Systematic Approach to Fundamental Analysis

SwingKing

Well-Known Member
#1
I am starting this new thread where I will teach how to value shares based on their fundamentals. I think most of the traders are Technical Traders here and few base their investment decision based on fundamental approach. However, I personally feel that some of the best investments come your way when you put the two approaches (Fundamental and Technical) together.

In this thread, I am going to start teaching valuation from scratch. This will include analysing a Country, its Economy, its fundamentally rich sectors and finally it's shares. I am going to start two threads on this. One is this in which I am writing presently and another one will be the 'Discussion Thread' which will relate to all the topics posted here. I would like to maintain a flow while writing and hence would request all the member's to post their doubts and other queries in the discussion thread and not to post anything in this thread.

I sincerely hope this thread will benefit all those who wish to learn Fundamental approach in investment. I'll be creating an index on this page which will give everyone a clear idea of how we will be progressing towards learning Fundamental Analysis. Please note that I follow the Warren Buffet methodology for investment and hence valuations methods here can be different from what many research firms, IB firms etc use. I don't pay much attention to the numbers which company's deliver (please understand this statement in its context). I look more towards the prospects of growth, capability of management and the scope of the business going forward. I believe if these factors are in place, then the numbers will automatically fall into place.

Once I finish with the basic theory behind fundamental analysis, I will hand pick certain companies and will show you to implement what we have learnt. For further reference you can read two books Analysing Companies and Valuing Shares by Michael Cahlill and Investment Valuation by Aswath Damodaran.

Please Do Not Post Anything In This Thread. Please post your doubts and comments in the 'Discussion Thread'

Index (Will be updating regularly)

1. Valuation: An Introduction
2. Importance of Sector Analysis - I
3. Importance of Sector Analysis - II
(a) Forecasts for Demand
(b) Forecasts for Prices
(C) Forecasts for Costs
4. Analysing Economic Factors
 
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SwingKing

Well-Known Member
#2
Valuation: An Introduction

Introduction to Valuation

What is Valuation?

Valuation Analysis is essentially determining the true or fair value of an asset, security, firm or any other entity. The basis of valuation lies in the fact that an analyst tries to compute the valuation of an entity and label it as overvalued or undervalued. If the value is overvalued then the analyst assumes that at some time the market will revert back to its true value and hence tries to avoid investment in the entity. On the contrary, if the analyst values the asset as undervalued, then he invests in the entity considering that markets will eventually have to catch up to the true value.
Hence, Valuation analysis is done to evaluate the potential merits of an investment or to objectively assess the value of a business or asset. Based on this, investment decisions are made.

What is the role of Valuation in the Financial World?

Broadly, the role of valuation has been divided into three wide domains; Portfolio Management, Acquisition Analysis and Corporate Finance. Although the role on broader note remains the same in each field, yet there are some minute details which have to be understood.

Role of Valuation in Portfolio Management- Fund managers throughout the world rely on valuation to dynamically allocate funds to specific stocks in their portfolios. This re-iterates a fact that valuations of stock is not a static process, it changes dynamically as time progresses. Hence, fund managers dynamically relate the value of the stocks to its financial characteristics its growth prospects, risk profile and future cash flows.By dong this, they then re-allocate their funds to stocks which look undervalued.

Role of Valuation in Acquisition Analysis In acquisition the role of valuation is two- fold. Firstly the target firm needs to know its true value before deciding to accept or reject the offer of the bidding firm and secondly the bidding firm needs to know the true value of the target firm before making an offer. Both the firms use valuation to identify the true value.

Role of Valuation in Corporate Finance The main objective in corporate finance is the maximization of a firms value by highlighting the relationship between the financial decisions, corporate strategy and the true value of the firm. Understanding of this relationship is extremely potent in making value increasing decisions.

Is Valuation Subjective or Objective?

On first look, it may seem that valuation is a lot objective. However, in reality this is not the case. It is true that valuation firms do have their models through which they determine a firms true value and hence things look objective. But there are numerous assumptions which the analysts make during valuation which can substantially vary the arrived true value of the firm. Hence, these set of assumptions make valuation subjective and hence leads to biasness in the value obtained.

