example, accounts receivable (a current assetconstituting money owed to the company by its customers) is reduced by an entry to a reserve for bad debts. This reduces the grossasset value and creates an expense. Many other kinds of reservesare set up to defer income and expenses so as to properly belong ina future year. These kinds of adjustments have been the source forpast distortions and misreporting by companies, and among thedozens of abusers most people remember Enron as one of the worstoffenders. In varying degrees, companies may practice what iscalled sugar bowl accounting, in which unusually high revenues thisyear are ‘‘deferred’’ to be recognized later when revenues might notbe as positive. The overall effect is to even out the ﬁnancial summaries.4. Assets or liabilities not reported on the balance sheet, or income and expenses not properly reported on the income statement.One of the greatest problems with modern accounting rules is thatcompanies are allowed to exclude many items from the balancesheet. For example, pension liabilities are not included in the liability
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section even when they are substantial. GM would have reported anet negative company value if it booked its pension liabilities. Similarly, many of the core earnings adjustments S&P makes are basedon accounting rules allowing companies to overreport income orunderreport expenses. For example, capital gains on the sale ofcompany assets should not be included as current-year operatingincome because it does not recur and is not part of the company’score business. In the past, even large stock option expenses simplydisappeared and were never shown as expenses. In years whereproﬁts were down, companies have been known to capitalize someexpenses to be written off over several years, a decision that exaggerates current proﬁts and misleads investors.There are many ways that the value and operating results ofcompanies can be distorted. The instances where this is done inviolation of the rules are very troubling and SEC investigations haveuncovered many. More troubling, however, are the continuing examples of distortions allowed under current accounting rules. Forexample, companies are not required to report their pension liabilities or the liability for long-term leased equipment. These are veryreal obligations, but they usually show up only in the footnotes.When the numbers are large, the value of equity is distorted.5. Contingent liabilities. These include pending lawsuits, whichmay be quite substantial. For example, Altria (Philip Morris) andMerck experienced thousands of pending lawsuits following the tobacco settlements and pharmaceutical judgments of recent years.Most large corporations have some level of contingent liabilities dueto lawsuits or losses in loans, subsidiary operations, or acquisitionactivities.6. Mergers and acquisitions activity. When companies are beingacquired or merging with other companies, it may take manymonths or even years to go through the entire process. Footnotesdiscuss ongoing merger and acquisition (M&A) activity, currentstatus, and potential impact on the company’s value and proﬁt orloss.Clearly, the footnotes are highly technical and complex, usuallyrunning dozens of pages in small print. Many are impossible to de-
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cipher for anyone without an accounting background, which is abig part of the problem. Most investors are at a disadvantage intrying to simply understand what is going on, and current reportingrules are a long way from true transparency or from even considering how information for investors can and should be improved. Thesolution to this problem is to rely on a short list of indicators designed to reveal what is really going on within a company. Distortions can be made to control results in the short term, but over manyyears, it is impossible to hide the truth. And the long-term trend iskey. No ratio or indicator should be looked at by itself, but shouldbe compared to other companies in the same industry, and studiedfor at least ﬁve years, preferably 10 years. Only by tracking the trendcan you see what has occurred in the past and in the most recentreport. This is the best way to overcome the complexity of the accounting methods in use today.
