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Derek Chipman
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Derek holds a B.B.A. in Finance, Economics, and is a candidate in the CFA program.
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  • The Dow's Fundamental Score

    Despite the anticipated bull-market rally from January to March, many market participants seem to wonder if a correction is on the way. The Dow Jones industrial average (DJI) is suppose to be a benchmark reflecting the performance of the market as a whole, however it has yielded a high return over the last month. January's strong US auto sales reported by General Motors (NYSE:GM) and Ford (NYSE:F) in combination with optimism surrounding the outlook for US jobs, sent the Dow soaring last Friday. On Friday, it was the first time since October 2007, the Dow broke 14,000. After witnessing this increase, I cannot say I disagree with anyone who thinks a short-term market correction is on the way. But regardless, the question surrounding fair value will continue to exist. Does the fundamental performance of each underlying security within the Dow, support its current price?

    For many, the price of the Dow is merely a number. A number that is a more accurate measure of how a trader feels about the economy, than an investor with a long-tem focus. Since January 1st, the Dow has yielded nearly 6.91%, and has a current price to earnings ratio of roughly 13.71x. Since 2009, the Dow's average return on equity has increased to 30.5% from 25.5%. But in terms of both gross and profit margins, we have yet to see a full recovery. This article provides a broad overview of the fundamental performance of the all thirty securities underlying the Dow through a scoring methodology that uses Poitroski's Fundamental Score.

    The fundamental scoring model used in this article is a slight variation of Poitroski's traditional model. For those who are unfamiliar with this model, it is simply a combination of nine different accounting checks used to derive a final score reflecting the quality of a specific firm. The final score is a discrete number ranging from zero to nine that focuses on a firm's financial position through concentrating on three key areas. These three key areas include profitability; leverage, liquidity, and source of funds; and operating efficiency. The maximum points that can be achieved from each category is four, three, and two respectively. Each firm receives a point for every constraint it satisfies below.


    1. Positive net income in the current year
    2. Positive operating cash flow in the current year
    3. Return on assets must be increasing and greater than the previous year
    4. Operating cash flow must be greater than return on assets and net income

    Leverage, Liquidity, and Source of Funds

    1. Lower level of long-term debt in the current year relative to the value of total assets in the previous year
    2. The current ratio must be greater than the previous year
    3. There must be no additional equity issued in the previous year

    Operating Efficiency (maximum, 2 points)

    1. Gross margin must be progressively increasing and higher than it was in the previous year
    2. Asset turnover must be increasing as well and higher than it was in the previous year

    The Fundamental Scoring Model

    The output shown below illustrates the fundamental score of each company in the Dow as well as the firms score for every category. Notice the firms have been ranked in alphabetical order and not by they fundamental score they received. The output of this model revealed a decent variation in the results. Not a single firm received a score of nine. The top two firms, Cisco Systems (NASDAQ:CSCO) and Home Depot (NYSE:HD), both received a score of eight. Next in line was Walt Disney (NYSE:DIS), AT&T (NYSE:T), and The Travelers Companies (NYSE:TRV), which all received a score of seven. The remaining twenty-five companies in the Dow received a score less than or equal to six. The stand-alone arithmetic average score of the overall index is 4.6, which is extremely low. If you take a close look at the figure below, you will notice the variation between a pass and fail score is easily distinguished by the green and pink highlighting, respectively.

    Among the three categories, profitability appears to be the Dow's strongest fundamental attribute. With the exception of Hewlett- Packard (NYSE:HP), every firm within the Dow displays positive operating cash flow. The parameters evaluating the quality of these firms earnings revealed great results, which is expected given positive signs of strong operating cash flow across the board. In regards to profitability, the primary concern is return on assets. From year over year, more than half of the firms in the index have failed to improve their return on assets.

    (click to enlarge)

    As indicated by the cells highlighted in pink, the key issues concerning these firms within the index are primarily concentrated around the right portion of the chart. This area includes operating efficiency, liquidity, and leverage. All of these factors have major implications on a long-term growth. A firm's sustaintable growth rate is indirectly a function of its leverage and operating efficiency. And the ability for a firm to sustain long-term growth can be heavily influenced by poor performance in these areas.

    In regards to leverage, the issue lies at the heart of a firms capital structure. This model does not take into account the specific value of a firm's weighted average cost of capital, however it contrasts its long-term debt with its assets from the previous period. This provides an understanding as to how leveraged a single firm is in terms of its financing through debt. As you will see above, this model reveals that majority of these firms are using a substantial amount of debt financing. In terms of liquidity, this model suggests roughly half of the firms in the Dow are experiencing lower levels of liquidity now as opposed to the previous year. Majority of the firm's current ratios declined over the past year. Five of the firms that improved their current ratio from the previous year engaged in the issuance of new equity. Using equity issuances for sources of funds was most likely utilized for paying off portions of long-term debt as well as finishing up existing projects. The last category this model focuses on is operating efficiency. Unfortunately, this area does not reveal the most promising results. The only three firms to pass both constraints under this category are HD, T, and Walmart (NYSE:WMT). All three firms not only increased gross profit margins from the previous year, but also have displayed a progressive increase in its turnover on fixed assets.


    Considering the definition of accuracy, all models are wrong. The value added from a model is not if its 100% right or wrong, but rather how its utilized. The value added solely derives from the utility you receive from it. In practice, as long as the underlying assumptions and data used in the model are credible and precise, the model therefore has a useful purpose. The model used in this analysis takes into account these firm's most recent financial data and was constructed with the intent of providing a big picture view of the financial condition for each firm in the Dow. Overall, the firms within the Dow are exhibiting strong levels of profitability, however there is a lot of uncertainty surrounding capital structure and operating efficiency. In the short-term, I feel a small-correction as a result of traders selling off positions to retain profits is highly plausible. However, my main concerns still reside underlying long-term growth prospects because lowered levels of liquidity and declines in operating efficiency will only suppress long-term growth.

