Seven Things to Look For In Fundamentals Trading
Low comparables, earnings growth and even taxes should be on your trading checklist when it comes to examining fundamentals.
I am often asked what I look at in a stock from a fundamental standpoint and it is always typically a question posed during the day, when I never have enough time to really delve into it.
First off, let me tell you that I believe there is a huge different between studying fundamentals for trading and studying fundamentals for investing. In my early days as a money manager, I would spend countless hours studying a company's balance sheet, calculating and projecting its return on equity, historic P/Es and trying to derive a current intrinsic value. Despite the fact that this effort was 80-90% quantitative there were still qualitative variables such as management, competition and at times other factors such as legal issues that needed to be assessed. This strategy of investing is extremely time consuming and daunting but can be incredibly exhilarating if done correctly.
I fondly recall one of my best recommendations that landed in client portfolios. It was around the summer of 2003 and a stock I had been digging into, Altria, (MO) had been significantly depressed due to legal issues surrounding cancer deaths from smoking. After calculating the intrinsic value of the company it was a no-brainer that the stock should be in the 60's or 70's, not the 30's, however with the uncertainty surrounding the legal proceedings, especially the one within the state of Illinois, it was very hard to predict the company's future. You see, value investing is not just about finding some hidden gem; most of the time it involves stepping in when no one else wants to do so because of great, perceived risk. Think back to Warren Buffet's incredible bet on American Express (AXP) during the salad oil scandal. I am sure at that time most thought the company was doomed.
Or how about Eddie Lampert's purchase of K-mart, today's Sears Holding (SHLD), out of bankruptcy for pennies on the dollar? The point is, that while value investing on the surface seems rather simple, it often involves stepping into the fires and then waiting the necessary time it takes for the tables to turn.
With Altria I felt very good about the deep discount, management and its international growth however I couldn't quite get a handle on the legal issues, until I stumbled upon a priceless piece of information that I believed most had skipped. You see, if the court ruled in favor of the people, the money was so outlandish that more than likely the case would send Altria into bankruptcy protection. Should this have happened, the money that the company had been paying out to states through previous tobacco settlements would cease.
What's the big deal, you ask? Well, the tobacco settlement money was originally supposed to be used for education and awareness surrounding tobacco, but most of the states were placing that money into their general budget. Whether this was ultimately right or wrong, it was my belief that there was no way the state would rule against a company that was funding many of its initiatives. I made a substantial investment and the rest is history.
The difference with investing fundamentals and trading fundamentals is great. When I study a company that I desire to trade, I am not attempting to calculate their intrinsic value. Furthermore, more often than not, I am not looking for deep discount bargains that I can hold for years. I am looking for growth at a reasonable price.
Typically, I look at the following seven items when it comes to a stock I am considering to trade. There is no absolute science; rather it is more of an art form as no two companies are the same.
1) Steady Revenue and Earnings Growth: This one is pretty simple. I definitely like to see a company that has been consistently growing its top and bottom line figures for several quarters, if not several years. Surprises are not my gig and I want to limit them as best I can. If a company has been successful in its historical growth, odds are it will continue.
2) Trailing P/E vs. Future Growth: I like to see the company's trailing Price to Earnings ratio below its future growth. For example, if a company is selling a 10 times trailing earnings, I want to see its future estimated growth as measured by year over year EPS more than 10%.
3) Forward P/E vs. Future Growth: Ideally, I love to see companies selling at a lower multiple (Price to earnings ratio) than their estimated future growth percentage. For example, I would definitely be interested in a company who was currently trading at a forward P/E of 30, but set to grow year over year estimates at 60% assuming projections are hit.
4) Steady Sequential Growth: Most of the comparisons I do are year over year, however I also desire to see sequential (quarter to quarter) top and bottom line growth.
5) Low Comparables: When a company grows, it will be continuously compared with its past numbers. As these numbers grow it becomes harder to maintain the robust growth that many have in the past. If the comparables remain relatively low for several quarters, I would be much more interested than if the comparables jump in the upcoming quarters.
6) Balance Sheet: Typically I like to take a quick glance at the balance sheet to make sure the company isn't too leveraged. When small to mid-size companies grow, they will often issue secondary stock offerings to raise capital, diluting their share count. This immediately drops all numbers and often creates a quick sell the news reaction. While it isn't a total determining factor, I like to see a healthy balance sheet.
7) Taxes: Many young companies go through the growth stages and rack up significant losses. This creates a tax advantage going forward that needs to be worked off. Whenever I enter a longer term trade, I like to get a handle on when a company will become 'fully taxed' as this will have an immediate result on EPS in a negative way. Most traders don't care to even consider this and will sell first and ask later. I want to be aware when this is coming so I can work this into my decision making process.
Ultimately, you have to make a decision and regardless of how much research you do or how long you study, there will still be unknowns. This is one of the primary reasons I use technical analysis to be my ultimate guide. If something is changing with one of my seven items listed above, more than likely it will be reflected in the chart long before it is reflected publicly. I study the internals but ultimately always let the chart speak.
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