Combining Technical and Fundamental AnalysisIt makes sense to adopt a view of caveat emptor in the modern stockmarket. Relying on the published ﬁnancial statements of companiesis simply not a wise idea. There are too many ways that the numberscan be manipulated within what is approved and allowed. Regulatory agencies, stock exchanges, and auditing ﬁrms are all in agreement about the ﬂaws in the liberal interpretation of accountingrules. There are many sound reasons for the complexities of thissystem; unfortunately, it means that you have to do your own homework. Fortunately, a lot of good basic information is available andis free through the research and analysis provided as part of onlinebrokerage accounts.Combining both technical and fundamental analysis enables youto view both ﬁnancial and price-based information, and to use eachto conﬁrm the other. You will discover that strong and consistentﬁnancial statements translate to low-volatility stock history. The twoare directly related. You will also see several shared attributesamong well-managed companies whose stock is available at a valueprice. These attributes include consistent rise in dividend payments
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105
over many years, a moderately low degree of price volatility, consistency in the ﬁnancial reports themselves, and little or no adjustments between reported earnings and core earnings. Collectively,these are the primary signs of well-managed companies.Financial outcome is best viewed over many years. When yousee steadily increasing revenues and net proﬁts, you get a sense ofreliability in the numbers. Every company goes through brief periods where the stock is out of favor, thus a stock price might faltereven when the fundamentals remain strong. However, as long as allof the fundamental signs are unchanged, the momentary effect ofmarket value will be a passing event. Long term, the fundamentalsare the key to sound stock selection.Market-wide trends will affect stock trading ranges even whenlong-term fundamental results are strong and consistent. Two goodexamples of this are Wal-Mart and Microsoft. Both are wellmanaged, successful companies that dominate their industries. WalMart’s stock price weakened toward the end of its 10-year historyending with ﬁscal 2007, reﬂecting retail industry weakness overall;in fact, Wal-Mart underperformed its industry in 2007 due to predictions that ‘‘hyper-store’’ sales were going to weaken over time. Inspite of these kinds of predictions, Wal-Mart continued to expandinternationally, adding hundreds of new outlets in many countries.Microsoft also experienced strong revenue and proﬁt growthwhile its stock price reﬂected market perceptions differently. Trading as high as $60 per share in 1999, stock prices settled down toas low as $21 per share in ﬁscal 2006. There has been no obviousweakness in Microsoft’s fundamentals; in fact, growth in revenuesand proﬁts has been consistent and strong. The fact that stock pricerange did not change very much between 2001 and 2007 reﬂectsthe market conditions and the industry more than Microsoft itself.Given the history of both of these companies, checking both technical and fundamental indicators is the wisest methodology for investors.A summary of the 10-year history of revenues, net proﬁt, andprice ranges for Wal-Mart and Microsoft is provided in Table 5-1.There seems to be an odd nonreaction in the case of Microsoftbetween the stock price and the revenue/proﬁts, notably between
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TAB L E 5 - 1 . F U N D A M E N TA L A N D T E C H N I C A L H I S T O R Y
Company
Year
In Millions of DollarsRevenueNet Proﬁt
Stock PricesHighLow
Wal-Mart
2007200620052004200320022001200019991998
$348,650312,427285,222256,329244,524217,799191,329165,013137,634117,958
$12,17811,23110,2678,8618,0396,6716,2955,5754,4303,526
$52556160645969704121
$42425146444241391911
Microsoft
2007200620052004200320022001200019991998
$51,12244,28239,78836,83532,18728,36525,29622,95619,74714,484
$14,06512,59912,2548,1689,9937,8297,7219,4217,7854,490
$36302830303538596036
$27212425232121203416
Source: Standard & Poor’s Stock Reports
1999 and 2001 and again between 2003 and 2007. Note how in themost recent series of years, revenue and proﬁts rise strongly eachyear, but the stock price remains unchanged until 2007. It is asthough a delayed reaction dominates on the technical side. However, the point to remember about this kind of comparison is thatover many years, consistent growth and fundamental strengthtranslates to growth in stock prices. The Wal-Mart historical comparison is more in line with this observation than that of Microsoft.In fact, the high price for ﬁscal year 2007 was just about the sameas it had been 10 years earlier, at $36 per share. The low end of therange, in comparison, was far stronger. In both cases, it may be true
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107
that some kind of saturation point was reached after 10 years ofgrowth, but until an actual slowdown occurs in the revenue/proﬁtstrend, there is every reason to believe that the stock’s price rangeswill continue to expand.Combining both technical and fundamental analysis makessense because it broadens your point of view. By studying past history you can see how the future is likely to go. For this reason, it iswise to come up with a short list of indicators to review in combination with one another. They collectively serve as a broad view offundamental and technical change, as well as providing many formsof conﬁrmation.
Basic List of 10 Indicators Every Investor NeedsEveryone has their own preferences about which indicators to use.Some are undeniably valuable for distinguishing between stocks inone manner or another. The list that follows includes one combined,two technical, and seven fundamental ratios. Most people will notwant to deal with more than 10 indicators; some will be conﬁdentwith fewer. All of these, used in combination, can be useful in developing your investment portfolio.
Combined Technical/Fundamental IndicatorThe P/E ratio is popular and revealing because of easy comprehension: It quickly casts the condition of stock in terms of valuationand is a great indicator for comparisons between stocks and to astandard.The standard recommended for most people is to limit yourselfto stocks with price per earnings (P/E) under 25. Consider whatthis means: When P/E is 25, the current price is 25 times earnings.So if the stock’s price is $50 per share and earnings per share (EPS)is $2, the P/E is 25:$50  $2  25
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Consider what would happen if the stock were to rise to $100per share. At that point, P/E would be 50. Clearly, the stock is moreof a bargain at $50 per share, especially if EPS remains unchanged.The perception of future value is reﬂected in P/E. Some highly popular stocks have grown so quickly that their P/E moved high as well.For example, Google’s (GOOG) P/E ranged between 52 and 33 in2006, and in its previous ﬁscal year (2005), went as high as 89. Soat some point in 2005, investors were willing to pay 89 times EPSfor shares of Google. The price since then has proven to have beena wise move, with the stock more than doubling to over $700 pershare in 2007, but the point to remember is that the higher theP/E, the higher the market risk.
