When trends can be very telling about a company’s future

Everyone has a bad day once in a while, if not a bad month or even year. The same goes for companies. It’s not uncommon for a company to hit a rough patch, perhaps due to an unexpected economic slowdown or a flop of a new product. A company’s net income or revenue or both might take a big hit in any given year.

When is a bad year something to get worried about? Investors who don’t perform trend analysis might make the common error of placing too much focus on the latest data from a company. If a company reports a bad quarter, for instance, some investors might rush to conclusions and assume it’s game over for the company, and its profits are about to go into free fall. The opposite is also true: Trend analysis can save you from getting overly optimistic about a company that’s just on a recent hot streak.

Trend analysis can also save you from myopic and short-term thinking. Studying dramatic historical distortions in the market — which we can look back at now and know what really happened — illustrates the importance of trend analysis.

Rewind back to 2002. It’s a long time ago, yes, but the “tech bubble” still remains one of the best time periods for understanding the value of trend analysis. Just to refresh your memory, that year, technology companies were suffering a dramatic downturn in their business. Technology spending fell off a cliff in 2002 as companies cut back on buying computers and software. Technology stocks started to crash in 2000 and continued falling for years as investors figured the industry’s best days were over. Many years later we know how wrong that thinking was. Technology has been a big gainer for investors throughout the 2010s and 2020s.

But it wasn’t so clear amid the tech downturn. Even Oracle, a dominant maker of corporate software, wasn’t spared by the tech wreck. After years of delivering strong profit growth, Oracle stunned investors on June 18, 2002 with uncharacteristically weak financial results for the fiscal year ending May 31, 2002. The company posted operating income, or income excluding one-time charges and taxes, of $3.6 billion. That was a decline of 5.5 percent from the $3.8 billion the company posted in fiscal 2001. Some investors, buying into the tech-is-dead argument, didn’t like what they saw. They thought Oracle’s future was dim.

But fundamental analysts who took the time to examine Oracle’s long-term trend were unfazed. If anything, 2002 results were the anomaly, a disruption in what had been many years of steady growth. By studying Oracle’s previous five years of operating income, fundamental analysts saw the company had grown by an compound annual growth rate, or CAGR, of 30.6 percent between fiscal 1997 (ended May 31, 1997) and fiscal 2001 (ended May 31, 2001). Table 17-1 shows how steady Oracle’s operating income had been leading up to the 2002 slowdown.

Hopefully you’re wondering how I just calculated the CAGR, because I’m about to show you. Let’s take a break from our story to talk CAGR, which is a tool you’ll use when you want to see how a company’s growth has done over a period of time. CAGR is calculated using the same present value formula you discovered in Chapter 11, just rearranged a bit. The formula looks like:

CAGR = (Last amount ÷ Starting amount) ^ (1 ÷ Number of years)

Yikes. I know what you’re thinking: That’s one ugly-looking formula. You’re right: It’s not going to win any beauty contests. But using the Oracle data as an example, it won’t be so bad. All you need to know is the:

• Last amount: This is the financial result for the latest year that you’re studying. For Oracle, this is operating income for fiscal 2001, or $3,777.
• Starting amount: Here is the starting financial amount. For Oracle, this is operating income for fiscal 1997, or $1,299.8.
• Number of years: The sum of the years you’re calculating the average return. This is a little tricky. While we’re analyzing five years of Oracle’s financial history, there are really only four full years of growth: from 1997 to 1998, from 1998 to 1999, from 1999 to 2000 and from 2000 to 2001.

The resulting formula looks like this:

CAGR = (3,777 ÷ 1,299.8) ^ (¼) – 1

After you run these numbers, you should come up with 0.306. To convert that into a percentage, 30.6 percent, simply multiply by 100. This means that Oracle’s operating income had been growing each year, on average, by a robust 30.6 percent.

The ^ symbol tells you to take the number in the previous set of parentheses to a power. Most calculators will help you do this using a key, usually labeled y^x.

If you and math just don’t get along, this might be another reason why you might want to invest in a financial calculator such as Hewlett-Packard’s HP 12C. The calculator can crunch these present-value problems down with just a few keystrokes.

Attempting to forecast the future using trends

Trying to forecast what a company might earn in the future is extremely difficult. Many Wall Street analysts get paid big bucks to attempt to forecast future revenue and profit.

