BHIC Investing Handbook.doc

Blue Hen Investment ClubGuide to Investment Fundamentals

Note: This guide was prepared by Jeremy Roethel

Fundamental Analysis – An Introduction

Table of ContentsIMPORTANT CONCEPTS................................................................................................................3

TIME VALUE OF MONEY....................................................................................................................3THE MIRACLE OF COMPOUNDING......................................................................................................3EFFICIENT MARKET HYPOTHESIS......................................................................................................3REAL RETURNS..................................................................................................................................4WHAT IS A STOCK?............................................................................................................................4

Common Stock...............................................................................................................................4Different Classes of Stock..............................................................................................................5

HOW STOCKS TRADE.........................................................................................................................5Listed Exchange.............................................................................................................................6Over-the-Counter Market..............................................................................................................6

FUNDAMENTAL ANALYSIS – AN INTRODUCTION................................................................7

WHAT IS AN INVESTMENT?................................................................................................................7WHAT IS RISK?...................................................................................................................................8WHY DIVERSIFY?...............................................................................................................................9CAPITAL GAINS & DIVIDEND DISCOUNT MODELS............................................................................9

INVESTMENT STRATEGIES........................................................................................................10

BUYING A BUSINESS........................................................................................................................10VALUE..............................................................................................................................................10GROWTH...........................................................................................................................................10

Income..........................................................................................................................................11GARP...........................................................................................................................................11Quality.........................................................................................................................................11

ARGUMENTS AGAINST FUNDAMENTAL ANALYSIS..........................................................................12QUANTITATIVE ANALYSIS - BUYING THE NUMBERS.......................................................................12

Company Size...............................................................................................................................12Screen-Based Investing................................................................................................................13Momentum...................................................................................................................................13CANSLIM.....................................................................................................................................14

ARGUMENTS AGAINST QUANTITATIVE ANALYSIS..........................................................................14

STOCK FUNDAMENTALS EXPLAINED....................................................................................15

BOOK VALUE...................................................................................................................................15CAPITAL APPRECIATION...................................................................................................................15DIVIDEND YIELD..............................................................................................................................15EARNINGS PER SHARE (EPS)...........................................................................................................15MARKET CAPITALIZATION...............................................................................................................16PRICE/EARNINGS RATIO (P/E).........................................................................................................16RELATIVE STRENGTH.......................................................................................................................16REVENUES........................................................................................................................................16SALES...............................................................................................................................................17VOLUME...........................................................................................................................................17PEG RATIOS.....................................................................................................................................17CASH FLOW......................................................................................................................................18RETURN ON ASSETS.........................................................................................................................18

BHIC Investment Guide – Fall 2000 1


RETURN ON EQUITY.........................................................................................................................18ANALYST RECOMMENDATIONS/EXPECATIONS................................................................................19DEBT TO EQUITY RATIO..................................................................................................................19

INVESTMENT RESOURCES.........................................................................................................21

ON THE INTERNET............................................................................................................................21MSN Moneycentral (http://moneycentral.msn.com)....................................................................21Quicken (http://www.quicken.com).............................................................................................21The Motley Fool (http://www.fool.com)......................................................................................21ASK Research (http://www.askresearch.com).............................................................................21TheStreet.com (http://www.thestreet.com)..................................................................................21



Important Concepts

Time Value of Money Is a dollar always worth a dollar? OK, you sly fox - you caught us, it's a trick question! And you guessed it - a dollar is not always worth a dollar. Sometimes a dollar is only worth 80 cents, and sometimes it is worth $1.20. (Say! You give us your dollars worth $1.20, and we'll give you ours worth $0.80, in an even trade! Have we got a deal?)

But let's think about this. How can it be? The value of a dollar changes dramatically depending on when you can take control of the dollar and invest it. The critical variable in the exact value of a dollar is time.

If someone owes you a dollar, do you want him to pay you today or next year? (Yes! Another trick question! The answer is, "Today.") With inflation consistently destroying the purchasing power of a dollar, a year from now a dollar will be worth slightly less than it is today. "Inflation" is an economic term used to describe the gradual tendency of prices to rise over time. If inflation is 2% per year, that means that prices, on average, will rise 2% over the next year, which in turn means that your dollar can purchase 2 cents less in a year than it can today. That's right, all you mathematicians out there - with 2% inflation, a dollar today is worth only 98 cents in a year.

However, if you got the dollar back today, you could invest it. If you invested it (along with a few of its cousins, we hope) in the stock market, and your investment returned 10% over the course of the year (which is somewhat less than the market average has historically returned), then you'd have $1.10 at the end of the year. So your money would be growing instead of shrinking, and you'd be staving off the negative effects of inflation.

The Miracle of Compounding In fact, if you leave this dollar invested, its value will mushroom over time through the miracle of compounding. As you earn investment returns, your returns begin to gain returns as well, allowing you to turn a measly dollar into thousands of dollars if you leave it invested long enough.

The more money you save and invest today, the more you'll have in the future. Real wealth, the stuff of dreams, is in fact created almost magically through the most mundane and commonplace principles: patience, time, and the power of compounding. To heck with your lousy odds in the lottery or with someone's "Wealth in Nanoseconds!" pitch.

Efficient Market HypothesisIn the 1960s, Eugene Fama developed a new theory about the market called the Efficient Market Hypothesis. Fama determined that, at any given time, the prices of all securities fully reflect all available information about those securities.

While that doesn't sound so radical, most people who buy and sell stocks do so with the assumption that the stocks they are buying are undervalued and therefore worth more than the purchase price. When you haggle with a car dealer over the price of a new car, you're aiming for a price that's less than retail. When you buy a stock, you're also hoping that other investors have overlooked that stock for some reason, in effect giving you the opportunity to buy for "less than retail."