Technical IndicatorsOn the technical side, two indicators are worth checking. Firstis the trading range itself. If you have tracked a stock over 10 yearsor more, you will see the change in the trading range. It is fair tosay that a climbing range is positive and a declining range is highlynegative. Many investors buy stock based solely on today’s price,without even considering whether the market price has grown ordeclined over 10 years. This common mistake—thinking about thepurchase price as a starting point—leads to many cases of poortiming or simply poor selection. For example, compare two wellknown companies, Eastman Kodak and Johnson & Johnson (JNJ).Table 5-2 shows the 10-year history of the trading range for eachof these companies.Both of these histories are dramatic, but in opposite directions.These price ranges are summarized graphically in Figure 5-2.The 10-year changes in trading range demonstrate signiﬁcantdifferences between these two companies. Whereas Kodak’s marketvalue has declined steadily, JNJ has experienced a steady rise, morethan doubling in market value ranges.A second technical indicator to track is trading volatility. This issimply the breadth between resistance (high price) and support (lowprice) within the trading range. However, there is more. The volatil-
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TABLE 5 – 2. TRADING RANGE COMPARISON: 10 YEARS
Stock PriceYearHigh
Low
Eastman Kodak
2007200620052004200320022001200019991998
$ 31353541285068808995
$19212420262435575853
Johnson & Johnson
2007200620052004200320022001200019991998
$69706459666153534534
$57604948414033393224
Company
Source: Standard & Poor’s Stock Reports (prices rounded)
ity factor also distinguishes between low-risk stocks and high-riskstocks. By deﬁnition, low risk means that the trading range remainsabout the same size. For example, a stock trading within a 10-pointrange last year still trades in a 10-point range this year and hasnot deviated from that breadth. Ideally, the trading range has beeninching toward higher price ranges during that period. In a highrisk stock, the range changes often. It may also be characterized bya number of breakouts above resistance and below support, withprices retreating soon thereafter, and by frequent trading gaps.These gaps themselves are not negative indicators but when theyoccur often, and when price moves quickly beyond its trading range
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FIGURE 5.2. 10-YEAR TRADING RANGE COMPARISON
Eastman Kodak959085PR 80I 75C 70E 65P 60E 55R 50S 45H 40A 35RE 30252015
97
98
99
00
01
02
03
04
05
06
99
00
01
02
03
04
05
06
Johnson & Johnson
PRICEPERSHARE
9590858075706560555045403530252015
97
98
Source: S&P Stock Reports
in a gap pattern and then returns, it is an indication of high volatility. A related factor is trading volume. When you see volume changing from one day to the next, and even spiking to unusually highlevels with dramatic price movement, it implies high-risk conditions.
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Fundamental IndicatorsThe fundamentals are the mainstay for many moderate and conservative investors. But because there are so many indicators available, no one can follow them all. In fact, with too much information,you lose the ability to identify a clear and obvious signal. Thus, youneed to reduce the number of indicators whenever possible. Anotherprinciple worth observing is that singular indicators are not as valuable as a dual analysis of two related indicators.The ﬁrst fundamental indicator is a combined test of both working capital and capitalization. By watching current ratio and the debtratio, you will be able to keep an eye on some very basic moneymovement within the company. Watching these two indicators together is absolutely necessary.Current ratio is a comparison between current assets (convertible to cash within the next 12 months) and current liabilities (payable within the next 12 months). To compute, divide the currentassets value by current liabilities, as shown in Figure 5-3.For example, a company’s current assets are $62,558 and current liabilities are $37,004. The current ratio is:$62,558  $37,004  1.7
The current ratio ‘‘standard’’ is that 2 or higher is consideredexcellent and depending on how much inventory is involved, a ratiobetween 1 and 2 is also acceptable. However, these are generalizations and by itself, current ratio reveals only one aspect of how wellthe company manages its working capital. The ratio demonstratesover time how much liquidity is available to pay current debts.