Historical trend analysis can be a helpful way to approach this extremely difficult task of forecasting. Sticking with the Oracle example, you can see how trend forecasting — along with some estimates — could be used to get a decent idea of how things would turn out after the 2002 tech decline.

It turns out fiscal 2002’s disappointing results were followed by another difficult year. Operating income fell another 3.7 percent in fiscal 2003, cementing the doubters’ beliefs that even the biggest technology companies had finally hit a wall, and the growth was gone.

Trend analysis, though, would help you know that growth wasn’t gone. It was just moderating a bit. Imagine that in 2002, when things looked bleak, you decided Oracle’s days of increasing operating income by 30 percent might have ended. But what about half that? Wouldn’t 15 percent growth be doable?

Although 15 percent growth isn’t 30 percent, that’s still outstanding growth for a company of Oracle’s size. A forecast of 15 percent growth, at a time when tech companies were struggling in 2002, would have seemed outlandish. But in reality, you would not be far off from what actually happened. Oracle’s actual compound average annual growth rate between fiscal 2003 and fiscal 2015 was 12.6 percent, as shown in Table 17-2. No, that’s not 30 percent growth. But it’s still a strong double-digit percentage many companies would love to achieve.

Paying close attention to Oracle’s financial trends could have been very profitable for you. While other investors panicked and sold, you could have found value. Had you invested in Oracle’s stock on June 18, 2002, right after it announced the lower earnings, and held through the end of its fiscal 2015 (ended May 31, 2015), you would have gained more than 384 percent. The market during that same time period gained just 103 percent. Not bad for a “dead” company, wouldn’t you say?

When forecasting a company’s future profit, it’s often best to use operating income, as I did in the Oracle example earlier. Operating income strips out one-time charges and gains, which are impossible to forecast, aren’t repeated, and can muddy up a historical analysis.

Note that Oracle’s operating income dipped again by 4.6 percent in 2015. This trend analysis showed the company at another important fork in its development. Fundamental analysts needed to look at the company anew and decide whether this would be a temporary blip, like it was during the tech crash in the early 2000s, or if something more concerning was afoot. And this time, the blip signaled a maturation of the company. Oracle largely missed out on many of the important technology innovations like smartphones and cloud computing. Being left behind in such critical areas of technology explains why Oracle’s operating income growth stagnated, as shown in Table 17-3. So, although companies like Apple, Microsoft, Alphabet and Amazon became the largest in the world, Oracle this time lost ground.

You can see that Oracle’s operating profit growth in the mid-2010s seriously hit the wall. Its compound average annual growth rate from 2016 to fiscal 2022 slowed to just 3.2 percent. That’s turtle-like growth, especially in technology. Oracle is a great example of how trend analysis, though useful, isn’t static. You must revisit your model, spot the trend, see if it has changed, and understand what the numbers are telling you.

Keep reading — and you’ll see some other ways to analyze growth (especially moving averages) to help you get a reasonable expectation for the company’s growth now.

Attempting to forecast the future using index-number analysis

Following the tremendous and sudden downturn in business when many companies suffered in 2008, fundamental analysts began wondering about the value of forecasting based on trend analysis. Similar doubts surfaced in 2020, when the world’s economy seized up due to COVID-19. After all, how can you trust a historical analysis when one bad year, or a pandemic, can come along and knock the whole model to smithereens?

One way to make sure your fundamental analysis has a long-term time horizon is by using index-number analysis. Despite the fancy name, index-trend analysis is just a way to see how a company’s financial results are changing over time. This analysis includes recent drastic ups or downs, but also lets you see the broader, long-term trend. You found out how to apply index-number analysis to the balance sheet in Chapter 6.

Index-number analysis, though, can also be applied to the income statement to help forecast a company’s growth rate into the future. The analysis attempts to help you put short-term declines in business into perspective.

To perform an index-number analysis, you just need to choose a year to act as a starting point, or base year. You then divide each year’s results by the base year and multiply by 100 to get the index number for the year.

For instance, imagine using Oracle’s fiscal 2000 operating income, $3,080, as the base year. To calculate the index number for fiscal 2001, simply divide that year’s operating income of $3,777 by the base year of $3,080, multiply by 100, and you get 122.6. Table 17-4 shows you how the index analysis puts Oracle’s downturn in fiscal 2002 and 2003 into perspective. Despite the downturn, the Oracle’s operating income kept chugging along. The index number never once dipped below the base year of 2000.