However, under the Efficient Market Hypothesis, any time you buy and sell securities, you're engaging in a game of chance, not skill. If markets are efficient and current prices always reflect all information, there's no way you'll ever be able to buy a stock at a bargain price.



Fama also asserted that the price movements of a particular stock will not follow any patterns or trends at all. Past price movements cannot be used to predict future price movements. He called this the Random Walk Theory -- stock prices move in an entirely random fashion, and there's no way to ever profit from "inefficiencies" in the price of a stock.

The end results of the Efficient Market Hypothesis and Random Walk Theory are controversial. If you can't predict stock prices, and picking stocks is really a matter of luck, how are we supposed to invest? And what are all those people on Wall Street doing, anyway?

Once you've resigned yourself to never beating the market, the Random Walkers say, you can be satisfied with matching the returns of the overall market. Instead of picking stocks or individual mutual funds, you should invest in the entire stock market. You can do this by investing in index funds, special mutual funds that are designed to allow you to match the returns of the overall market.

Real Returns Compounding is so miraculous that even at relatively low returns you can double and triple your money over long periods of time. When someone brags about doubling his money in 10 years, for instance, you shouldn't just smile and nod about how great he did. You only need a 7.1% annual return to double your money in 10 years. If the Standard and Poor's 500, a widely used barometer of the stock market, has gone up 10.6% a year, the poor fellow who doubled his money in ten years has actually underperformed the market. So now the trick becomes: In order to increase your money, how could you invest it so that it outperforms the market?

Now, let's say your investments earned 10% last year. How much did you really make? Well, the last time we checked the taxman wants to grab a piece of what you earn. One of the most significant factors investors tend to leave out when assessing their investment returns is the tax consequence. Even if you have a long-term capital gain that is only taxed at 20%, a 10% return quickly becomes 8%. And for short-term gains, the tax bite is even greater. At any rate, the question of importance for you is: "How much do I end up with at the end of the day?"

Another factor that affects returns, as we mentioned above, is inflation. So if your investments made 10% after taxes last year and inflation reduced your principal's buying power by 2%, then you actually only made a real return of 8%. All you need to do is to take your annualized after-tax return and subtract the annual rate of inflation. How can you find out what inflation was? Every quarter the government reports the Consumer Price Index (CPI), which is what most investors use as a proxy for general inflation at the consumer level. You can find it in your local newspaper's business section or at the Bureau of Labor Statistics.

What Is a Stock? Want to own part of a business without having to show up at its office every day? Or ever? Stock is the vehicle of choice for those who do. Dating back to the Dutch mutual stock corporations of the 16th century, the modern stock market exists as a way for entrepreneurs to finance businesses using money collected from investors. In return for ponying up the dough to finance the company, the investor gets shares of stock - specialized financial "securities," or financial instruments - that are "secured" by a claim on the assets and profits of a company.

Common Stock.

Common stock is aptly named, as it is the most common form of stock an investor will encounter. It is an ideal investment vehicle for individuals because anyone can own it; there are absolutely no restrictions on who can purchase it. Young, old, savvy, reckless - heck,



even professional mimes are allowed to own stock. [Editor's note: Complaints about this gratuitous and completely unnecessary shot at the fine profession of mime should be directed to the Association of Professional Mimes or, if you're really feeling ornery, the White House.] Common stock is more than just a piece of paper; it represents a proportional share of ownership in a company - a stake in a real, living, breathing business.

By owning stock - the most amazing wealth-creation vehicle ever conceived (except, maybe, for just inheriting money from a relative you've never heard of) - you are a part owner of a business. Shareholders "own" a part of the assets of the company and part of the stream of cash those assets generate. As the company acquires more assets and the stream of cash it generates gets larger, the value of the business increases. This increase in the value of the business is what drives up the value of the stock in that business.

Because they own a part of the business, shareholders get one vote per share of stock to elect the board of directors. The board is a group of individuals who oversee major decisions made by the company. Far from being a perfunctory collection of do-nothings, the board normally wields quite a bit of power in corporate America. Boards decide how the money the company makes is spent. Decisions on whether a company will invest in itself, buy other companies, pay a dividend, or repurchase stock are all the purview of the board of directors. Top company management - who the board hires and fires - will give some advice, but in the end the board makes the final decision.

As with most things in life, the potential reward from owning stock in a growing business has some possible pitfalls. Shareholders also get a full share of the risk inherent in operating the business. If things go bad, their shares of stock may decrease in value - or even end up being worthless if the company goes bankrupt.

Different Classes of Stock.

Occasionally, companies find it necessary for various reasons to concentrate the voting power of a company into a specific class of stock where the majority is owned by a certain set of people. For instance, if a family business needs to raise money by selling equity, sometimes they will create a second class of stock that they control that has ten votes per share of stock and sell a class of stock that only has one vote per share to others.

When there is more than one kind of stock, they are often designated as Class A or Class B shares. On most company lookup pages, this is signified on the New York Stock Exchange and American Stock Exchange by a period and then a letter following the ticker symbol, a shorthand name for the company's shares that brokerages use to facilitate transactions. For instance, Berkshire Hathaway Class A shares trade as BRK.A, whereas Berkshire Class B shares trade as BRK.B. On the Nasdaq stock market, the class of stock becomes a fifth letter in the ticker symbol. For example, Tele-Communications, Inc. has TCOMA, the Class A shares, and TCOMB, the Class B shares.

How Stocks Trade Probably one of the most confusing aspects of investing is understanding how stocks actually trade. Words such as "bid," "ask," "volume," and "spread" can be quite confusing if you do not understand what they mean. Depending on which exchange a stock trades, there are two different systems.