This brings us to a very important point that valuations are subject to analyst biasness. A classical example of this has been found in the Investment Banking Industry. Eg Lets assume an investment bank is bringing out an IPO of a firm. Do you think the analysts of the Investment bank will value the company as overvalued? Well, recent findings do suggest that analysts are marked with biasness in this case. Furthermore, there are some analysts who also think that complex valuations model generate much better results. Research in this particular case has illustrated that the simpler the valuation model is, the more accurate is the valuation (though this is not true in every case). The reason why a simple model is preferred is because the more complex the model, the more number of inputs it requires. This can (and cannot) lead to biasness.

Identifying overvalued stocks or undervalued stocks is not the only thing. Things gave to be taken into perspective before deciding to invest. In the coming sessions, we will learn the different valuation techniques and the process of valuing the stocks to make sound investment decisions.

Kindly Do Not Post Anything on this thread. You can post your comments on the Discussion Thread.
 

SwingKing

Well-Known Member
#3
Importance of Sector Analysis - I

Importance of Sector Analysis - I

What does a typical Investor do when he spots a stock that is buzzing around with growth prospects? Well, research shows that more than 80% of uninformed investors buy the concerned stock without analysing its future prospects. Neither do they analyse the stock nor do they analyse the sector. One might wonder, why isn’t analysing stocks sufficient for profitable investments. Why is analysing a sector important?

Well, analysing just a stock is not sufficient for rationale investment decisions. One has to dig deep inside to understand the future prospects of the sector and the economy on the whole. Stocks move when they are backed by growth, sustainability of profits, rationale management decisions and prospects of sector growth going forward. I belong to the Warren Buffet investment philosophy and hence I don't pay much attention to the numbers which company's deliver (please understand this statement in its context). I look more towards the prospects of growth, capability of management and the scope of the business going forward. I believe if these factors are in place, then the numbers will automatically fall into place. Moreover, it is often seen that sectors and their respective industries tend to move together and hence, if one stock looks attractive one must look into the broader sector to see if there is a broad based movement building up. (For eg, If Automobile Sector does well then Auto Ancillary Industry will automatically do well).

Factors which typically impede the growth of a Sector:

Listed here are the key things one must look for while looking for a sector for investment purpose.

1. Are the number of participants in the sector too high – Under this segment, we look for the number of entities competing in the sector. The reason we do so is because if there are many ‘like’ participants, then eventually everyone will try to capture the volume in the sector (severe competition). This indirectly will lead to a price war (poor pricing) and which would eventually impact the profit potential and growth prosperity within the sector. Tele communication sector in our country is facing this problem. Going forward, things are expected to become worse as the number of participants is bound to increase.

2. Is the sector highly capital intensive – If a sector demands high capital investments, then there is a possibility that the companies within that sector will have high debts on their balance sheets. Also due to high fixed costs, companies will try to compete for volumes to attain economies of scale and scope. High capital investments when combined with poor pricing leads to lower profits and lower returns on capital.

3. Do they companies have pricing power– A sector in which there is no pricing power due to many participants (switching costs of consumers is low) or due to local/global competition will always struggle to generate long term wealth. In our economy, Airlines sector is one which is marked by this problem. There is no scope of growth as the competition is high and the switching cost for consumers if low. This is a sector which demands more consolidation (Mergers or acquisitions).

4. How cyclic is the sector- Many sectors in an economy go through cyclic phases. What usually happens in these phases is that companies find it very difficult to generate long term sustainable wealth for the investors. When the cycle is up, they tend to invest more in the business for it to sustain in the downward cycle and when the cycle is down, the companies barely struggle to sustain the growth depicted earlier. This leads to lower profits and hence affects the entire business cycle.

It is very difficult in the economy to find sectors which are perfect. What we have to do is find sectors which will relatively outperform others. In the next post we will see what are the factors which drive the profits of sectors and will learn how to identify sectors for profitable investments.

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SwingKing

Well-Known Member
#4
Importance of Sector Analysis - II Outlook for Demand

Importance of Sector Analysis II - Forecasts for Demand

In the previous post we saw the importance of analyzing a sector. In this particular section we will learn to dig deep into understanding what drives the sector and its profits. Once we understand what drives the sector, we can follow a ‘Bottom up’ approach focusing on the strength, weaknesses and economics of individual company belonging to that sector. There are essentially three things which we need to look into while analyzing the catalysts for sectors; Forecasts for demand, Forecasts for prices and Forecasts for cost.

Forecasts for Demand – There are essentially two important factors (Economic cycle and the Industry growth cycle) to look out while assessing the scope of demand in the sector. First we will address the Industry growth cycle phase as there is one entire section which will be posted on Economic cycle. In the Industry growth cycle phase we need to identify the category of the concerned industry. Broadly we divide the categories into three different groups; Cyclic industry, Mature industry and Growth industry.

