Technique of Fundamental Analysis

The Technique of Fundamental Analysis

Fred Schwed, Jr. In his charming and witty exposé of the financial community in the 1930s, Where Are the Customers’ Yachts?, tells a Texas broker who sold some stock to a customer at $760 a share at the moment when it could have been purchased anywhere else at $730. When the outraged customer found out what had happened, he complained bitterly to the broker. The Texan cut him short. “Suh,” he boomed, “you-all don’t appreciate the policy of this firm. This heah firm selects investments for its clients not on the basis of Price, but of Value”.

In a sense, this story illustrates the difference between the technician and the fundamentalist. The technician is interested only in the record of the stock’s price, whereas the fundamentalist’s primary concern is with what a stock is really worth. The fundamentalist shrives to be relatively immune to the optimism and pessimism of the crowd and makes a sharp distinction between a stock’s current price ans its true value.

In estimating the firm-foundation value of a security, the fundamentalist’s most important job is ti estimate the firm’s future stream of earnings and dividends. To do this, he or she must estimate the firm’s sales level, operating costs, corporate tax rates, depreciation policies, and the sources and costs of its capital requirements.

As soon as you trust yourself, you will know how to live (Johann Wolfgang von Goethe). Photo by Elena

Basically, the security analyst must be a prophet without the benefit of divine inspiration. As a poor substitute, the analyst turns to a study of the past record of the company, a review of the company’s investment plans, and a firsthand visit to and appraisal of the company’s management team. This yields a wealth of data. The analyst must then separate the important from the unimportant facts. As Benjamin Graham put it in the Intelligent Investor, “Sometimes he reminds us a bit of the erudite major general in “The Pirates of Penzance,” with his “many cheerful facts about the square of the hypotenuse.”

Since the general prospects of a company are strongly influenced by the economic position of its industry, the obvious starting point for the security analyst is a study of industry prospects. Indeed, in almost all professional investment firms, security analysts specialize in particular industry groups. The fundamentalist hopes that a thorough study of industry conditions will produce valuable insights into factors that may be operative in the future but are not yet reflected in market prices.

A brief, but deadly, example will help illustrate the process. It involves a research study undertaken late in 1980 by the investment firm of Smith, Barney & Co. The analysis covered the funeral service industry and the prospectus for Service Corporation International.

The report first gave a broad picture of the funeral service industry. Demand for the industry’s services is governed by an indisputable fact: We all die.

Thanks to the abundance of data gathered by the U.S. Census, it is easy to estimate the industry’s potential market. You just look at the number of people in various age categories and then multiply by the mortality rate for each age group. The Smith, Barney report presented two tables, based on census data, that showed the mortality rate rising until the year 2000. The grim fact is that funeral services is a growth industry. The Smith, Barney report also pointed out that the industry was highly fragmented, consisting of small, family-owned and -operated companies averaging about $150,000 in annual revenues. Because of their small size, most operations could not take advantage of economies of sale and were not well suited to professional management techniques.

The report then turned to an analysis of Service Corporation International, which at the time operated 189 funeral homes. Not only was this the largest organization in the industry, its revenues of $550,000 per unit were more than three times the national average. Management, of course, is key to any firm’s profitability, and in this case the executives had decided to make the company an industry leader through selective acquisitions and the introduction of professional management practices. This decision was not being executed with a sledge-hammer. Rather, generous financial incentives were used to encourage the principals of all acquired firms to remain, and a decentralized management systems was put in effect. Service Corporation International believed its advanced managerial approach was unique within the industry, and the Smith, Barney report did not contradict this assumption.

The report went on to note the particular innovations made by Service Corporation’s management. Its relatively large size permitted it to take advantage of centralized purchasing power for all its supplies from caskets to floral arrangements. The latter aspect of the business was particularly profitable. Service Corp. Opened floral shops in all of its larger funeral homes.

Since almost half of all floral sales are funeral related, these shops gave the company a substantial captive market. In addition, the company pioneered in marketing prearranged funeral services. These “pre-need” sales had two important advantages for Service Corp: 1) They assured continuing volume stability and future revenue growth and 2) they produced interest earnings on the prearranged payments, which became a source of the company’s earnings.

For the preceding decade, Service Corp.’s sales and earnings per share had grown at better than a 15 percent rate. The Smith, Barney report projected that future growth would be at least as large, particularly since Service Corp.’s management had positioned the company to increase its share of the market. This, plus the fact that the company’s stock was selling at a P/E multiple 40 percent below that of the S&P 500, indicated that the stock’s price was below reasonable estimates of its firm foundation of value.

Recall that the first principle of valuation of the firm-foundation theory is that a stock is worth more – should sell at a higher price-earnings multiple – the larger its anticipated rate of growth. In late 1980, Service Corporation International sold at a price-earnings ratio of 5, while the price-earnings multiple for the market as a whole was approximately 9. The expected growth rate of earnings and dividends for the market as a whole in 1980 was less than 10 percent, but Service Corp. Was expected to grow at a rate of better than 15 percent; hence, by the first valuation principle, it deserved to sell at a higher multiple than that of the market as a whole. Since the stock actually sold at a lower multiple than that of the market (5 versus 9), it could be considered undervalued.

Of course, other principles of valuation are also relevant. By the second principle, stocks are worth more to investors, other things being the same, if the company can finance its growth and still pay out a reasonable share of its earnings in dividends. On this score, one could probably justify a bit of a discount for Service Corp., since its dividend yield (based on the estimated dividend for 1980) was only about half of that for the market as a whole. Still, on balance, the extraordinary growth potential of the company had to be the dominant factor for valuation.

The firm-foundation theory also suggest that the riskier a stock, the lower the multiple it should sell at. While it is true that Service Corp. Was a small company and thus riskier than some of the more established blue-chip companies, other aspects of its business actually made it less risky than the general market. Service Corp. Had a great deal of resistance to economic downturns, since people do not stop dying during recessions. Moreover, it dealt in those markets where the parameters of growth could be relatively precisely defined. Hence, on this score, Service Corp. would deserve a premium multiple to the market.

It is also possible to use the empirical relationships to argue that Service Corp. Represented a good value. In 1980, when the analysis was made, stocks for which a 15 percent rate of growth was expected sold, on average, at over 15 times earnings, and Service Corp.’s multiple was only one-third of that. This further enhanced its appeal and made it an excellent candidate for multiple improvement. For all these reasons, Smith, Barney recommended purchase of Service Corporation International.

The Smith, Barney report represents the technique of fundamental analysis at its finest. People who followed its “buy” advice found that Service Corp. enjoyed much better performance than the market during the 1980s despite suffering some business reverses late in the decade which necessitated the company taking some large write-offs