Listed Exchange.

The New York Stock Exchange and the American Stock Exchange (composed of the Boston, Philadelphia, Chicago, and San Francisco Exchanges and now merged with the Nasdaq stock market) are both listed exchanges, meaning that brokerage firms contribute individuals known as "specialists" who are responsible for all of the trading in a specific stock. With the help of technology, the specialist quickly matches buyers with sellers. Sometimes referred to as "an auction market," the specialist can see who has blocks of stock to buy or sell at various prices and links them up. In return for this service, the specialist charges the buyer an extra fee of $6.25 or 12.5 cents per share, depending on the price of the stock. Volume, or the number of shares that trade on a given day, is counted by the specialist.

Over-the-Counter Market.

The Nasdaq stock market, the Nasdaq SmallCap, and the OTC Bulletin Board are the three main over-the-counter markets. In an over-the-counter market, brokerages (also known as broker-dealers) act as market makers for various stocks. The brokerages interact over a centralized computer system managed by the Nasdaq, providing liquidity for the market to function. One firm represents the seller and offers an ask price (also called the offer), or the price the seller is asking to sell the security. Another firm represents the buyer and gives a bid, or a price at which the buyer will buy the security.

For example, a particular stock might be trading at a bid of $6 and an ask price of $6.50. If an investor wanted to sell shares, he would get the bid price of $6 per share; if he wanted to buy shares, he would pay the ask price of $6.50 per share. The difference is called the spread, which is paid by the buyer. This difference is split between the two firms involved in the transaction. Volume on over-the-counter markets is often double-counted, as both the buying firm and the selling firm report their activity.



Fundamental Analysis – An IntroductionInvesting, like most other things, requires that you have a general philosophy about how to do things in order to avoid careless errors. Would you make a souffle without a recipe? Would you play cello in the London Philharmonic Orchestra without sheet music? Would you aim a shuffleboard disk without figuring out whether you're trying to knock off your own color or your opponent's? We hope not. And while investing is not nearly as difficult as these other challenges (especially the souffle), you certainly need a considered plan before investing your hard-earned savings.

What is an investment?An investment is a current outlay in exchange for a future or expected benefit stream. The basic valuation model must consider investor preferences for return (benefits), where returns are cash flows after taxes. We will use financial statement information as a primary source of information on the issuer of securities and on the securities themselves. But remember that financial statements tell us about the past, not the future, and financial statement data may have to be adjusted to be more useful in the securities analysis context. The investor preferences for return relate to:

size of return timing of the receipt of return risk of receipt of the return

With regards to risk, investors are risk averse, but different investors have differing degrees of risk aversion.

An application of basic financial mathematics yields the following valuation models:

N N

Vo = Σ Bt / (1+r)t Po = Σ Bt / (1+ř)t

t=1 t=1

Vo = estimated value today; investment value or intrinsic worth/value of a company, stock, etc.

Bt = estimated expected benefit in period t, in dollars

r = required rate of return; investor’s cost of capital

ř = expected rate of return on investment; internal rate of return; this is an ex ante, or anticipated, rate of return; it does not necessarily equal the rate of return that will be realized, i.e., the ex post return on the investment.

N = number of periods to maturity or selling date; investment horizon or holding period

The equation on the left is similar to finding the present value of expected cash flows in capital budgeting analysis. Subtracting Po from Vo gives us the equivalent of net present value (i.e. if NPV > 0 then the investment is undervalued). The equation on the right is similar to the internal rate of return method in capital budgeting. We can compare the internal rate of return to the required rate of return to assess the attractiveness of the investment.

Bt is the expected dollar benefit in period t. It is a measure of central tendency and is usually measured as the expected value of the probability distribution of values that the benefits may take. Generally speaking, the wider this probability distribution, the riskier the investment.



The expected rate of return on an investment is reflected in the yield, ř. Examples of return are total return, yield to maturity, and the holding period yield or return. Total return is the sum of yield (income such as dividends) and price change (capital gain or loss). Total return is also known as holding period yield, which is computed as (ending price – beginning price + cash distributions) / beginning price.

The required rate of return on an investment is r. Risk and other factors are imputed into r and ř. A basic premise in finance is that risk and return are positively related. A key purpose of securities analysis is to try to find those assets where the expected return differs from that properly associated with the level of risk taken, i.e. the investment’s return is out of equilibrium with that expected for the investment’s risk. This leads to the concepts of overvalued and undervalued assets (see NPV example above).

By examining prospective changes in the components of the basic valuation model, e.g. the expected benefit stream and the required rate of return, we can see what drives changes in value and price.

Value can change if there are changes in the size, timing, or quality of the expected benefits. Quality generally relates to risk and the required rate of return. By understanding the factors that can cause a change in the required rate of return, we can gain insight into the factors causing a potential change in value. It is these factors for which investors demand compensation.

What is risk?Simply stated, risk is variability in return. Variability may be cases where actual may differ from expected or where actual may be less that expected. Overall variability in return is referred to as total risk, which consists of systematic risk and unsystematic risk.

Systematic risk is also known as market risk. This is variability in returns that cannot be reduced via diversification, and is attributed to broad macro factors affecting all securities. Beta is a widely used

Unsystematic risk is also known as specific risk. This is variability in returns that can be attributed directly to a security, and typically can be reduced via diversification.

Beta is a measure of systematic risk. It is computed from the regression of an asset’s excess returns on the market’s excess returns. Beta is sometimes said to represent a measure of volatility and is a relative measure of risk, i.e. variability of a given security versus the market.

As risk relates to returns, there is a simple relationship: to realize greater returns, an investor must be willing to accept higher levels of risk.


