Sunday, October 25, 2009

Why Catholic Investors Should Use Fundamental Analysis - Part I of II

Fresco at the Vatican, by Michelangelo, depicting the personifications of Fortitude, Prudence, and Temperance

The Virtues
In Catholic teaching, there are 2 major categories of virtues: human virtues and theological virtues. Theological virtues (i.e. faith, hope, and charity) are the basis of all other virtues and they relate to God. The human virtues, virtues that help us do good, are divided into 4 Cardinal Virtues: prudence, justice, fortitude, and temperance. Today, we will look specifically at the virtue of prudence.

Prudence, as defined by the Catechism of the Catholic Church (CCC 1806), "is the virtue that disposes practical reason to discern our true good in every circumstance and to choose the right means of achieving guides the other virtues by setting rule and measure." Simply speaking, prudence helps us choose good and how to attain it with care. It is a virtue that proves to be invaluable to every investor.

Reckless Investing
When not using prudence in investing, it becomes what I call, "reckless investing". I have done some of that myself. It was the year 2000...I was 22 years old and had a beautiful image of the world (I still do, but in a different way). I have heard about people buying and holding stocks and making a small fortune over time.

I was hired as an engineering intern at Celestica, Inc. (Ticker: CLS). The dot-com days were coming to an end, but I had no idea. It seemed like everyone was doing very well in their stocks, because as we all knew, the internet will revolutionize the way we do everything! And the high-tech companies that were involved with manufacturing the infrastructure were bound to benefit. So, I bought into this thinking and invested my savings into the likes of Celestica, Nortel (ticket:NT...but they're in bankruptcy protection now, so you won't find much), AMD (ticker: AMD) and Nvidia (ticker: NVDA).

At that time, I had no idea what fundamental analysis was. Heck, I didn't even know what technical analysis was. I simply just bought stocks that had names attached to "tech". The most that I did was look at the stock's chart and extrapolated into the future to see how much money I would make. What happened after that, you are all fully aware. I made a couple of thousand of dollars at first, but soon saw much of my investment vaporize into thin air. This is the perfect example of "reckless investing".

Why was it reckless? Let me illustrate with an analogy. One sunny Sunday afternoon, you walk into a flea market. You want to buy something, but you don't know what. Soon, you see a crowd gathering around a booth, swarming to buy a gadget you have never seen before. You have no idea what the gadget does, but it does look kind of fancy with some spinning fins and a long cord. Most of the people around you don't know what it was either, but they all know it was a good buy since everyone else was buying it. So, you whip out a fresh $20 bill and hand it to the seller. As you walk home with the gadget, you admire at how shiny it is. Once you get home, you show it to your wife. She takes a look and says, "Hey, that's the USB fan they were selling on TV for $3.99 including shipping!"

That story sounds a little unbelievable, but that is exactly what investors were doing in the late 90s and early 2000s. They bought into companies, which they had not a clue what they were about, but most of all, they had no idea what they were worth. This is a result of lack of prudence on the part of investors. To be prudent is to know what a stock is worth and buy at a price below that.

Fundamental Analysis
Fundamental Analysis attempts to find the value of each stock. It's like buying bread at the supermarket. Even if everyone was buying a loaf of bread at $200 per loaf, you wouldn't pay $200 (unless there was a widespread famine), because you know a loaf of bread is only worth $3. Therefore, fundamental analysis seeks to find the intrinsic value of a stock.

Before we begin, let's look at a misconception of how stocks work. Stocks are traded in a stock exchange (e.g. New York Stock Exchange), where you, me, Warren Buffet, or the bum down the street may have access to (as long as we each have an account with a broker). The price of a stock at any given moment is simply the last price at which it was bought/sold. There is absolutely NO fixed relationship between a company's assets, earnings, or future prospects with how much a share of its stock is sold for. It is entirely determined by the price people are willing to buy/sell the stock for. However, having said that, people who buy/sell stocks are somewhat rational (at least most of the time), and will look at the company's well-being to determine what price is right.

There are instances where euphoria or depression hits the entire stock market. You can find evidence of the former in the late 90s where companies were bid up to prices hundreds of times above their earnings. The latter occurs in more recent memory in March of 2009, when the S&P 500 hit 666 points, more than 55% off its peak. The stocks were either traded at prices way above or way below what they were worth. So, our quest is to find out what the stocks are worth, buy at prices way lower than their worth, and sell at prices way higher.

Some Basics
Instead of looking at public companies, let's look at a small business to simplify things. Say your brother-in-law comes to you one day and proposes a business deal. He wants you to chip in to buy a local coffee shop. "Hmm," you think to yourself, "How do I know I'm not buying a sinking ship?" You then ask him to show you some numbers.

The current owner is asking for $500K for the coffee shop. For the past 5 years, business has grown from making profits of $40K/year to $75K/year. You have to admit, as well, that their coffee is pretty darn good. Ok, you say to yourself, if we invest $500K to buy this coffee shop, how long is the payback period? Assuming the profits continue to hover around $75K/year, it would take you a bit more than 6 years to recoup your initial investment. After that, it's all free money! You decide that it's a good deal and go ahead with your brother-in-law's proposition.

What we just looked at is the Price-to-Earnings ratio or P/E ratio as it is more commonly known. We essentially divide the price of a company by the profits it makes in the last year. How does that work for a stock? It's pretty much the same. When you research into a stock, you will readily find the earnings per share (EPS) published. That number is calculated simply by dividing the money the company makes in the last 12 months by the number of outstanding shares. You can then calculate the P/E ratio by simply dividing the share price by the EPS.

So you now know what the P/E ratio is, but how do you use it? It's simple. If the P/E ratio of a company is 1, it means in one year, the company made the same amount of money as it is currently valued. It is an excellent deal for a stable company, because you know the money will keep rolling in and you will have recouped your money in one year. There's very little risk in this investment.

If you find a company with a P/E ratio of 100, it would take 100 years for you to recoup your initial investment if earnings were to be kept consistent. That would not be a good deal!

The S&P 500 have averaged a P/E of between 12-18 in the past 50 years. For a company with steady earnings, you can expect the P/E to be around 10. For a growth company, the P/E can be 15 - 40. Many companies in the dot-com days had P/Es of greater than 100! As you can see, its not an exaggeration when I call my investing, reckless investing!

To Be Continued...
The P/E ratio only paints a small part of a bigger picture. If you find a company with a P/E of less than 5, it doesn't necessarily mean you have found a gem. The company may be in decline and its competition is about to wipe it out. Conversely, if you find a company with a P/E of greater than 100, it does not necessarily mean that it is overvalued. It may have been losing money in previous quarters, but the business is turning around. Earnings barely broke even, and therefore, the P/E ratio is inflated. Or, maybe the company is in growth mode and its earnings are on a straight trajectory to the moon. We need to look at many other factors to determine the value of a company.

In the second part of this post, I will go into more depth the different tools an investor can use to estimate a company's value.