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In this article, I will try to explain some of my opinions on fundamental analysis and how to reconcile the stock price if it does not seem to agree with the facts on the financial statements of the company. Such an analysis is a good way to understand why some companies trade at 10X sales when they lose money on their operations, while others trade at 5X operating earnings although they have a spectacularly profitable and stable business.

The main argument that I would like to make is that fundamental analysis, especially in the stock market, should not be limited to only the financial statements and DCF analysis. It should also include other fundamental reasons investors are putting money into (or selling) certain stocks. In my opinion, such an extended analysis of the fundamental reasons of investor sentiment for a certain stock should also predict the medium-term price developments of that stock more precisely than financials statements alone.

To make my argument a little clearer, I would like to use some specific examples. The sectors and the stocks that I would like to concentrate on are below.

Cloud stocks:

Salesforce (NYSE:CRM), F5 Networks (NASDAQ:FFIV), RedHat (NYSE:RHT), Fushion-IO (NYSE:FIO), Netsuite (NYSE:N), NetApp (NASDAQ:NTAP), Qlogic (NASDAQ:QLGC), DemandWare (NYSE:DWRE), Splunk (NASDAQ:SPLK)

Solar Stocks:

First Solar (NASDAQ:FSLR), LDK Solar (NYSE:LDK), Sunpower (NASDAQ:SPWR), TrinaSolar (NYSE:TSL), SunTech Power (NYSE:STP), Yingli Green Energy (NYSE:YGE)

Cloud Stocks

The Problem: These stocks usually have valuations that are baffling to even seasoned speculative investors. Many of the stocks trade around 10X sales. Many of the companies in this sector also routinely lose money on their operations, although they try to explain that by using adjusted earnings measures. The main argument of the bulls that invest in these stocks is that the revenue growth is phenomenal.

However, the reality usually is that the revenues grow only because these companies aggressively push their products at levels and structures that make them lose money. It is quite obvious that if these companies changed their structures so that they would start to be profitable, their revenue growth would slow precipitously.

The strange thing is that some of the companies that actually run profitable operations such as NetApp and QLogic are usually the ones that are valued at way lower valuation multiples. It is as if losing money is preferable to making stable profits for the investors in this sector. Another strange thing is that the valuation anomaly in some of the stocks such as Salesforce has been quite persistent, as they have been that way for more than three years, as of this writing. So why is this seemingly "scamish" sector able to survive?

The reason: It is just a hopeless exercise to try to understand the valuations on these stocks based on their operating metrics. The real reason these stocks trade at the levels they do is something completely different than their financials. These stocks have served a special function since the financial crisis and that is fulfilling the demand from speculative investors.

Some investors choose to invest in stocks for a single reason: The probability that the specific stock they hold can increase by more than 20% in a single day or can triple in a single year. These investors don't choose to invest that way because the profits justify the risks. The risks are obviously very high. However, it is the possibility of making such a huge profit on a short-term investment that is enticing to these investors. Some investors might strongly disapprove of such investing activities, but that doesn't change the fact that such investors do exist.

The way to justify such speculative investments is to move the investor attention away from profitability and to focus it on revenue growth prospects. Cloud stocks are doing this exact thing. And the key reason that investors tolerate the high valuation levels is that since the financial crisis, cloud stocks have been the only sector to generate revenue growth that is high enough to justify speculation.

Although cloud stocks have accomplished revenue growth at the complete expense of profitability, they are unfortunately the only choices in large stocks that have generated revenue growth of 30% or more annually. To put it in simpler terms, high rates of revenue growth is the only way to make a large stock move in a speculative way, and cloud stocks are the only ones that have been able to generate such growth. What proves that reasoning even furthermore is that some companies in the cloud sector which have very profitable operations, but rather slower growth, have been severely punished by investors. A great example is NetApp, which is very profitable, but has been reduced to almost 5X EV/EBITDA.

That, in no way, indicates that the business models of these companies are sustainable. These companies will crash very hard when speculative investors move on to another sector. However, it is an indication that to go short these stocks because of the valuation multiples, is the wrong premise to trade on. These stocks trade at the levels they do not because of their fundamentals, but because they serve a specific purpose in the stock market.

Solar Stocks

The problem: Solar stocks, very interestingly, experience the exact opposite of the situation in cloud stocks. Solar stocks have generated great revenue growth and they too have started to lose money on their operations due to the decline in solar panel pricing. However, unlike cloud stocks, investors choose to concentrate on the profitability of the business, rather than revenue growth for the solar sector. So why the discrepancy in investor approach to valuing such a growing sector? And why aren't the value investors negating the effect of speculators, as many solar stocks trade at roughly 3X their operating earnings in 2010 when solar panel pricing were at more reasonable levels?

The reason: The main reason behind the decline of solar stocks is that they have served the demand for speculative investment, but in this particular situation, the demand from the short speculators. Basically, the premise behind shorting the solar sector is that solar energy is not viable and that many of the companies in this sector will simply cease to exist. In simpler terms, investors are simply speculating not on the valuation of the company, but on the possibility of many of these companies going bankrupt.

Such speculation on the short side is harder to establish since value investors would come in to buy up the stock once the valuation reaches very low levels. However, there have been some factors that have prevented this with the solar stocks - which have made it easier for the short speculators to prevail.

One reason is that value investors usually concentrate their efforts on larger and more stable stocks. Unfortunately the market caps of many solar companies, such as LDK and Trina Solar, have decreased so much that they don't merit the attention of larger institutional value investors. Even if they wanted to make investments, a $50-million institutional investment would make a $300-million market cap stock probably triple and that would negate the value argument anyway.

Another reason is that the Eurozone is the leading consumer of renewable energy modules. The crisis in Eurozone has unfortunately overlapped with an oversupply of solar panels, which has put the solar sector in an unexpectedly bad macro environment.

In my opinion, there is one more factor to consider though, and it might make this sector survive the speculative short attacks. The solar sector has proven to be the most profitable and viable in the green energy sector. Its problems are due to over-investment in the sector by the Chinese not a flaw in the viability of solar panels. If it weren't for the Chinese investment practices, the sector would be largely profitable as was the case in 2010.

Some investors choose to attack the Chinese solar companies precisely for that reason, that the companies that are going to go bankrupt are the Chinese ones. However, these companies have fairly large operations with many companies having revenues of a couple billion USD. In my opinion, there is effectively no chance that the Chinese would let such large companies go bankrupt. Once that fact is realized by the investors, the investment mantra on solar stocks might change abruptly. All the speculators that short the stock on the premise that these companies will go bankrupt might cover their shorts and go long on the premise that there is no chance that these companies are going bankrupt, despite their financials. That might, then make solar stocks soar.

In my opinion, such analysis of the reasons for investor demand and sentiment should also be a part of the fundamental analysis of stocks. I will try also to follow up with another article to analyze mREITs and commodity miners using a similar premise.

Disclosure:

I am long FSLR, YGE.

Source: Fundamental Analysis Isn't Just About Financial Statements: A Look At Cloud And Solar Stocks