Risk

Return

Expected ReturnsA

Actual Return Expected Return


In its simplest form, this graph shows that an investor cannot expect higher rates or return without also taking on higher levels of risk. Any investment that falls to the right/below the expected return line is considered extraordinary – higher return realized that should be expected by the level of risk taken.

Why diversify?As an example, lets say that you as an investor own only stock A. Over an arbitrary holding period, lets say that given the level of risk you assumed for owning the stock, the actual return you received was less than the expected return associated for that risk level. Obviously, this is not a desirable outcome, however it is a very possible occurrence.

To continue this example, let’s now assume that you own stocks in several companies, designated by the black circles. In this case, even though company A did not return what you expected it to, its impact on your overall return is diluted significantly. Some stocks earned you extraordinary returns, others earned appropriate returns, and the rest returned below the expected level. Diversification then has the effect of reducing the effective beta of an entire portfolio of securities.

Note: in this example not earning the expected level does not necessarily mean that the stock had negative returns. For instance, most of us would agree that a 15% annual return on an investment is quite good. However, if you invested in a high-risk security and expected 25% return while the stock actually returned 15%, this “good” investment would fall above/to the left of the expected return line.

The concept of diversification does not necessarily imply similar security types. For instance, it is possible to diversify an equity portfolio using stocks of varying risk and return levels. In addition, it would also be possible to diversify this portfolio by introducing a fixed income (bond) component.

Capital Gains & Dividend Discount ModelsAn investor buys common stock in anticipation of cash flows represented by dividends and capital gains. Actually, it is the difference between the current purchase price and the anticipated terminal price at the end of the holding period or investment horizon that gives rise to capital gains. This is consistent with the general valuation concept that value is a function of expected cash flows. The value of common stock from the capital gains model is

N

Vo = Σ Dt / (1+r)t + PT / (1+r)T) Vo = Σ Dt (1+g) t / (1+r)t = Dt / (r-g) t=1

where Vo is the stock’s fair value, Dt is the expected divident in period t, and PT is the terminal price in period T, r is the investor’s required rate of return (a.k.a the discount rate or capitalization rate), and g is the growth rate in the company’s dividend.

The future cash flows must ultimately consist only of the future dividends from the common stock. If we assume that the dividends will grow at a rate g, we can transform the left equation to the right, which is known as the constant growth dividend discount model. Further developments of this model lead to multi-stage growth models (fast growth from time 0 to T, then slower growth into perpetuity) and other more complicated models.

The current value (and price) of a security are ultimately based upon the present value of the expected future cash flows and benefits an investor expects to receive.



Investment Strategies

Buying a BusinessMany people rightly believe that when you buy a share of stock you are buying a proportional share in a business. As a consequence, to figure out how much the stock is worth, you should determine how much the business is worth. Investors generally do this by assessing the company's financials in terms of per-share values in order to calculate how much the proportional share of the business is worth. This is known as "fundamental" analysis by some, and most who use it view it as the only kind of rational stock analysis.

Although analyzing a business might seem like a straightforward activity, there are many flavors of fundamental analysis. Investors often create oppositions and subcategories in order to better understand their specific investing philosophy. In the end, most investors come up with an approach that is a blend of a number of different approaches. Many of the distinctions are more academic inventions than actual practical differences. For instance, value and growth have been codified by economists who study the stock market even though market practitioners do not find these labels to be quite as useful. In the following descriptions, we will focus on what most investors mean when they use these labels, although you always have to be careful to double-check what someone using them really means.

ValueA cynic, as the saying goes, is someone who knows the price of everything and the value of nothing. An investor's purpose, though, should be to know both the price and the value of a company's stock. The goal of the value investor is to purchase companies at a large discount to their intrinsic value - what the business would be worth if it were sold tomorrow. In a sense, all investors are "value" investors - they want to buy a stock that is worth more than what they paid. Typically those who describe themselves as value investors are focused on the liquidation value of a company, or what it might be worth if all of its assets were sold tomorrow. However, value can be a very confusing label as the idea of intrinsic value is not specifically limited to the notion of liquidation value. Novices should understand that although most value investors believe in certain things, not all who use the word "value" mean the same thing.

The person viewed as providing the foundation for modern value investing is Benjamin Graham, whose 1934 book Security Analysis (co-written with David Dodd) is still widely used today. Other investors viewed as serious practitioners of the value approach include Sir John Templeton and Michael Price. These value investors tend to have very strict, absolute rules governing how they purchase a company's stock. These rules are usually based on relationships between the current market price of the company and certain business fundamentals. Some examples include:

Price/earnings ratios (P/E) below a certain absolute limit

Dividend yields above a certain absolute limit

Book value per share at a certain level relative to the share price

Total sales at a certain level relative to the company's market capitalization, or market value

GrowthGrowth investing is the idea that you should buy stock in companies whose potential for growth in sales and earnings is excellent. Growth investors tend to focus more on the company's value as an



ongoing concern. Many plan to hold these stocks for long periods of time, although this is not always the case. At a certain point, "growth" as a label is as dysfunctional as "value," given that very few people want to buy companies that are not growing. The concept of growth investing crystallized in the 1940s and the 1950s with the work of T. Rowe Price, who founded the mutual fund company of the same name, and Phil Fisher, who wrote one of the most significant investment books ever written, Common Stocks and Uncommon Profits.

Growth investors look at the underlying quality of the business and the rate at which it is growing in order to analyze whether to buy it. Excited by new companies, new industries, and new markets, growth investors normally buy companies that they believe are capable of increasing sales, earnings, and other important business metrics by a minimum amount each year. Growth is often discussed in opposition to value, but sometimes the lines between the two approaches become quite fuzzy in practice.