    Sources: TD Ameritrade, Bloomberg, Google Finance, and The Wall Street Journal.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Tags: CSCO, DIS, F, GM, HD, HP, T, TRV, WMT, market-outlook
    Feb 11 3:05 PM | Link | Comment!
  • Investment Strategies For Profting Of Alcoa's Success

    In a recent article of mine, "Alcoa's Short-Term Price Volatility Is Irrelevant; It's Time To Look At Future Growth", I provided a deep overview of Alcoa's (NYSE:AA) fundamentals and initiated a buy rating based off improving economic conditions in combination with the expected increase in the price of aluminum. As I stated in my previous article, it is clearly understood Alcoa's profitability is linked in one or more ways to the price of aluminum. And as a result, the volatility swarming commodity markets seems to steer individuals away from investments as such with the potential down side risk that may arise from this connection. The use of options with an underlying positon can effectively help avoid this. This article provides an overview to a different investment strategy that can be utilized to benefit off an increase in Alcoa's price over the next two years, yet help preserve your capital with only a minimal level of exposure to downside risk. Specifically, this options strategy caters to two different investment horizons ranging from approximately one to two years from now. For further detail on the company please visit my previous article and Alcoa's company website.

    To clearly illustrate this strategy, I am going to use the one year price target I computed of $20. Note this is my price target for the end of December FY 2013 and while the expiration date of the options contracts I will discuss exceed this date, it is important to recognize American call options can be traded or exercised up to any point before or on the date of expiration. Please refer to my first article for details behind this calculation. This options strategy involves using a regular call option. Looking at figure 1 below, you will see Alcoa is trading at roughly $8.85 per share. Hence, at this market value per share Alcoa is nearly $11.15 from my price target, which suggests a significant upside.

    Figure 1: AA's Five Year Price Graph

    (click to enlarge)

    Initiating a long position in a single company provides exposure to ones capital that is not suitable for everyone due to a wide assortment of risks. There are many additional ways to benefit from the potential rise in Alcoa's price and in this scenario a call option is most appropriate. Below I have provided the most recently updated options chain for Alcoa call options expiring on January 18, 2014 and January 17, 2015, which can be easily at Google Finance. For both investment horizons, I am going to focus on the options contracts with a $10 strike price.

    The closing price for one Alcoa call options contract expiring on January 18, 2014 at a strike price of $10 was $0.49, or the equivalence of $49 per contract. This provides extreme leverage for individuals striving to benefit from future rising prices in Alcoa's security market price, but do not want to suffer in the case there were to be a significant decline in its security market price. In other terms, by January 18, 2014 if Alcoa's security market price per share was below $10 and the investors still remained holding the contract, it would expire worthless and the investor would face a maximum loss of the premium he paid, which in this case was $49. As you can see, the potential leverage to be achieved can be significant, while an investors loss is capped at a maximum.

    Figure 2: January 18, 2014 Call Options Chain

    (click to enlarge)

    This next options chain for Alcoa extends the investors horizon by an another year, which you will see is priced into the premiums in contrast to the options chain expiring one year prior. Notice the variation in the premiums for the call options with a $10 strike price in contrast to the previous year. This takes into account maturity and from one view implies market participants may have a more bullish view of Alcoa's performance in FY 2014 as opposed to its performance in FY 2013. But from a broad perspective, the major difference is there is a $52 dollar difference in the premium for contracts with an expiration date of one year longer in maturity.

    Figure 3: January 17, 2015 Call Options Chain

    (click to enlarge)

    If Alcoa's market value per share reaches $20 on or before January 18, 2014, the total profit for investors would be $951 per contract, and respectively $897 per contract for options expiring the following year. This assumes a $49 and $103 premium paid per contract for January 17, 2014 and January 18, 2015, respectively and excludes brokerage transaction costs. Note after Alcoa's market price per share exceeds the strike price of $10 it is classified as in-the-money, and due to the nature of being an American option can be exercised on or anytime before the expiration date. Therefore, investors will begin to profit as they surpass the value required to break even, which is simply the strike price plus the premium. The break even point for the call option chains for 2014 and 2015 are $10.49 and $11.03, respectively.

    In addition two these two investment strategies, there is another alternative that is more conservative in nature and suitable for those interested in initiating a long position in the security its self. This strategy involves initiating a long position in the security and simultaneously purchasing put option contracts that correspond with your desired investment horizon. These contracts will hedge the investors position to a decline in Alcoa's market price per share. Given analysts expectations surrounding the future price of aluminum, the most suitable investment horizon for this strategy is roughly two years. Looking at figure 3 below, you will see the premiums for the $17, $15, $12, and $10 are all significantly high and this is because of all these options are currently in the money. Put options are inversely related to call options and principally exactly the opposite. For instance, if one were to purchase 100 shares of Alcoa at its current market price per share of $9 with the intention of holding the underlying position for quite some time, the investor would then want to purchase one put option contract with a strike price of $10 as the price of the security slowly increases. In this case, by waiting for the security price to increase closer towards $10 per share the premium for which you can purchase the put option for will decrease because it will be closer towards being out of the money.

    Figure 3: January 17, 2015 Put Options Chain

    (click to enlarge)

    In conclusion, Alcoa has serious potential to provide investors with a substantial upside and utilizing options is just one method for investors to benefit from Alcoa's success.

    Sources: The graphs and options tables used in this analysis were retrieved from YCharts and Google Finance.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Feb 03 3:23 PM | Link | Comment!
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