Once we categorize the Industry, we then need to look at the demand prospects in them. The first segment of our industry is Cyclical Indsutry. If we identify the Industry as cyclical, we need to identify what essentially drives demand in such sectors. It may be a product, a particular genre (demand by age group, by trends) demand or can be purely based on seasonality. Cyclic Industries are in general tough to analyze. The main reason behind this is that historically Cyclic Industries have not been good performers. During economic boom every industry prospers but when the time goes tough, cyclical industries are the one’s which get impacted the most. Along with the above mentioned factors these industries get impacted by other economic factors (interest rates, consumer spending etc). Hence, though some fund managers might prefer to stay invested in such industries, I personally stay away from it. It is more important to invest in industries whose earnings (quality earnings) are more clearly visible. However, for those who still want to stay invested in these industries, there is a way to find out whether the cycle is bottoming out or not. If a industries’s margins are falling along with several quarters of revenue dip followed by depressed prices and poor demand, then it is quite likely that the sector is entering a bottoming out phase. On the contrary, if a industrie’s revenues are increasing and margins are high, then it is quite likely that the sector is approaching saturation phase.

The second segment of Industry is the Mature Industry. In this industry, the growth rate remains steady. The demand for products of these industries does well in all economic situations. It has been observed that such industries grow at or slightly below the GDP. If we take an example of such Industry in our country, then the tobacco industry fits these criteria. Tobacco is an industry which does well under all situations. Even in the current 2008 recession, tobacco companies did comparatively well. The prices of tobacco related products have been going up in every budget. But do you think this leads to reduction in demand? Demand for the products keeps increasing at a steady rate. Such industries are income generating industries. One can expect steady income from investing in such industries.

The third segment of Industry is the Growth Industry. These industries are the one’s which need to be identified. These are wealth generating industries and anyone who identifies one such industry stands a good chance of generating significant wealth over a period of time. One of the key things in identifying such industries is to look at its growth rate. Such industries have a growth rate which clearly outperforms the GDP. Moreover, such industries do not have any regulation glitch and are usually less affected by economic cycles. One must keep in mind that getting in early in such industries is absolutely essential. The reason I say so is because once the initial demand gets absorbed, new companies begin to enter this industry which causes companies to chase volumes. This leads to a price war which eventually impacts the revenues. An example of such industry in our economy was the telecom and mobile industry. When regulations changed in the 90’s era, the telecom and mobile industry saw a surge of demand. Look at what Bharti was back then and look at what it has become today. This has all happened in the span of 10-15 years. However, now the competition has increased, lot of demand has been absorbed and the regulations have forced the companies into a price war. This is the reason this industry has entered a stagnation phase. However, this is not going to remain forever. In my opinion, the company which now taps the rural market, is going to rule in the years to come. Lets see eventually who turns out to be the winner.

This brings us to the end of identifying demand in the sector. In the next post we will see how to identify forecast of prices.

Kindly Do Not Post Anything on this thread. You can post your comments on the Discussion Thread.
 
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SwingKing

Well-Known Member
#5
Importance of Sector Analysis - II Outlook for Prices

Importance of Sector Analysis II Forecasts for Prices


Determining the prices of products in a sector is perhaps the most important part of a sector analysis. Prices are very important as they directly affect the bottom line growth of the company. In the previous post we saw the importance of analyzing the forecast of demand. In this post we review the important points which are required to forecast the outlook of prices.

Nature of the Product

This refers to the category of products that a sector produces. Some products which are also High ticket products sell well only in good economic conditions. These products are not necessities of life and hence are categorized in luxury product segment. In the recent recession, tourism declined globally as individuals decided to save their earnings. This led to wide spread impact on the tourism industry. However, Low ticket products which are necessities of life do well under all economic circumstances. Research has shown that consumer goods industry tends to perform very well after an economic slump. Hence, when sectors are selected for investment, it is always better to categorize its product as High ticket or low ticket product and then economic analysis should be conducted to determine the current stage of economy.

Nature of Industry

I mentioned in the previous post that price war leads to less revenue. Although some may disagree from this statement, but sooner or later this proves to be true. We need to analyze the composition of the industry. By composition I mean analyzing the number of players, the nature of the players and their balance sheet. If an industry faces a lot of competition then at some stage if the companies need to increase the products price, consolidation (M&A) must happen. Consolidation does not guarantee price rise, but it at least ensures a step in that direction. For investment purpose, we need to identify industries which have a good balance between competition and pricing.

