Challenges Facing an Independent Fundamental Analyst

by: Kevin Kelly

I received an email from a reader, Ryan, yesterday. Ryan had this to say:

What’s the point of studying the fundamentals? I know things can be cheap and all, but really how can you outsmart a team of analysts?? At least with TA [technical analysis] you have a chance…

Ryan makes a point that I hear very frequently against fundamental analysis – how can the individual investor gain an edge over the big firms. The truth is there are different types of fundamental analysis. For example, one person might use the fundamentals of a company to speculate on an earnings report (e.g. Jim Cramer betting on a tech stock beating analyst forecasts), another might use the fundamentals to find the fastest growing companies in a given sector, and so on. However, the type of fundamental analysis that I subscribe to is studying a company to find its true value. How does one come about finding a true value? Why isn’t the stock already trading at its true value? Why can I do better valuations than large firms?

A company’s true (or “intrinsic”) value can be determined several ways. The textbook definition of intrinsic value is “the present value of a company’s future cash flows discounted back at an appropriate rate.” However, this is a very hard method for most market participants to apply as it’s rather hard to predict a company’s cash flows to infinity. In addition, there is controversy over finding a proper discount rate — (weighted average) cost of capital (academia) versus opportunity cost (Charlie Munger). That being said, I always use a very conservative discounted cash flow model in my valuation process to - at the very least - find a very conservative valuation using safe assumptions.

A more concrete way to find a company’s true value is to study the firm’s assets. This is rather easy method for a cash-rich company but it becomes harder to apply as you move further down the balance sheet. For example, how should you value the company’s property, plant and equipment line? How should you value accounts receivables? Etc. But because this is difficult, the pricing is often inefficient and becoming an expert in this type of valuation, as Marty Whitman has, can obviously be a very rewarding use of time. The simplest way to know a company is cheap is to find a company below its cash value with no debt and losing little (or no) money. HRSH was in this situation earlier this year and Shai Dardashti emailed me about it on March 31st. Since then the stock is up about 80% versus about 4% for the S&P. In addition, investors can try to find companies trading below their “working capital.” I find working capital by subtracting all liabilities from net current assets. This figure is more conservative than the Investopedia definition in which they recommend only subtracting current liabilities. current assets minus all liabilities. Mike Price highlighted one of these situations, LKI, on his blog here and since then the stock is up 18% versus 7% for the S&P. While both of these gains occurred relatively quickly, this is not always the case.

Another way to find a company’s value is finding its correct comparables in the public market and applying the ratios (e.g. EV/EBITDA, EV/FCF, EV/EBIT) that the comparable carries to the company you’re valuing. This should not be your primary valuation as it is very difficult to find an “apples-to-apples” comparison. When looking for a comparable company be sure to see similar balance sheet conditions, margins (gross, operating, net) and returns on equity, capital, and assets.

Sometimes I use “scenario analysis” as I did with Home Depot. As such, I look at potential earnings growth, multiple expansion and dividends to formulate a probabilistic value. I apply various multiple, earnings and dividend scenarios, apply a percentage of likelihood to each, and arrive at a valuation. For example, if I thought there was a 30% likelihood of a $41 intrinsic value, 40% likelihood of a $45 intrinsic value, 20% likelihood of a $48 intrinsic value and 10% likelihood of a $54 intrinsic value, I’d arrive at a value of roughly $45 per share. These percentages are found by ranking your confidence in your projected multiple and EPS levels.

The last method I typically apply in valuing companies is an LBO model. In doing this I make assumptions as to what a leveraged buyout [LBO] firm could pay for a stock and still make a very solid return on their investment. I assume various levels of debt, interest costs, cash flows, and so on. For this valuation I use numerous proprietary spreadsheets to arrive at a value.

Why isn’t a stock always trading at its true value? As you can probably gather from my various valuation scenarios, it would be impossible for the market to always price a stock at its true value. In fact, a stock has no perfect value. However, if you have valued a stock using rather conservative inputs in all your methodologies and have arrived at a valuation significantly above the current stock price, the idea is worth continued research. A stock often trades at a significant discount (or premium) to its conservatively appraised value due to excessive investor optimism or pessimism or structural sell-offs or purchases. An example of excessive pessimism can often be seen when a stock sells off 20-40% due to missing analyst forecasts and receiving downgrades. An example of a structural sell-off is when a company is spun off from a larger parent company. Because several large mutual funds who owned the parent company are “large-cap only” or “mid-cap only” they must immediately sell the small/mid-cap spin-off, even if it is undervalued. I recently highlighted a spin-off here. Structural buys occur when a stock is added to an index and the index funds are forced to buy that stock.

Why can I do valuations better than large firms? Well, I probably can’t. However, I don’t have the limitations and pressures facing many Wall Street analysts and firms today. For example, many analysts are pressured to downgrade a stock simply because it is going down. Why? In the analyst world, emphasis is placed on the short term upcoming events (e.g. monthly sales numbers, quarter-to-quarter earnings per share, etc.) rather than the long term valuation. In addition, many hedge fund and mutual fund analysts can’t employ the simple strategy of “time arbitrage” – purchasing a clearly undervalued stock (such as Home Depot) because they don’t know exactly when it will go make a move (there is no definitive catalyst). Because the hedge/mutual fund industry is so competitive, many funds are afraid to purchase a clearly undervalued stock if it might have 10-15% “quotation loss” risk, as such this creates an inefficiency.

Regarding your comments on technical analysis: I do occasionally look at the technicals however, I’ve found their predictive value to be less than satisfactory and therefore quite a waste of time. In the long run I figure studying and understanding companies and their values is more beneficial than knowing where to draw the fresh line on a gold chart. For example, if I want to purchase a small business, help a family member analyze a business opportunity, etc. then my knowledge of appraising public companies certainly will help. As Warren Buffett said, “I’m a better investor because I’m a businessman, and I’m a better businessman because I’m a better investor.”