Investiv Daily Sunday Edition

[Sunday Edition: Recognizing Fundamental Strength] By Thomas Moore on September 4, 2016 [pexels-photo-4]I can’t believe Thomas is sharing this with you. Last week I emailed him and asked for content for this weeks Sunday Edition. Typically he pulls something from a past issue of Rebel Income (annual subscription $1,164) but this week he has written an entirely new piece where he shares with you the exact fundamental metrics he uses to identify deeply undervalued companies. The kind that have helped him turn every $10,000 invested into over $18,075 in just over two years. Today’s article is a little long, but I promise it’s well worth the read. If you implement these analysis techniques, your market returns will improve substantially. Here’s Thomas: --------------------------------------------------------------- Week 6: Recognizing Fundamental Strength There are a lot of different ways to analyze a stock. For example, you can focus on the stock’s price movement from one period of time to another, over time, to identify patterns and likely reversal points. You can pay attention to the flow of supply and demand for a company’s shares in the marketplace to determine whether buying or selling exerts more influence on the stock’s price direction. You can expand your view to focus on the market as a whole to try to determine whether investors are generally buying stocks in one industry over others right now, or use global, national and regional economic data to help measure the overall health of the market. There is value in all of these methods, but we believe that the proper place to begin your analysis is by looking at the business that underlies the stock you’re considering for an investment. This is a process generally known as fundamental analysis, because it focuses on what the company is doing, week by week, month by month, quarter by quarter, and year by year, to generate revenue, manage costs, forge a profit, and find ways to expand the business. If you run an Internet search of “fundamental analysis,” you’ll find hundreds, even thousands of articles about the information and data points you can use to analyze a company’s business. It’s easy to get bogged down and overwhelmed by the deluge of data you can find, which is why the average investor doesn’t focus on fundamental analysis. I’ve worked hard to refine the Rebel Income system to focus on the fundamental items that I think provide the most efficient and thorough view of what a company is doing, including: - Stock Dividends - Earnings and Revenue Growth - Debt - Free Cash Flow - Return on Equity - Return on Assets Stock Dividends One of the least appreciated aspects of investing in the stock market is the role dividends can play in a successful investing system. Directional trading strategies, which usually emphasize relatively short-term trades based on price swings from low to high points that might last anywhere from a few weeks to a few months, tend to ignore dividends altogether, since in many cases you might not actually hold a stock long enough to be counted for a dividend distribution. The same is true of directional investing strategies that focus on equity options, since buying and selling call or put options on a stock will rarely translate to actual ownership of that stock. Long-term investing concepts usually differentiate between stocks based on the underlying company’s size and scope of business, how much their business has grown in the past and what analyst’s forecast of future growth is likely to be. Large, established and easily recognized companies, like General Electric Co. ([GE]), Caterpillar Inc. ([CAT]), and Microsoft Corp ([MSFT]) among others, are referred to as blue-chip stocks. These stocks are usually included in the major market indices including the Dow Jones Industrial Average and the S&P 500. Medium-sized businesses who have been successful at building their businesses but have not yet reached the status or size of a blue-chip stock are usually called mid-caps, and smaller, up-and-coming companies are called small caps. One of the main reasons that blue-chip stocks are considered to carry a higher level of safety comes from the fact that most of them pay a regular dividend to their shareholders. Why do some stocks pay dividends while others don’t? Because companies are naturally allowed to decide what they want to do with their profits. What they actually do with those profits can tell you a lot about the strength of the business and what management thinks about the future. Dividends are one of the simplest and most transparent means companies have to return a portion of their profits back to their shareholders. Smaller, less-established stocks often don’t pay a dividend simply because their profitability can be widely variable from one year to the next. Dividends have to be approved by the company’s board of directors, and they won’t be likely to commit to pay out a portion of their profits if they aren’t confident they will be able to maintain a level of profitability that is higher than the dividend. The most common line of thought suggests that a stock shouldn’t begin to pay a dividend until the business has reached a size and scope that makes a dividend easier to maintain. Microsoft Corp, for example, didn’t pay a dividend to its shareholder for almost 20 years after their initial public offering in 1986 despite their domination of the software industry and the mountains of dollars they held in cash. When they finally declared their first dividend in January 2003, MSFT held more than $43 billion in cash. Their initial dividend payout was only $864 million of that amount, or about 1.8% of their total cash. This is a good example of why identifying stocks that pay a dividend—even a small one—is so important; it says a lot about management’s confidence in their business as well as recognizing the important role shareholders play in their overall success. Another interesting aspect of dividends is that while blue-chip stocks are the most likely places you’ll find attractive dividends, it also isn’t unusual to find mid-cap and in some cases, even small-cap stocks that have committed to a consistent dividend payout. There is a lot of power in finding these types of stocks, which are even more in the minority than their larger brethren; most of these companies prefer instead to reinvest their profits in their business to keep driving growth. Those that do decide to pay a dividend are communicating a different level of confidence in themselves and the future of their business than those that don’t. They are using the dividend payout to attract shareholders that can buy in