Barriers to Entry

Barriers to Entry means the amount of resources a company has to commit to enter into a particular sector. If the Barriers to Entry are high and the competition is severe, then companies tend to avoid that sector. If this is the case, then at some stage we can expect consolidation to happen in that sector which would then make the firms pricing power attractive. As an example consider the Telecom sector in the country. The barriers to entry, in my opinion are significantly high, but the competition among the current operators is also fierce. Hence, any new company that enters in this sector is bound to face pricing pressure. Their understanding curve of the sector (including economics of scale and scope, distribution network, product differentiation, customer service) will certainly not match that of the current operators. Hence, investing in such a company makes no sense.

Regulatory Issues and Government Influence

The least thing I would want is to invest in a sector which has lot of regulatory issues and government intervention. Such interferences make the sector less transparent and make the earnings visibility poor. Thus investing in this sector would mean to take significant risk in terms of non-predictable, non-negotiable random risk. In the UK, the utilities sector for example faces significant government intervention in terms of pricing. The OFWAT (regulatory body) decides upon the pricing for various companies. Now, such uncertainty reduces earnings visibility and growth visibility. Similar situation is faced in India in the sugar industry. Government intervention and regulatory changes makes me very uncomfortable. Hence I prefer to stay away from the sector.

Regulatory issues exist at International level too. The recent policy changes by Mr. Barack Obama encourages firms to stop outsourcing to India. This is a sought of regulatory change which is beyond our control. Hence, if this gets implemented, this is bound to have impact on the outsourcing business.

In conclusion, we need to identify sectors in which pricing power is an option which companies can exercise. We need to also look at the competitor landscape and regulatory issues in order to identify and forecast earnings. Overall, we are on the lookout of sectors where visibility and transparency are its foremost attributes.

This brings us to the end of identifying pricing power in the sector. In the next post we will see how to identify forecast of costs.

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SwingKing

Well-Known Member
#6
Importance of Sector Analysis II Forecasts for Costs

Importance of Sector Analysis II – Forecasts for Costs

While forecasting the costs for a sector, we need to focus on three main category of costs; Fixed Costs, Variable Costs and Sales Costs. Every company in a sector has different composition of its overall costs. Some companies may have more of variable costs and less of fixed and sales costs. Whereas some companies, typically in manufacturing sector will have more of fixed costs and less of variable costs. An analyst needs to know the cost structure of the sector and the company to get his investment right.

When a company has more of variable cost than that of fixed cost then one need’s to determine the future demand and supply of variables affecting the variable costs. For example, let’s take the Airline Industry into consideration. Airline industry usually has a composition of high variable cost in terms of their overall costs. Bulk of their variable costs is a result of fluctuating fuel costs. Rise in prices of fuel can severely affect their profitability and operating margins. Thus in this case, when an analyst decides to research the airline industry, he needs to be sure of the forecast of fuel prices in the coming quarters. Also, analyst must also try and foresee if the current rise in cost of fuel could be transferred back to the customers. This usually results in the airlines increasing the costs of travel. Historically, this has not worked in the favor of airlines as due to severe competition the companies within this sector eventually run into price wars.

When a company has more of fixed costs then it is seen that even small movements in volume of goods and services sold can have an adverse impact on the bottom line growth. Usually such companies try to sell their products on high volumes. This is mainly done in order to spread out costs. However, this strategy can back fire as companies would have to lower the price to concentrate more on volumes. Manufacturing sector is marked with high fixed costs as compared to any other sector. Thus in this sector there are frequent price wars which lead to reduction in profits.

The third category of the costs is sales costs. This is basically the expenditure undertaken to promote the sales of a product or to maintain the current products brand image. Usually we will see that in strong economic cycles, sales costs typically tend to be higher as companies are possessing extra cash. However, as the economic cycle tends to drift down, sales costs usually begin to come down. What an analyst needs to look at is how much ‘value’ and ‘competitive advantage’ do sales costs offer to the company. Thus while looking at the cost composition is important, it is also important to look at the value added.

In conclusion, we are looking for sectors and companies which are providing a balance between the three categories of costs suitable to the economic cycle and competition. In future when we analyze examples, we will get a good grasp of how to apply these concepts.

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