FIGURE 5.3. CURRENT RATIO
current assets= ratiocurrent liabilities
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The current ratio should be tracked along with the most important capitalization ratio, known as the debt/equity ratio. This is acomparison between long-term debt and equity. Every companyand industry has different standards for this ratio. However, overtime you may see a creeping effect, in which debt grows. GM experienced a growing debt ratio over a decade, resulting in debt over100 percent of equity. This is an extreme case. Microsoft, at theother end of the spectrum, carries no long-term debt on its balancesheet. Also called the debt-to-capital ratio, this is computed by adding together the long-term debt and the shareholder’s equity to ﬁndtotal capitalization. The long-term debt was previously explained. Aquick review: A company currently has $92,064 in long-term debtand $117,680 in equity. Total capitalization is $209,744 ($92,064$117,680). The debt ratio is:$92,064  $209,744  43.9%
If this ratio were fairly consistent over many years, then thetrend is acceptable. A falling debt ratio is always preferable becauseless debt translates to lower interest expense and more capital available for expansion and dividend payments.Watching current ratio and debt ratio together is crucial, because a hidden trend can emerge if you are not cautious. A companywishing to maintain its current ratio during years when it is losingmoney may easily increase its long-term debt and hold onto theborrowed funds in cash. Even as the ﬁnancial condition deteriorates, the current ratio can be held at the same level but long-termdebt continues to rise. In other words, by allowing long-term debtto rise each year, a company can report declining proﬁts and evenlosses, but its current ratio remains consistent. So if you check onlythe current ratio, you will miss this trend.An example of this occurred over the 10-year history of Eastman Kodak, from 1997 through ﬁscal 2006. This is summarized inTable 5-3.There is a dramatic trend underway in this 10-year history.However, if you give great weight to working capital as a primaryindicator and you track only the current ratio, Kodak was able to
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A Few Valuable Fundamentals
TABLE 5 – 3. CURRENT RATIO AND DEBT RATIO ANALYSIS
Eastman Kodak:Year
Net Income(in millions of dollars)
CurrentRatio
DebtRatio
20072006200520042003
$ 600– 1,45581238793
1.11.11.11.00.8
66.2%58.432.741.429.5
20022001200019991998
$
0.90.90.90.91.1
36.5%25.0011.115.6
761,4071,3921,3905
Source: Standard & Poor’s Stock Reports
maintain approximately a 1.0 ratio through the entire decade. All iswell, or so it would appear. When you study the deterioration in netincome, you see a downward spiral underway. With less proﬁt, andin the two most recent years, net losses, how can Kodak maintainits 1.1 current ratio? The answer is found in ever-higher levels oflong-term debt. Ten years before, debt represented only 15.6 percent of total capitalization; at the end of ﬁscal 2006, this had grownby over 400 percent to 66.2 percent of total capitalization. This isnot a positive trend by any means, and for stockholders it is verytroubling—in spite of the positive current ratio history.The second and third fundamental indicators deal with dividends. These are the current yield and the 10-year history of dividend growth. Current yield, you will recall, is calculated by dividingthe annual dollar value of dividends by current share price. For example, total dividends are declared at $1 per share, payable eachquarter (for a total of $4 per year), and current share price is $80per share. So current dividend yield is:$4  $80  5.0%
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Winning with Stocks
As a minimum standard, current yield should be set at a reasonable level. Dividend yield will end up representing a signiﬁcant portion of your overall investment return, so dividends should not beignored. Additionally, a company’s ability to pay an attractive dividend is a very positive attribute. A company cannot continue payingdividends unless it has proﬁts and positive cash ﬂow. For example,you may decide to isolate your search only to companies with 4percent or better annual dividends. This will reduce your selectionconsiderably.The history of dividend growth is best studied over 10 years.Those companies that have increased dividends every year for 10years or more (‘‘dividend achievers’’) are among the best-managedand most successful companies available to the public. This provides you with a secondary dividend-related qualiﬁer in narrowingdown your list of stock candidates for inclusion in your portfolio.The fourth basic fundamental indicator is a comparison between revenue and net proﬁts. There are several points worthchecking in the multiple-year trend, including growth of revenuescompared to changes in proﬁts, the rate of growth, and the questionof why it sometimes occurs that revenues increase but proﬁts fall, avery troubling and negative change in the trend. Focusing only onever-higher revenues is worthless unless the company is also able totake ever-higher portions of revenues to the bottom line.For example, look at the 10-year history summarizing revenueand net income for two companies, American Airlines (AMR) andAmazon.com (AMZN). These are shown in Table 5-4.Both companies show a very disturbing trend, and this highlights the importance of tracking revenue and net income together.American Airlines has had a high volume of revenue that increasedthroughout the decade. However, its proﬁts have never been impressive and, in fact, most recent years reported net losses. Amazon’s history has always been characterized by very low proﬁtmargins, in fact, it has only shown a proﬁt during the four mostrecent years. The troubling aspect here is that in 2006, althoughtotal revenue jumped considerably and annual revenue growth wasspectacular, net income for the three latest years declined. Eventhough the company became proﬁtable, increased revenue has beenaccompanied by ever-smaller net. Seek companies whose revenues
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A Few Valuable Fundamentals
TABLE 5-4. REVENUE AND INCOME TRENDS
Company
Year
In Millions of DollarsRevenueNet Proﬁt
American Airlines
2006200520042003200220012000199919981997
$22,56320,71218,64517,44017,29918,96319,70317,73019,20518,570
$ 231 861 7611,2282,5231,7627796561,306985
Amazon.com
2006200520042003200220012000199919981997
$10,7118,4906,9215,2643,9333,1222,7621,640610148
$
19033358835 150 5771,411 720 12528
Source: Standard & Poor’s Stock Reports
and net income grow each year. When you see higher top-line results with lower bottom-line results, it is a negative trend.The next indicator worth following is fundamental volatility, thedegree to which the numbers vary from one year to the next. Forexample, compare the low volatility of Wal-Mart with the muchhigher fundamental volatility of DuPont in the same decade. Theseresults are summarized in Table 5-5.Notice how Wal-Mart’s revenues climb steadily year after yearand, more to the point, so do net proﬁts. However, DuPont’s revenues have been relatively ﬂat for most of the period, while net income was inconsistent. Compare the 1997 result, in which net was5.3 percent of revenue to the next year (6.7 percent) and the year
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TABLE 5 – 5. FUNDAMENTAL VOL ATILITY COMPARISONS
Company
Year
In Millions of DollarsRevenueNet Proﬁt
Wal-Mart
2007200620052004200320022001200019991998
$348,650312,427285,222256,329244,524217,799191,329165,013137,634117,958
$12,17811,23110,2678,8618,0396,6716,2955,5754,4303,526
E.I. DuPont de Nemours
2006200520042003200220012000199919981997
$ 27,42126,63927,34026,99624,00624,72628,26826,91824,76745,079
$ 3,1482,0531,7801,0021,8414,3282,3142191,6482,405
Source: Standard & Poor’s Stock Reports
after that, 1999, when net was 0.8 percent. The most recent year,2006, reported 11.5 percent net income. With ﬂat revenues, thecompany’s net income is highly inconsistent.Another important fundamental test is a comparison betweennet income and core net income. Examples of these variations havebeen previously provided, and the important point to emphasize isthe underlying signiﬁcance. When you see very low core earningsadjustments in companies (such as Wal-Mart’s, which is miniscule),this is a very positive sign. When you see volatile core earnings adjustments (such as the multibillion adjustments for General Motors)it indicates accounting problems or inconsistency in the ﬁnancialreports.
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Two ﬁnal fundamental indicators to keep in mind are the company’s competitive and management status and its credit rating. Oneof the basic standards of value investing is to concentrate on companies with exceptional management that are strong leaders in theirindustry sectors. Well-managed, strongly competitive companiesare more likely to perform better than average even in soft or downturning markets. Credit rating is often overlooked, and that is amistake. Few investors pause to realize that GM has a very poorcredit rating so that its corporate bonds in 2007 had junk bondstatus. Similarly, American Airlines, with a 2006 debt ratio of 105.3percent of total capitalization, had its debt rated Caa2 (in poorstanding) in 2007. In those instances where credit ratings are in thejunk bond classiﬁcation, investors have to wonder whether it makessense to invest money. This is especially true when long-term debthas grown so high that it puts equity in the negative.S E V E N F U N D A M E N TA L I N D I C AT O R S
1. Current ratio combined with debt ratio2. Current yield3. Dividend growth4. Revenue and net proﬁts5. Fundamental volatility6. Competitive and management status7. Credit rating
The indicators worth following are valuable only when trackedon a comparative basis between companies, and over many years(at least ﬁve, preferably 10 years). As a matter of basic risk, knowinga company’s ﬁnancial strength or weakness and being able to identify bargains versus overpriced stocks is a good starting point forbuilding a strong portfolio. In the next chapter, the big issue of riskis explored, both in historical context and to explain the variouskinds of risk everyone faces in the stock market.
Note1 Annual report, 2006, www.gm.com.
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H
A
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6
IDENTIFYING THE RISK
T
he famous market illogic known as ‘‘tulip mania’’ occurred hundreds of years ago in Holland. Speculation in tulip bulbs was sowidespread that entire fortunes were invested in single bulbs. It wasnot until the whole thing came crashing down that people