Income

Although today common stocks are widely purchased by people who expect the shares to increase in value, there are still many people who buy stocks primarily because of the stream of dividends they generate. Called income investors, these individuals often entirely forego companies whose shares have the possibility of capital appreciation for high-yielding dividend-paying companies in slow-growth industries. These investors focus on companies that pay high dividends like utilities and real estate investment trusts (REITs), although many times they may invest in companies undergoing significant business problems whose share prices have sunk so low that the dividend yield is consequently very high.

GARP

GARP, aside from being the name of the title character to John Irving's The World According to Garp, is an acronym for growth at a reasonable price. The world according to GARP investors combines the value and growth approaches and adds a numerical slant. Practitioners look for companies with solid growth prospects and current share prices that do not reflect the intrinsic value of the business, getting a "double play" as earnings increase and the price/earnings (P/E) ratios at which those earnings are valued increase as well. Peter Lynch, who may be familiar to you through his starring role in Fidelity Investments commercials with Lily Tomlin and Don Rickles, is GARP's most famous practitioner.

One of the most common GARP approaches is to buy stocks when the P/E ratio is lower than the rate at which earnings per share can grow in the future. As the company's earnings per share grow, the P/E of the company will fall if the share price remains constant. Since fast-growing companies normally can sustain high P/Es, the GARP investor is buying a company that will be cheap tomorrow if the growth occurs as expected. If the growth does not come, however, the GARP investor's perceived bargain can disappear very quickly.

Because GARP presents so many opportunities to focus just on numbers instead of looking at the business, many GARP approaches, like the nearly ubiquitous PEG ratio and Jim O'Shaughnessy's work in What Works on Wall Street are really hybrids of fundamental analysis and another type of analysis -- quantitative analysis.

Quality

Most investors today use a hybrid of value, growth, and GARP approaches. These investors are looking for high-quality businesses selling for "reasonable" prices. Although they do not have any shorthand rules for what kind of numerical relationships there should be between the share price and business fundamentals, they do share a similar philosophy of looking at



the company's valuation and at the inherent quality of the company as measured both quantitatively by concepts like return on equity (ROE) and qualitatively by the competence of management. Many of them describe themselves as value investors, although they concentrate much more on the value of the company as an ongoing concern rather than on liquidation value.

Warren Buffett of Berkshire Hathaway is probably the most famous practitioner of this approach. He studied under Benjamin Graham at Columbia Business School but was eventually swayed by his partner, Charlie Munger, to also pay attention to Phil Fisher's message of growth and quality.

Arguments Against Fundamental AnalysisThose who do not use fundamental analysis have two major arguments against it. The first is that they believe that this type of investing is based on exactly the kind of information that all major participants in publicly traded markets already know, so therefore it can provide no real advantage. If you cannot get a leg up by doing all of this fundamental work understanding the business, why bother? The second is that much of the fundamental information is "fuzzy" or "squishy," meaning that it is often up to the person looking at it to interpret its significance. Although gifted individuals can succeed, this group reasons, the average person would be better served by not paying attention to this kind of information.

Quantitative Analysis - Buying the Numbers Pure quantitative analysts look only at numbers with almost no regard for the underlying business. The more you find yourself talking about numbers, the more likely you are to be using a purely quantitative approach. Although even fundamental analysis requires some numerical inputs, the primary concern is always the underlying business, focusing on things like management's expertise, the competitive environment, the market potential for new products, and the like. Quantitative analysts view these things as subjective judgments, and instead focus on the incontrovertible objective data that can be analyzed.

One of the principal minds behind fundamental analysis, Benjamin Graham, was also one of the original proponents of this trend. While running the Graham-Newman partnership, Graham exhorted his analysts to never talk to management when analyzing a company and focus completely on the numbers, as management could always lead one astray.

In recent years as computers have been used to do a lot of number crunching, many "quants," as they like to call themselves, have gone completely native and will only buy and sell companies on a purely quantitative basis, without regard for the actual business or the current valuation - a radical departure from fundamental analysis. "Quants" will often mix in ideas like a stock's relative strength, a measure of how well the stock has performed relative to the market as a whole. Many investors believe that if they just find the right kinds of numbers, they can always find winning investments. D. E. Shaw is widely viewed as the current King of the Quants, using sophisticated mathematical algorithms to find minute price discrepancies in the markets. His partnership sometimes accounts for as much as 50% of the trading volume on the New York Stock Exchange in a single day.

Company Size

Some investors purposefully narrow their range of investments to only companies of a certain size, measured either by market capitalization or by revenues. The most common way



to do this is to break up companies by market capitalization and call them micro-caps, small-caps, mid-caps, and large-caps, with "cap" being short for "capitalization." Different-size companies have shown different returns over time, with the returns being higher the smaller the company. Others believe that because a company's market capitalization is as much a factor of the market's excitement about the company as it is the size, revenues are a much better way to break up the company universe. Although there is no set breakdown used by all investors, most distinctions look something like this:

MICRO - $100 million or less

SMALL - $100 million to $500 million

MID - $500 million to $5 billion

LARGE - $5 billion or more

The majority of publicly traded companies fall in the micro or small categories. Some statisticians believe that the perceived outperformance of these smaller companies may have more to do with "survivor" bias than actual superiority, as many of the databases used to do this performance testing routinely expunged bankrupt companies until pretty recently. Since smaller companies have higher rates of bankruptcy, excluding this factor helps "juice" up their historical returns as a result. However, this factor is still being debated.

Screen-Based Investing

Many quantitative analysts use "screens" to select their investments, meaning that they use a number of quantitative criteria and examine only the companies that meet these criteria. As the use of computers has become widespread, this approach has increased in popularity because it is easy to do. Screens can look at any number of factors about a company's business or its stock over many time periods.

