High levels of fundamental volatility are a warning sign that management may be tinkering with its accounting policies or, at the very least, is not able to control expenses. Management is supposed to create a strategic marketing plan, track it from month to month, and generate revenues. At the same time, they are supposed to control costs and expenses. When this is done properly, the result is low volatility in the numbers. When man- agement does not know how to control its forecasts and internal expenses, the result is high fundamental volatility.
3. Are you looking for good investments or do you just like the com- pany? So many investors pick companies because they like the product without considering the relative value of the company as an investment. Many people hate Wal-Mart because they employ a smart, but ruthless marketing strategy. They offer lower prices than small local shops and, as a consequence, a lot of small busi- nesses cannot compete. So as a potential investor, you need to make a distinction between personal feelings and investment value. It is a fact that, based on numerous fundamental tests, Wal-Mart is an excellent growth investment; Sears, by compari- son, has been losing market share over many years. So you might like shopping at Sears and hate Wal-Mart. But that would not be a sound reason to buy Sears stock, which is fundamentally weak, and to reject Wal-Mart stock, which is fundamentally strong.
The same case applies to the selection of soft drinks, food companies, tobacco giants, computer software manufacturers, or recreation industry companies. If you do decide to invest on moral terms or on personal preferences for products, be aware of the underlying reasons for your choices. If you want to employ fundamental tests, it is important that you put aside personal preferences based on products or marketing strategies. The two do not mix well.
What Selected Financial
Every investor faces the dilemma of how to narrow down the list of potential investments. There are plenty of well-managed corporations to choose from, some with more risk than others, and some better managed than others. The range of indicators you choose to test also dictates how well you narrow the list. If your requirements are too stringent, you may find no stocks at all. If too loose, your list will be too long to enable you to make an informed decision.
When you already own stocks, analysis is part of your portfolio management task. It is never wise to buy stocks and then forget about them; and there is a tendency, even among fundamental in- vestors, to watch price only. This is a mistake. To- day’s well-selected, fundamentally strong stock may change tomorrow, based on news and events, com- petitive changes, and the basic fundamental trends themselves.
Some of the areas worth monitoring include:
1. News and developments. The financial news often is uninteresting, but now and then an important story emerges that affects the fundamental value of your stock. For example, if a class action lawsuit is filed that could cost the company billions of dollars, that would certainly change its valuation. By the same argument, a corporation may receive a large contract. In the aerospace sec- tor, a manufacturers’ stock is invariably affected by large orders for planes but adversely affected by looming threats of strikes.
News may not be restricted to business, either; it may be eco- nomic, political, or both, and the effect on a stock’s value, at least in the short term, can be substantial.
When news—good or bad—affects a company you own or are thinking of buying, the most important question to ask is: How does this affect long-term value of this company as an investment?
The purpose in narrowing down a list of potential investments is to avoid guesswork and to arrive at an informed decision.
Key Point
portfolio management a series of tests and monitoring procedures de- signed to ensure that a stock’s fundamental strength remains;
when that posi- tion changes, it may also be time to sell the stock.
Of course, virtually everything is going to affect stock prices short- term, but most news does not change the long-term value of the company, so it should be discounted.
2. Product announcements. A similar impact on a company’s value grows from product announcements. Some industries are more vulnerable to this than others. For example, FDA approval of a major new drug can boost a pharmaceutical company’s value sig- nificantly, as well as its long-term value. If the FDA rejects a new drug, the opposite effect is seen; and if an existing drug is pulled from the market, lost revenues and the possibility of lawsuits also raise many questions concerning the value of the company for many years to come.
Some industries are involved with research, and new prod- uct inventions or revisions will have a great impact on price. For years now there has been talk of developing alternate energy sources. If that ever comes to pass, would the current energy sec- tor be a lead player in a new fuel technology market? Or would the sector suffer because it is heavily dependent on oil and gas?
These kinds of questions surrounding products are complex.
One sign of a company’s vision is its ability to change with the times, branch out, diversify into new product areas, and antici- pate obsolescence.
3. Earnings surprises. The favorite pastime on Wall Street is predict- ing and then comparing earnings announcements. Analysts predict quarterly earnings to the penny and then, when those earnings announcements are published, everyone compares the actual out- come to what the analysts predicted. Ironically, more weight is given to the prediction than to the actual outcome, and a differ- ence of anything beyond a few pennies per share is an earnings surprise. But astute investors should question this system. What is the basis for the analysts’ target for earnings? How did they ar- rive at it? Was it a fundamental or a technical estimate? Just as an- alysts set price targets, how is the earnings per share devised? If we do not know how the estimate was arrived at, then we cannot know how much validity to assign to it.
A company may be very happy with its quarterly earnings, es- pecially if those earnings exceed the previous period. However, if the analyst estimated a higher earnings than the company realizes,
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Wall Street treats the outcome as negative news. The investing community is obsessed with technical indi- cators and short-term price movement and has little or no interest in financial information.
4. Mergers and acquisitions. Finally, be aware of how corporations merge with others or acquire smaller competitors. The acquisi- tions trend may be a positive or a negative factor. During the era of corporate scandals from 2001 to 2002, hindsight revealed that many of those corporations that ended up in trouble had been heavily acquiring others. The traditional view of acquisition has been that it eliminates competition, consolidates markets, and makes companies stronger. Rather than having to figure out how to capture added market share, companies have been viewed as buying that market share through mergers and acquisitions.
During the 1990s acquisitions took on a different face. The roll-up strategy used by many companies involved buying up hundreds of smaller corporations in the industry, often paying for them with stock. If a smaller company reports a net loss, those losses can be rolled into the short year of an acquisition (the “stub period”) while revenues are deferred to the following full year. This has the result of inflating earnings, at least tem- porarily. One of the biggest cases of abusive reporting growing from big-volume acquisitions was Waste Management, Inc. Dur- ing the 1990s it acquired hundreds of smaller companies and, according to SEC estimates, exaggerated its pretax profits by
$1.43 billion. The company’s auditors, Arthur Andersen, which approved the misleading financial reports, paid a $7 million fine and settled shareholder lawsuits for another $220 million.1
earnings announcements published sum- maries of quar- terly earnings per share that a pub- licly traded corpo- ration reports to the SEC. The an- nouncement is used on Wall Street in comparison to analysts’ earnings estimates.
Analysts’ predictions about earnings are given more weight than actual outcome. Investors may rightfully wonder if these estimates were based on financial or technical information . . . and even on whether analysts understand how to interpret the fundamentals.
Key Point
Paying for smaller companies with stock is inflationary, especially when the value is not there. It is a shell game and most of the corporations playing it ended up losing money and many even filed bankruptcy. It deceived investors, regulators, and ac- counting firms for years. If you notice a large volume of acquisi- tions on a financial report, the matter requires a closer look.