to their long-term plan and prospects. This is why dividends are the first piece of the Rebel Income investing system; stocks that don’t pay a dividend are automatically excluded. Earnings and Revenue Growth Earnings and revenues are perhaps the two most basic elements of fundamental analysis. They are naturally among the first things that any investor should make sure to pay attention to. Revenues are the lifeblood of a healthy business; if it isn’t making sales, it can’t pay its bills. Earnings are simply the profits that are left over after a company has met all of its capital obligations. One of the mistakes about analyzing these items that a lot of people make, however, is whether a stock’s latest earnings announcement met, exceeded, or failed to meet the market’s expectations. From our perspective, that’s a little bit like a child looking at the pile of presents she got for Christmas and saying, “is that all there is?” I believe that the most important aspect of a company’s earnings and revenues reports comes in the pattern they establish over time. SEC regulations require that stocks listed on U.S. exchanges report quarterly and annual results. Financial websites like [reuters.com], [finance.yahoo.com], and others, compile these results and make them easy for any investor to review and analyze, as shown below. [20160904 - figure 1] Under ideal circumstances, both earnings and revenues should be seen to increase on both a quarterly and annual basis. I also prefer to see earnings growing slightly faster than revenues as an indication the company maintains strict cost controls. Keep in mind, however, that deviations from the ideal are not always indications of problems, but should be used to help generate questions and dig deeper for more insight. One of the most common examples of this is when revenues grow over a period of time, but earnings do not. Increasing revenues are a positive, but the fact the company failed to increase profits as well could be attributed to several factors. Has management failed to contain spending properly, or are they perhaps investing in research, development or acquisitions that have temporarily curbed their profit profile? The only way to know is to look at the report itself; but the graphic above serves as an effective way to identify whether or not there are questions that need to be answered. Debt Because we generally accept the idea that consumer debt—things like credit cards, revolving department store credit, and so on—is not healthy in personal finance, so too must corporate debt also be a bad thing. The truth is somewhat different. Debt in business can be used to facilitate a number of important aspects of a company’s operations; for example, it can help provide capital to expand the scope of business through acquisitions and mergers, or help to enhance a company’s financial flexibility and sustainability during uncertain economic conditions. This is why as an investor, you should care more about how much debt a company carries and how it’s used. The simplest and most common way to measure the impact debt has on a company’s business is a number called the Debt to Equity Ratio, which can be found on most financial websites like the ones we’ve already mentioned, or through your broker. Here’s an example: [20160904 - figure 2] Equity, for the purposes of this ratio, is the total value of shareholder equity in the company. For example, if a company has 1 million outstanding shares and the stock is priced at $20 per share, shareholder equity is $20 million. The Debt to Equity ratio simply compares the company’s total debt to its shareholder equity. A ratio of 1 means that the two numbers are identical; a ratio below 1 means that total debt is less than shareholder equity, and a ratio above 1 means that total debt is greater than shareholder equity. Under normal circumstances, a ratio below 1 is a good indication that a company’s debt is reasonable and manageable, while a ratio above 1 may signify that debt is too high and could create a drag on profits. Free Cash Flow For as long as publicly traded companies have been required to disclose their operational results, earnings per share have been the default metric used to analyze and track a company’s profitability over time. The reliability of earnings per share as an accurate measurement was called into serious question during the “dot-com” bust from 2000 to 2001. It became clear that dishonest companies had devised ways to use earnings per share to obfuscate their real operational status; companies, that in reality had no capital to operate with, were reporting increasing earnings per share every quarter to drive their stock price to impossible heights. The most notorious and infamous example of this corporate malfeasance came from an energy company called Enron. Before the truth of their profitability came to light, their stock climbed as high as a little above $90 as investors clamored to buy into one of the best performing stocks of the dot-com era. Executives issued earnings reports that demonstrated a false pattern of earnings growth that encouraged investors to keep buying shares (including their employees, many of whom were holding Enron shares as the only asset in their 401(k) accounts), forecasting a top-end price around $140 per share even as they began selling out of their own positions. The insider selling spurred a decline in the stock price that management continued to spin as a temporary drop that investors should use as an opportunity to buy more shares at a discount. The stock was around $15 per share when the truth about their corporate governance and criminal insider trading finally came to light, the stock began an immediate free-fall that pushed the price to penny-stock levels before it was finally delisted. Besides being thrown out of work as the company was finally forced to close its doors, thousands of employees were also faced with the grim reality that the entirety of their retirement savings had disappeared into thin air. As a result of this incident and others around the same period of time, experienced investors began to distrust earnings per share as a viable reflection of a stock’s profitability and to look for other metrics that could not be so easily manipulated. For many, Free Cash Flow is a more practical and realistic measurement of a company’s real status at any given time. The simplest explanation of Free Cash Flow is the cash that is left after the company has covered its capital expenditures. Tracking the increase or decrease in cash flow from quarter to quarter or year to year can provide insight about whether the company is successfully generating enough