While some investors use screens to generate ideas and then apply fundamental analysis to assess those specific ideas, others view screens as "mechanical models" and buy and sell purely based on what comes up on the screen. These investors claim that using the screen removes emotions from the investing process. (Those who do not use screens would counter that using a screen mechanically also removes most of the intelligence from the process.) One of the proponents of using screens as a starting point is Eric Ryback, and one of the most famous advocates of screens as a mechanical system is James O'Shaughnessy. One of the most well-known screens is the Dow Dividend, also known as the Dogs of the Dow and Beating the Dow. For more information on screening, check out web sites like MSN Moneycentral (investor.msn.com) and the Foolish Workshop at the Motley Fool (www.fool.com).

Momentum

Momentum investors look for companies that are not just doing well, but that are flying high enough to get nose bleeds. "Well" is defined as either relative to what investors were expecting or relative to all public companies as a whole. Momentum companies often routinely beat analyst estimates for earnings per share or revenues or have high quarterly and annual earnings and sales growth relative to all other companies, particularly when the rate of this growth is increasing every quarter. This kind of growth is viewed as a sign that things are really, really good for the company. High relative strength is often a category in momentum screens, as these investors want to buy stocks that have outperformed all other stocks over the past few months.



CANSLIM

CANSLIM is a system pioneered by William J. O'Neil that is a hybrid of quantitative analysis and technical analysis, detailed in his book How to Make Money in Stocks. According to Investor's Business Daily, O'Neil's newspaper, the "C'' and ''A'' of the CANSLIM formula tell investors to look for companies with accelerating Current and Annual earnings. The ''N'' stands for New, as in new products, new markets, or new management. ''S'' stands for Small capitalization and big volume demand. ''L'' tells investors to figure out whether the company is a Leader or Laggard. ''I'' has them look for Institutional sponsorship, and ''M'' concentrates on the direction of the Market. O'Neil originally created Investor's Business Daily to be a tool that investors could use to practice CANSLIM, although it has become a very widely read business publication by all types of investors. CANSLIM also includes components of the next type of analysis - technical analysis.

Arguments Against Quantitative AnalysisBecause quantitative analysis hinges on screens that anyone can use, as computing horsepower becomes cheaper and cheaper many of the pricing inefficiencies quantitative analysis finds are wiped out soon after they are discovered. If a particular screen has generated 40% returns per year and becomes widely known, and if lots of money flows into the companies that the screen identifies, the returns will start to suffer.

As "fuzzy" as fundamental analysis might be, there are often times that knowing even a little about the company you are buying can help a lot. For instance, if you are using a high-relative-strength screen, you should always check and see if the companies you find have risen in price because of a merger or an acquisition. If this is the case, then the price will probably stay right where it is, even if the "screen" you used to pick this company has generated high annual returns in the past.



Stock Fundamentals Explained

Book ValueThe current value of an asset on a company's balance sheet according to its accounting conventions. The shareholders' equity on a company's balance sheet is the book value for that entire company. Many times when investors refer to book value, they actually mean book value per share, which is the shareholder's equity (or book value) divided by the number of shares outstanding. As the book value is theoretically what a company could be sold for (liquidation value), this book value number is sometimes used as a rough guide as to whether or not the shares are undervalued.

Capital AppreciationOne of the two components of total return, capital appreciation is how much the underlying value of a security has increased. If you bought a stock at $10 and it has risen to $13, you have enjoyed a 30% return from the appreciation of the original capital you invested. Dividend yield is the other component of total return.

Dividend YieldA ratio of a company's annual cash dividends divided by its current stock price expressed in the form of a percentage. To get the expected annual cash dividend payment, take the next expected quarterly dividend payment and multiple that by four. For instance, if a $10 stock is expected to pay a 25 cent quarterly dividend next quarter, you just multiple 25 cents by 4 to get $1 and then divide this by $10 to get a dividend yield of 10%.

Dividend Yield =

Ann. Div.

Price

=

$0.25 * 4

$10

= 0.10 = 10%

Many newspapers and online quote services will include dividend yield as one of the variables. If you are uncertain whether the current quoted dividend yield reflects a recent increase in the dividend a company may have made, you can call the company and ask them what the dividend per share they expect to pay next quarter will be.

Earnings Per Share (EPS)Earnings, also known as net income or net profit, is the money that is left over after a company pays all of its bills. For many investors, earnings are the most important factor in analyzing a company. To allow for apples-to-apples comparisons, those who look at earnings use earnings per share (EPS).

You calculate the earnings per share by dividing the dollar amount of the earnings a company reports over the past 12 months by the number of shares it currently has outstanding. Thus, if XYZ Corp. has 1 million shares outstanding and has earned $1 million in the past 12 months, it has an EPS of $1.00.

$1,000,000 = $1.00 in earnings per share (EPS)



1,000,000 shares

Market CapitalizationThe current market value of all of a company's shares outstanding. To calculate market value, you take the number of shares outstanding and multiply them by the current price of each share. You can find information about shares outstanding from the company's last quarterly report or any online quote service.

For instance, if a company has 10 million shares outstanding and trades at $13 per share, the market capitalization is $130 million.

Market Cap. =Shares Outstanding * Share Price=10 million * $13 = $130 million

Price/Earnings Ratio (P/E)Earnings per share alone mean absolutely nothing. In order to get a sense of how expensive or cheap a stock is, you have to look at those earnings relative to the stock price. To do this, most investors employ the price/earnings (P/E) ratio. The P/E ratio takes the stock price and divides it by the last four quarters' worth of earnings. If XYZ Corp. is currently trading at $15 a share with $1.00 of earnings per share (EPS), it would have a P/E of 15.

