various dodges to avoid being labeled as debt-laden? What really comprises the income statement? Are there extraordinary items? Has the company recently changed the accounting for depreciation?

Companies manipulate these numbers because they know that most people won't look any deeper. After all, these are audited statements. So the numbers, and any derivates thereof (like PE, cash-to-debt ratios, etc), must be absolutely true and factual. But after Enron and Arthur Andersen, we know that that is not the case.

The statement of cash flows is comprised of three sections: cash flow from operations, cash flow from investing activities and cash flow from financing. The section that I focus on is the first: cash from operations.

Businesses exist to sell products or services to customers at a profit. That is the absolute basic reason for business. Cash flow from operations attempts to remove all the outside factors and looks basically just at revenue from sales and the cost of producing the good or service that is being sold. The resultant answer tells you if a company can satisfy it's basic reason for being.

We can then look at past quarters' or past years' cash flows to determine if the company is growing, shrinking or staying even. The cash flow from operations should be a positive number, except in extraordinary circumstances.

After finishing the cash flows, we would next pull a 10-K report from the EDGAR Database at SEC.gov. Why the 10-K?

The 10-K is essentially the annual report, but it contains some additional sections. The most significant for my purposes was the section on risks. This is where the company would disclose the relevant risks that needed to be disclosed, while avoiding having them in the annual report. You can also find some unusual information about the operations of the business in the 10-K.

Let me provide an example of how this worked.

I had a client one day in late 2001 that wanted to look into Lucent as a long-term investment. The stock was trading at about $4/share at the time. The company appeared to be a potential turnaround, if you analyzed just the balance sheet and income statements.

When we started looking at the cash flows, we realized that the company was losing a significant amount of money from operations, every quarter. We also noticed a very high positive cash flow from investing activities. This is not the ideal pattern that you're searching for when looking for a new opportunity.

So we started to look through the 10-K. In there we found a small spreadsheet showing the companies the Lucent had acquired during the previous year and how the acquisitions were all financed. Every one of them was financed through the issuance of additional shares of Lucent stock.

All few pages further along, we found a list of divestitures that Lucent had made during the year and what was received in kind. We quickly realized that many of the same names were on both lists.

Lucent was issuing stock to acquire companies, which it in turn sold for cash.

If you had looked at the balance sheet, it was showing a growing cash position. If you looked at the cash on hand at the end of each quarter, it was improving. If you looked at the income statement with the extraordinary items included (which is how they published it) everything looked good. The PE ratio was even reasonable.

But the statement of cash flows told the true story. Lucent couldn't make a dime selling telephone equipment. They were surviving essentially by selling their goodwill.

If you know what the industry average is for price to operating cash flow you can usually make comparisons with other, similar companies. We found at one point that AOL/Time Warner was trading at 125 times operating cash flows. The average for the media industry at the time was around 30 times OCF. During the next 9 months or so, AOL slid from $40/share to $13/share - which brought the cash flow number in line.

Fundamental analysis is easy as long as you remember that it is fundamental. The idea is to learn about the company you are researching and to determine its business condition. Complex formulas like price to sales over inventory less work in progress don't really tell you anything worthwhile. They might be good management tools, but remember, you're an investor, not a manager. Keep it simple: what does the company do and can they really make money doing it?

If you like what you see there, then maybe its time to move on to looking at the technicals. If not, it's time to move on to another stock.

To get straight to the other sections:

Part II - Technical Analysis

Part III - Options

Part IV - The Economy and The Market

Part V - Market Mechanics

Part VI - Mutual Funds

Part VII - Asset Allocation

Part VIII - Bonds