cash to expand their business and keep creating value for its shareholders. Here’s an example: [20160904 - figure 3] While increasing free cash flow is the preferred pattern for a fundamental investor, it’s important to remember that decreasing cash flow isn’t automatically an indication of deteriorating fundamentals. Forward-thinking companies know how to use their available cash for a variety of strategic purposes. For example, in periods of economic uncertainty and industry-wide difficulty, companies that have been smart about building their cash position during more prosperous periods are more likely to weather even a prolonged downturn, but it would be natural to see their free cash flow decline during this period. Another possibility can be seen when free cash flow declines temporarily because a company is directing major portions of cash into research and development or capital acquisitions that should pay greater dividends in the long run. If you see a pattern of declining free cash flow, you’ll need to dig a little more into the company’s earnings statements to identify the reason for the decline and decide whether it translates into a positive or negative situation. Return on Equity Return on Equity (or ROE) is a commonly used fundamental metric. It is intended as a reflection of a company’s ability to return value back to its shareholders. The calculation is straightforward: Net Income / Shareholder’s Equity = Return on Equity The logic is also relatively simple: for each dollar invested, how much return has management been able to deliver back over the past twelve months? ROE is expressed as a percentage, and while investors differ on how high it should be, it is generally accepted that high-growth companies should have ROE of 20% or more. Since the Rebel Income method is designed to work with a broader range of stocks, many of which are too large to fit the “high-growth” definition just mentioned, a somewhat lower percentage is acceptable. ROE of 12% or higher is generally considered acceptable for the purposes of practical income generation. This is a number that should be readily available through any broker’s trading interface; it can also be found on free sites like [finance.yahoo.com], [money.msn.com], [reuters.com] and others. Here’s an example: [20160904 - figure 4] Return on Assets Return on Assets (or ROA) gets overlooked by most investors, because it isn’t talked about on popular media or by analysts as much as Return on Equity. Since it is also expressed as a percentage, but is almost always much lower than ROE, it’s easy to dismiss Return on Assets, but the truth is that when you understand how ROA works in conjunction with ROE, you can give yourself a much clearer idea about a company’s real financial health. Return on Assets is calculated in similar fashion as Return on Equity: Net Income / Total Assets Assets is a balance sheet line item that includes cash, accounts receivable, property, equipment, inventory, and so on. ROA reflects a company’s ability to leverage its assets effectively. Think about it like this: for every dollar in assets, how much does a company earn? While this number is naturally lower than ROE, the generally accepted notion is that ROA should be 5% or higher under ideal circumstances. Take another look at the graphic above for Return on Equity; the line above it provides the percentage for Return on Assets. Most sites list these numbers together, because they work better when you use them in tandem. First, it’s important to understand why these numbers tend to be so different. It really boils down to debt. We mentioned earlier that Shareholder’s Equity is used to calculate ROE. Shareholder’s Equity is defined as total assets minus liabilities, which means that debt is not factored into an evaluation of how much return a company generates for its shareholders. Assets however does include liabilities, which makes sense since if a company does take on debt, the objective should be to use it to find ways to expand the company’s business. Looking at both numbers at the same time gives you a way to determine if management is maintaining a healthy, happy balance in both areas. Sometimes you’ll see a stock with very impressive ROE numbers, but an extremely low ROA. This is an imbalance that could mean trouble. Remember that if debt increases, shareholder equity decreases; that lower number divided against net income can give ROE an artificial increase, which will lead investors that only pay attention to ROE to conclude that the company’s financial health is better than it really is. Let’s go back to the example I used earlier. [20160904 - figure 5] ROE is acceptable at a little over 12%, but since ROA is less than 5%, you should automatically question this company’s financial foundation. It is true that this is a simplified comparison that doesn’t factor what management is using its debt for or how long this condition may last. The real power of the items I’ve just covered doesn’t come from any of them by themselves; they work best as a collective whole to get a quick-glance look at a company’s fundamental profile. Together, they give you a pretty solid, “big-picture” perspective about whether a stock is worth paying attention to, and possibly whether it’s worth actually making an investment in. If you see any information that is less than ideal, it may be a reason to discard the company from further consideration; but if most of them are healthy and only a few are questionable, it may be a reason to dig deeper to see if there is a reasonable, justifiable explanation. --------------------------------------------------------------- Over the last two years, Thomas has outperformed investing legends such as Warren Buffett, Carl Ichan, and David Tepper. Earning nearly 30% per year applying his unique Rebel Income system selling put options. Quite frankly, his track record is unheard of in the financial publishing business. He’s closed exactly [107 trades], of which 104 have been winners with only 3 small losers. He is the first to admit that much of his success, especially when it comes to his winning percentage, has to do with identifying deeply undervalued companies using the analysis techniques he just outlined in today’s post. To get a first-hand look at how Thomas creates such a high percentage of winning trades and annual returns that match those of the best investors in the world, we’ve arranged for you to follow his picks for the next 30 days for only $9, with no obligation to continue. You’ll also receive two incredible bonus items free. [Click here] to get started on your $9 30-day trial. 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