$15 share price

$1.00 in trailing EPS

= 15 P/E

Relative StrengthRelative strength, also known as relative price strength, rates the performance of a stock versus the performance of the market as a whole over a given time period. The rating system gives a numerical grade - just like the ones Mr. Spicer used to scrawl in bright red ink on your algebra quizzes - to the performance of a stock over a given period, normally the past 12 months. Thus, relative strength is a momentum indicator.

The most popular form of relative strength ratings are those published in Investor's Business Daily, which go from 1 to 99. A relative strength of 95, for example, indicates a wonderful stock, one that has outperformed 95% of all other U.S. stocks over the past year. However, given that relative strength is only a mathematical relationship between the stock's performance and an index's performance, many others have created their own relative strength measures.

RevenuesAlso known as sales, revenues are how much the company has sold over a given period. Annual revenues would be the sales for a given year, whereas quarterly revenues would be the sales for a given quarter.



SalesAlso known as revenues, sales are literally how much the company has sold over a given period. Annual sales would be the sales for a given year, whereas quarterly sales would be the sales for a given quarter.

VolumeThe number of shares traded on a given day is known as the volume. Many investors look at volume over a month or a year to come up with average daily volume. Market watchers will say a company has traded at a certain number of times the average daily volume, giving the investor a sense of how active the stock was on a certain day relative to previous days. When major news is announced, a stock can trade as much as 20 or 30 times its average daily volume, particularly if the average daily volume is very low.

The average number of shares traded gives an investor an idea of a company's liquidity - how easy it is to buy and sell a particular stock. Highly liquid stocks trade easily in large batches with low transaction costs. Illiquid stocks trade infrequently and large sales often cause the price to rise or fall dramatically. Illiquid stocks on the Nasdaq also tend to carry the largest spreads, the difference between the buying price and the selling price.

PEG ratiosPEG ratios, in various forms, are used by many analysts intent on buying "growth at a reasonable price." It is based on the notion that the ratio of a company's current stock price to its annual earnings, while useful, is an imperfect measure of the stock's real value. The PEG ratio is calculated by dividing the P/E multiple by the company's projected earnings per share growth rate over the next year. The theory is that if the resulting value is less than 1 -- as this alert signals -- the stock may be undervalued; if the PEG ratio is over 1, the stock may be overvalued. The farther from 1 the value, the stronger the signal. Some analysts prefer to look for their "buy" candidates among stocks with a PEG rating no higher than 50%.

PEG is considered particularly helpful in valuing small and mid-cap growth stocks. These companies often pay minimal, if any, dividends and are valued primarily on how fast they are expected to grow earnings. However, there are variations of the PEG calculation that some advocate as useful measures of larger stock values as well. One such variation, proposed by stock market superstar Peter Lynch, adds a company's dividend yield to its projected five-year earnings growth rate on the theory that larger, more established firms are valued by investors for their current payout as well as their growth prospects.

Classic growth stocks -- those that have been around for a few years, show steady rates of sales and earnings growth of 10% or more, and which may even pay modest dividends -- typically have PEG ratios around 1.5.

PEG ratios don't help in valuing companies that are losing money. They are considered less useful in assessing cyclical stocks, as well as companies in industries like banking, oil or real estate where assets are a more important determinant of value. And, of course, the PEG ratio alone is not enough on which to base a "buy" decision. A company's growth rate may be exceptionally high for reasons other than the ongoing strength of its business, and therefore be unsustainable, for example. And be aware that a low PEG ratio may reflect high risk.



Cash FlowSome analysts consider cash flow as perhaps a company’s most important financial barometer, and the ratio of stock price to operating cash flow is favored by many over the price-earnings ratio as a measure of a company’s value. Operating cash flow -- which is comprised of net earnings minus preferred dividends plus depreciation -- is arguably the best measure of a business’s profits. A company can show positive net earnings and still not be able to pay its debts. It’s cash flow that pays the bills -- and underwrites dividend checks to stockholders.

Price-to-cash-flow ratios vary widely from industry to industry, with capital-intensive industries such as auto manufacturing or cable TV tending to have very low multiples, and less infrastructure-heavy industries, like software, sporting much higher ones. At this writing, the price-cash-flow ratio for the Standard & Poor's 500 companies is about 14. In other words, for every $1 that flows through those companies, their stock price is $14. But the average price-to-cash-flow ratio in the auto industry is 5, and in the software industry it’s 39.

Price-to-cash flow is particularly favored to value companies in the "hard asset" business -- gold, oil, and real-estate companies, for example.

Generally, the lower a company's price-to-cash-flow ratio and the bigger its discount from the industry average multiple, the more likely that the firm may be undervalued. But that doesn't mean you should race out and buy the stock. The firm may have earned its lower multiple by a track record of blunders.

Generally, the higher this ratio and the larger the gap between its multiple and the industry average, the more likely that the firm may be overvalued. But that doesn’t mean you should race out and sell your stock. The firm may have earned its higher multiple by a track record of above-average earnings growth, for example.

Return on AssetsReturn on assets (ROA in financial shorthand) measures how much a company earns on each dollar sunk into assets. It’s calculated by dividing total assets into net income for the period. Assets are listed on the company’s balance sheet and include such items as inventory, and plant and equipment. The number tells investors how productively a company and its management are using the physical resources that the company owns -- the higher the ROA, the more efficient the operation.

ROA is a particularly effective way of measuring the efficiency of manufacturing companies, but it doesn't always work so well in the service industry, or for companies in which the primary assets are people instead of equipment.

Return on EquityReturn on equity (ROE in financial shorthand) measures how much a company earns on each dollar that investors in its common stock have put into the company. It’s calculated by dividing shareholders’ equity into net income for the period (after deducting preferred stock dividends from income but without deducting common stock dividends). The number tells shareholders how effectively a company and its management are using their money. It is a more global measure of management efficiency than return on assets, and one which works across a broader selection of industries.



A word of caution: Cyclical industries such as airlines, automobiles and chemicals will show a falling return on equity as they slide from the most profitable part of their cycle towards the red ink that characterizes a bottom. Comparing return on equity across an industry will still work for cyclical companies as long as they are at approximately the same point in the industry cycle.

Analyst Recommendations/ExpecationsThere are over 3,000 analysts working for more than 200 brokerage firms who keep a close watch on the performance of the thousands of publicly traded North American companies. One of their main jobs is estimating how much those companies will earn on a per-share basis each quarter.

Most of the ingredients for the estimate come from guidance that the company offers in the form of press releases, conference calls or personal, one-on-one discussions. But some analysts add other elements to the recipe: One analyst might visit the company’s customers and discover that sales of certain products are not as brisk as the company has publicly declared. Another might determine that the company is going to qualify for a lower tax rate than is generally expected. Another might determine that a company faces a price war that will grind down profit margins.

For the country’s oldest and most established industrial concerns, analysts’ estimates are usually fairly accurate. But estimates for the country’s newest companies, and particularly high-tech companies, can range all over the map. The mean estimate therefore amounts to a consensus expectation of results for the coming quarter.

Companies often work very hard to "manage" analysts' expectations, because they know that missing the consensus earnings estimate for a quarter -- even if only by a penny or two per share -- has come to mean that their stock price will get pummeled. By contrast, a company that beats analysts' consensus estimates is likely to see the price of its stock jump. The latter is known as a "positive earnings surprise," and it's obviously something that existing shareholders like to see as well.

One "surprise" does not make a trend, however. Check out analyst information to see whether this is another in a string of positive surprises for this firm -- which would be very bullish. If not, you might want to wait another quarter before getting too excited.

Also, be aware that there has been a growing tendency to focus on the "whisper number" for a company's anticipated earnings. This is the highest estimate of its future profits, and it tends to be 7% to 10% higher than the consensus estimate. So these days, a company can beat the consensus estimate, but still see its stock price punished because it failed to reach the "whisper" figure.

Debt to Equity RatioCompanies borrow money because it is often a cheaper way to fund the business than selling stock or using retained earnings, or when it makes sense to match the time period of the obligation to the duration of the need for cash or the life expectancy of the asset being purchased.

A falling debt-to-equity ratio happens when a company is paying off debt. (The debt-to-equity ratio is calculated by dividing the dollar amount of a company’s long-term debt by the dollar amount of shareholder equity.) A company only contemplates this alternative when it’s



generating excess cash flow. Paying down debt is a good use of cash when the debt that’s being retired carries a high interest rate. Instead of money going out the door to pay banks and bondholders, in the future it will become earnings that should drive the stock price higher or pay higher dividends. This kind of decline in a debt-to-equity ratio can be great news for investors.

An investor will get the most bang out of an improving debt-to-equity ratio when a company’s been so highly leveraged that its debt level raised concerns with investors. A company’s stock will get a boost if one of the rating agencies -- Moody’s or Standard & Poor’s -- upgrades its opinion on the company’s debt.



Investment Resources

On the InternetAs most everyone is aware these days, there is an almost obscene amount of information contained on the Internet pertaining to investing and researching companies. There are several sites that stand out though for the quality of their information, research interface, analysis tools, and thoughtful insight. Listed below are recommended sites which fall into this category:

MSN Moneycentral (http://moneycentral.msn.com)

Microsoft has put together a top-notch site for investors to use. In addition to supplying the normal stock information, it boasts an Analyst FYI section to quickly report alerts about a company’s stock price, valuations, condition, and recent news. Moneycentral also has a powerful, easy to use screening tool for filtering companies. The Insight section typically has well written commentary about the state of the market and sectors, and the Strategy Lab and Supermodels section can give you some new perspectives on how to look for investments.

Quicken (http://www.quicken.com)

Quicken does the job of all of the basic finance sites (Yahoo, Zachs, Altavista, CNNFN, etc.) and offers much more as well. To begin with, we keep track of the BHIC Portfolio on Quicken, so it’s a decent place to start your stock research. Be sure and frequently check up on the portfolio and the stocks in your sector by using the News and Alerts tab on the portfolio page. The company research area has plenty of useful features, perhaps the most useful of which is the Evaluator. This will let you size up a possible opportunity section by section – growth trends, financial health, management performance, market multiples, and intrinsic value. Details are provided in each section to make it easier to use. The Fundamentals section is also very useful as it clearly shows how the selected company compares to its primary industry.

The Motley Fool (http://www.fool.com)

The Motley Fool takes a more educational approach to investing than the others here. It is geared more towards personal investors who (understandably so) are not entirely proficient in investment analysis. There are several good sections on this site about valuing companies and the investment process in general. A great resource if you’d like to learn more about investing at any level.

ASK Research (http://www.askresearch.com)

ASK is a relatively unknown site whose main strength is its simple to use graphing tool. It allows investors who like to look at more technical oriented graphs to quickly apply overlays and analysis tools such as Bollinger Bands, MACD, Stochastics, and %R (these are not discussed in this guide, as they are more advanced technical techniques). Still, for viewing graphs it is easily one of the best on the web.

TheStreet.com (http://www.thestreet.com)

TSC strengths lie in the content of the site. There are plenty of methods for obtaining in depth commentary and news about most companies, and TSC also posts a good deal of analyst commentary. Although an excellent site for gaining insight, be sure to evaluate the bias and views of the writers.
