Sunday, July 07, 2013

Fundamental analysis and value investing: from a book review

Charles Sizemore wrote a book review on Intermarket Analysis And Investing by Michael E.S. Gayed in Forbes.

He wrote, "Gayed addresses the strengths and weaknesses of each of the major schools of investing thought. For example, of fundamental analysis he writes that it is “more reliable than any other approach…tangible and logical.” But also acknowledging its shortcomings, he notes that 'fundamentals tend to lag behind the price action. The discounting mechanism of the market often senses evolving financial problems before the company actually discloses them.'"

I think this is a common misconception of fundamental analysis. In fundamental analysis, we don't wait for company's disclosures to know its financial problem. we can sense the company's financial problems easily and ahead of others by noticing its changes in balance sheet's items like inventory, receivable, payable, gearing, etc., its cash flow and the consistency of three elements in financial reporting, i.e. financial performance, changes in balance sheets and announced stories.

What we need is a complete analysis on balance sheets and cash flow statements to smell troubles ahead.

In fact, Daniel Fisher, another writer of Forbes wrote this article, "Those Evil Naked Short-Sellers Actually Trade On Fundamentals, Study Says", stated that the short-sellers rely on fundamental analysis to trade. They detect and exploit financial weaknesses of companies. It is not beautiful, but fundamental analysis allow them to act before market price action.

Balance Sheets' Items

The health of a company's business operations reflects in the management of inventory, receivable and payable. A good company with healthy operations shows a "thin" working capital items like inventory and receivables. The balance sheet of a company with healthy inventory turnover, prompt collections of account receivables and willingness of suppliers to provide longer financing reflects a small Net Current Asset's value of "Inventory ADD Account Receivables (Debtors) LESS Account Payable (Creditors)" ("I+D-C"). Consistent increase of this "I+D-C" value reflects deterioration of management performance, e.g. mismanagement or bad planning of inventory, raw materials, and problematic production processes, longer credit period to keep unhappy customers from leaving, non-collectible sales revenue, disputed sales, lacking clout on suppliers and is forced to pay cash for inventory due to bad reputation, etc.

A balance sheet with bulky inventory, bulky receivable, and small payable indicates either a mediocre company or a troubled company with manipulated income statements. Read here.

Fundamental analysis enabled you to avoid such company. Or alert the value investor early enough to sell the stocks before market price actions.

Cash flow

Has the company been generating positive operating cash flow? Has it been paying down its borrowings? Has the gearing less than 30% of its total assets? If the answers of any of the above are NO, we need to be alarmed.

Avoid or sell the stocks of the company that does not generate operating cash flow. In some cases, I even avoid those that generate positive operating cash flow but with negative net cash flow.

Opportunities in the stocks market are unlimited but our money is limited. Sell and run, if the company you invested in was not generating positive net cash flow. We don't have to wait. Whether there will be a financial problem in the future, it is irrelevant to value investors like us.

Announced Stories

We can estimate future performance from the announced statements and notes to the financial statements. I remember one of the stocks I held:
It was a listed company. In one of its quarterly reports it explained that the profit reduced as there were many festive holidays during the quarter and that the plant had already reached its full capacity. Six months down the road, when it announced the purchase of a new plant, I immediately knew that the profit was going to increase before the commission of new plant.
I just wish to make a point that by linking the financial numbers to Notes to the Financial Statements and announcements, we usually can see the underlying business progress. Sometimes, we can pick up things that missed by the management. We can "smell" what is coming before the market price actions. And this is fundamental analysis.


In true sense of value investing, we would have dump the stocks when its balance sheets reflect a mediocre operations management with lackluster performance, with or without its subsequent financial troubles. With such complete fundamental analysis, the actions of value investors (to sell/ to avoid) always come much earlier than the market price actions.

Relevant resources: