TheStockAdvisor Advice

Analyze This

So you have decided to invest, but are not sure how to determine what is a good investment choice or what will be simply like throwing your money away.  There are many ways of evaluate stocks and the companies behind them.  We will discuss three methods of analyzing stocks.

  1. Fundamental Analysis

  2. Quantitative Analysis

  3. Technical Analysis

1) Fundamental Analysis - Investors generally figure out how much a stock is worth by assessing the company's financials in terms of per-share values. This allows them to calculate how much the stock’s 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.

Methods of evaluation such as Value, Growth, Income, GARP, and Quality are used when doing a Fundamental Analysis.  Below is a general definition of each.  Specific definition of these terms may vary from investor to investor, so double-check what someone using them really means.

Value - 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.

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

Growth - Growth investing is the idea 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.

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 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 is an acronym for Growth At a Reasonable Price. GARP investors combine the value and growth approaches and add 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.

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.

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.

As we stated earlier, Fundamental Analysis is just one of three methods of analysis we will be discussing. Those who do not use Fundamental Analysis have two major arguments against it. The first is they believe this type of investing is based on exactly the kind of information 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 it is often up to the person looking at it to interpret its significance. Although gifted individuals can succeed, the nay-sayers reason, the average person would be better served by not paying attention to this kind of information.

2) Quantitative Analysis -  Pure quantitative analysts look only at numbers with almost no regard for the underlying business. 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. Management could always lead one astray, but the numbers hold the truth.

In recent years as computers have been used to do a lot of number crunching, many "quants," as they like to call themselves 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 if they just find the right kinds of numbers, they can always find winning investments.

Some of those numbers a "quant" looks at are:

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

Screen-Based Investing - Many quantitative analysts use "screens" to select their investments, meaning 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.)

Momentum - Momentum investors look for companies that are not just doing well, but are flying high. "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 things are 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 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.

3) Technical Analysis - Some investors have taken a unique route, attempting to create a set of tools that might tell them what other investors thought about a stock at any given time, particularly looking for the footprints of large institutional investors that tend to cause the most extreme price changes. Investors who focus on this kind of psychological information call themselves technical analysts and believe charts can sometimes provide insight into the psychology surrounding a stock. Although there are plenty of pure chartists, some investors just use charts to time investments after looking at them from a fundamental or quantitative perspective.

There is no set of clearly defined approaches to technical analysis, but there are a number of different tools. The most important indicators seem to be specific chart formations that show certain price movements at times when trading volume is at a certain level. The most common kinds of charts include point and figure charts, logarithmic charts, and Japanese candlesticks, to name a few.

Technical analysis assumes certain chart formations can indicate market psychology about either an individual stock or the market as a whole at key points. However, most of the statistical work done by academics to determine whether the chart patterns are actually predictive has been inconclusive at best. Much of the faith in technical analysis hinges on anecdotal experience, not any kind of long-term statistical evidence, unlike certain quantitative and fundamental methodologies that have been shown in many instances to be pretty predictive. Critics of technical analysis feel it is basically as useful as reading tea leaves.

Now we have run down the basics on fundamental, quantitative, and technical approaches to picking stocks. Chances are, like most investors, you'll find elements of each suit your investing style. As your education continues, you'll develop your own investing philosophy that targets your needs and goals with bull's-eye precision. If you're itching to start putting your newfound philosophy to practice, then it is time to start looking for a broker, and invest smartly.

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