Wall Street Cosmos
Fundamental Analysis
Part I: The Beginning
Part I: The Beginning
Fundamental Analysis (Part I)
by James A. Maccaro
"Fundamental Analysis" is derived in part from research conducted by the author for Technical
Analysis, Inc., which was published in their magazines and website. This material is copyrighted,
2001 - 2006, by Technical Analysis, Inc., which reserves all rights, and is used with the permission of
the publisher.
Many people know virtually nothing about the stock market other than the fact that
Warren Buffett is the most successful investor in history. Consistently ranked as
the second richest man in the world (behind only Bill Gates of Microsoft), Buffett’s
career demonstrates the rewards of a patient adherence to a set of deceptively
simple principles of investing.
Thanks to his wealth, Buffett is a celebrity. Yet his mentor, Benjamin Graham, the
person Buffett credits with setting him on the path to success, is obscure outside
of the ranks of stock market enthusiasts.
Benjamin Graham was arguably the most influential thinker and writer about the
stock market. Indeed, he is often called "the father of security analysis."
Graham was a long-term “buy and hold” investor. In contrast to Charles Dow and
the technical analysts who followed Dow, Graham believed that daily price and
volume fluctuations were irrelevant to stock market investment. Instead, he
focused on the fundamental value of a business, that is, the company's earnings
and its prospects for the future. For this reason, his approach is called
fundamental analysis.
Graham asserted that "price fluctuations have only one significant meaning for the
true investor. They provide him with an opportunity to buy wisely when prices fall
sharply and to sell wisely when they advance a great deal. At other times he will do
better if he forgets about the stock market and pays attention to. . . the operating
results of his companies."
Graham was born in London, England, on May 9, 1894, and his family immigrated
to the United States when he was a small child. In 1914, he began his Wall Street
career as a clerk at a brokerage firm, but soon became a money manager and
subsequently also taught at Columbia University and at the University of California
at Los Angeles. He set forth his investment philosophy in two classics of financial
writing, Security Analysis, a textbook co-written with David Dodd and published in
1934, and The Intelligent Investor, published in 1949 (revised in 1973), which
summarizes for the general public the ideas presented in Security Analysis. Graham
put his ideas into practice as the president of the Graham-Newman Corporation, a
money management firm.
Warren Buffett was a student of Graham at Columbia. Graham must have
recognized talent in the young man, because he hired Buffett as a securities analyst.
Thereafter, Buffett would use his investment skills, many of which he learned from
Graham, to become one of the richest men in the world. According to Buffett,
“I’m 85 percent Graham.”
Graham is most noted among investment professionals for expressing the idea that
every stock has an "intrinsic value" that is based on the issuer's ability to generate
earnings, and that a stock should only be purchased when the price is below this
value. In such cases, investors are provided with a "margin of safety" (the greater
the discount, the greater the margin of safety), and eventually the market will
recognize the stock's intrinsic value and bid it up to its proper price.
In Graham's words, "in the long run, securities tend to sell close to a price level not
disproportionate to their indicated value. This statement is indefinite as to time; in
some cases the day of vindication has actually been deferred for many years." In
other words, having recognized that a stock is undervalued, Graham believed that it
should be purchased, but not because he thought the share price would
immediately shoot-up. Rather, he believed that eventually the market would
recognize the stock’s intrinsic value and the stock price would rise accordingly,
but this could take months and even years. Essential to Graham’s approach is
patience.
Graham determined a stock's intrinsic value based on its earning power value,
which he calculated by estimating its earning power and applying a suitable
multiplier. Of course, earning power is merely a prediction, or an educated guess,
about future earnings.
Graham believed that a multiplier of 12 is suitable for stocks with "neutral
prospects." He would increase the multiplier for growth companies up to a
maximum of 20 and decrease it for companies that could have a future decrease in
earnings. In effect, Graham had a target price/earnings ratio for each stock in his
portfolio.
Today, many followers of Graham believe that the multiplier should be the earnings
growth rate. For example, if a company’s earnings were growing at a rate of 25
percent per year, they would apply a multiplier of 25. More aggressive investors,
such as Jim Cramer of TheStreet.com, are comfortable with P/E ratio as much as
twice the earnings growth rate. However, because no company has been able to
maintain astronomical levels of growth indefinitely, most fundamental analysts (and
certainly all true followers of Graham) would apply a limit to how high a multiplier
they would tolerate irrespective of current earnings growth.
According to Graham, little if any value should be given to non-tangible assets, a
view which most today find out-of-date. Tangible assets are assets such as real
estate, equipment and raw materials, which have a physical presence, as opposed
to other assets that are abstract in that they represent the value of the firm’s
reputation, relationships and intellectual property.
Graham concluded that if intrinsic value is more than a third greater than the
market value, the security is likely to be undervalued and should be purchased. If
earning power value is more than a third less than the market value, the stock is
likely to be overvalued and should be sold.
In essence, at the heart of intrinsic value is an attempt to provide a reasonable
estimate of the likely earnings of a company into the near-future. Graham asserted
that it is “that value which is determined by the facts,” as opposed to unfounded
optimism or wishful thinking. The next step is to determine if there is a margin of
error (that is, whether the stock is undervalued), in which case the stock should be
bought, or if the reverse is true and the stock should be shunned.
He summarized his approach by asserting that "a successful listed company is one
which earns sufficient to justify an average valuation of its shares in excess of the
invested capital behind them." This is a fancy way of saying that he was only
interested in companies that demonstrate that they are likely to produce a
reasonable profit for shareholders.
Graham advocated several basic principles that can be easily summarized:
Make sure to diversify -- Graham believed that a portfolio should have between ten
and 30 stocks to protect against becoming too reliant on the performance of one or
two firms. He recognized that even the best-run companies could have setbacks
and that not all investments end on a positive note.
Focus on solid stocks – Graham only invested in large, prominent and
conservatively financed companies. It is clear that Graham believed that an investor
wins by not losing; he wanted to minimize the risk of putting money into a
company that eventually fails. This was particularly important to Graham because
he sustained huge losses during the stock market crash of 1929.
Pay attention to a corporation’s performance history – Graham would only invest
in companies with a long and continuous record of dividend payments. Today, this
probably does not make sense because the market generally is more interested in a
company’s ability to generate capital gains, rather than dividends. For many years
after Graham’s era, a large number of solid companies did not pay dividends and
some others paid only a token amount. While there is now more of a focus on
dividends because of tax reforms concerning their treatment, many fine
corporations still do not pay dividends or pay a small amount. However, the
underlying principle still makes sense: Graham was only interested in companies
with a proven ability to generate positive results. Today, that generally translates as
companies with a record of growing earnings.
Do not overpay – As previously mentioned, Graham believed that the price to
earnings ratio should not exceed 20. In the present market, a P/E limit of 20 might
be too conservative because the average P/E is much greater than in Graham’s day.
But the principle is still valid. A stock that has an exceptionally high P/E is risky
even if the company is in great condition because there is the danger that the stock
has “gotten ahead of itself” and become overpriced. Some investors, according to
Graham, make “the common error of buying good stocks at high levels of the
general market. It would also bar the purchase, even in normal markets, of a
number of fine issues which sell at unduly high prices in anticipation of greatly
increased earnings. We feel that such common stocks are not appropriate for the
defensive investor . . ."
Graham's investment approach is based on bargain hunting. He searched for out-of-
favor companies that were fundamentally sound and held them until market
sentiment became favorable. Thus, he bought stocks when most investors were
selling and sold when most were buying, which is the essence of the style of
analysis known as contrarian investing.
To continue to Part II, click here
To continue to Part III, click here