If you’re rolling your eyes thinking the tech-stock crash was so long ago it’s not relevant anymore, listen up. The tech-stock crash may be more than two decades old, but the lessons from that period are among the best ever taught to investors. It was one of the biggest market dislocations in history that fundamental analysts could have — and did — profit from. It’s an example fundamental analysts still talk about, so you should be aware of what happened.

Applying moving averages to fundamental analysis

Another technique used in long-term forecasts in fundamental analysis is the moving average. With this analysis, investors attempt to smooth out unusual bumps in a company’s results. A moving average serves the same role as your seatbelt when your airplane hits turbulence.

Moving averages may be applied to annual results or to quarterly results, based on how volatile the company’s profits are.

To conduct a moving-average analysis, you first must choose how many years you want to incorporate. A common time period would be three years. You add up the company’s results over three-year chunks and then divide by the number of years, or 3. Table 17-5 shows you what a three-year moving-average analysis on Oracle’s operating income would look like.

Using this analysis, you can see that the company’s compound average annual growth rate was really starting to slow down. Oracle’s compound average growth rate based on five moving-average periods is 8.8 percent. That might be a reasonable basis with which to make a forward-looking growth forecast. It also would’ve tipped you off to Oracle’s subpar performance in the mid 2010s and early 2020s.

When a CEO is bullish, should you be, too?

Ever go to a restaurant and notice the workers are eating the restaurant’s food, too, on their lunch break? There’s something kind of comforting about seeing the people in charge of a company using that company’s products.

Fundamental analysts carry that same idea when looking at companies. It’s often considered to be a positive sign when a company’s top management, including the CEO, is buying shares of the company. If nothing else, it’s comforting to at least know that the CEO stands to lose money, too, if things don’t work out.

It’s not just a theory. Shares of companies commanded by an executive who owns 5 percent or more of the shares outstanding have beaten the broad market, according to a study published in 2014 by Ulf von Lilienfeld-Toal of the University of Luxembourg and Stefan Ruenzi of the University of Mannheim. If the executives owned even more stock — 10 percent or higher — the stock outperformed even more.

Even CEOs aren’t perfect. Sometimes CEOs’ own optimism can lead to not-so-great investments in their company’s stock. In 1998, then-dominant PC seller CompUSA began reporting softening earnings, and the stock price was skidding. But James Halpin, an experienced retailer and CEO of CompUSA at the time, couldn’t have been more bullish about the company. He spent $3 million of his own money buying 200,000 shares of the company’s stock. “I didn’t wake up one morning and say, ‘Gee, I have this $3 million … what am I going to do with it?’” Halpin told Investor’s Business Daily in 1998. “People (insiders) sell stock for a lot of reasons. But they buy for only one.”

Turns out, though, the company’s future wasn’t all that bright. The company replaced Halpin just a few years later. Eventually the company wound up selling most of its stores and was ultimately sold.

Paying attention to when a company buys its own stock

Some investors think the ultimate bullish signal is when companies announce they’re buying back their own stock. What could be more bullish than a company investing in itself, right? From time to time, when a company feels especially flush with cash and deems its stock price to be cheap, it might plan to buy outstanding shares.

Turns out, though, companies have had pretty lousy timing when it comes to buying their own shares. Companies spent a record $158 billion buying back their stock in the second quarter of 2007, only to pay peak prices ahead of the market’s gigantic swoon. As companies were paying up for their stock, the Standard & Poor’s 500 hit its bull-market peak on Oct. 9, 2007 and proceeded to fall into one of the worst bear markets since the Great Depression. Something similar happened in 2021. Companies bumped up spending their own stock that year by nearly 70 percent. And guess what happened immediately after in January 2022? Stocks peaked and crashed into a bear market in just a few months. So much for good timing. Table 17-6 shows you how much companies have spent buying back their stock in recent years.

2007 and 2021 weren’t the only times companies had lousy timing buying their own stock. Stock buybacks surged in the first quarter of 2000 ended in March, just when the market was peaking and about to collapse.

There are additional risks to stock buybacks other than bad timing. When companies use cash to buy their own stock back, that is cash that wasn’t used to invest in future products or even to reduce the company’s debt load. Investors also would rather get extra cash back as dividend than see the company paying up for overvalued shares of the company’s stock.

Watching when the insiders are selling

When insiders sell stock, it almost instantly gets investors’ attention. Investors might fear the executives know something they don’t when there’s a great deal of selling going on.

Don’t assume just because the management team is selling shares that you should dump your holdings, too. CEOs may sell their stock for lots of reasons, such as paying for junior’s college or a new car or home renovation. But when you see a flurry of selling at a company, or an industry, it pays to be extra skeptical.

Many investors were shocked and surprised by the dramatic meltdown of the real-estate business and of homebuilders’ stocks starting in 2005. Everyone, that is, except the top executives at major homebuilding companies. Many of these executives, as a group, sold 4.8 million shares in July 2005, says Thomson Reuters. That was the largest level of selling in the industry since Thomson started keeping records in 1990. The timing couldn’t have been better, since the homebuilders’ stocks hit their peaks on July 20, 2005.

How to track insider selling

Now that you’ve seen how watching what the insiders are doing can be somewhat telling, you probably can’t wait to get started seeing how the other half lives. Here’s the problem. You probably can’t call or email the CEOs of companies you’re investing in and ask them if they’re buying or selling stock.

Fundamental analysis, again, is your way to get the full story. There are two main ways to track the insider buying and selling at companies, including from:

• Companies’ regulatory filings: Given how sensitive the topic of insider selling is, you can imagine how regulated it is. There is a whole array of filings executives must provide to the Securities and Exchange Commission when buying or selling company stock.

  The most common form containing insider-selling activity is Form 4. When an executive buys or sells stock, that activity must be reported on Form 4 within two business days. Form 4 documents are available in the SEC’s EDGAR database. Flip back to Chapter 4 if you want to refresh your memory on how to get regulatory filings from EDGAR.

• Financial websites: Several financial websites spare you the trouble of having to dig up Form 4 filings yourself and compile all insiders’ buying and selling in one place.

  The Nasdaq’s website provides comprehensive insider-trading data. At Nasdaq.com, enter the stock’s symbol and click on the name of the company when it pops up. Next, scroll down and click the Insider Activity option located on the left of the page. You’ll get a summary of how much insider buying and selling is going on. You can also drill down and get the names of the executives doing the buying and selling. There are also dedicated websites for tracking money moves by big-time investors like Warren Buffett. One such site is WhaleWisdom (https://whalewisdom.com).

Examples of what screening can tell you

Screening is fundamental analysts’ way of narrowing down the search for companies that have all the traits they are looking for. By carefully instructing the screening tool to filter out the universe of all stocks for only those with certain characteristics, fundamental analysts can get a shorter list of strong candidates that deserve closer attention.

Typically, stock screens fall into one of several categories, including those that look for:

• Cheap stocks: By searching for stocks with low valuations relative to their industry, such as price-to-earnings ratios or price-to-book ratios, investors can pinpoint potential bargains.
• Fast-growing companies: Investors who like to find companies that seem to have momentum on their side often seek out those with strong earnings or revenue growth.
• Efficient companies: Pinpointing companies with strong efficiency ratios, such as accounts receivable turnover, are often the ones handling their resources effectively. Chapter 8 discusses efficiency ratios and other ratios you may decide to include in a screen.
• Well-managed companies: Ratios like return on equity and return on assets, especially compared against peers, can give fundamental analysts an idea of which companies have an able set of hands behind the wheel.
• Financial strength: Companies with excellent balance sheets, filled with cash and light on debt, may be well-positioned to endure an economic downturn.

You may build screens that find companies that score well in all the areas listed here. Some professional fundamental analysts screen for companies based on dozens of criteria.

Step-by-step instructions on building a sample screen

Now you’re ready to stop reading about screens and start building them. I’ll give you an example of a basic screen in this section: A list of the largest companies, based on market value, that are large core stock holdings and that also generate return on equity that’s greater than 15 percent.

I’ll be using Morningstar’s screening tool for this example, but this is not the only stock-screening tool that is available to you. Several websites offer screening tools; some are free and others require a subscription. Here are a few of the screening tools available that are helpful for fundamental analysts:

• Finviz: https://finviz.com/screener.ashx
• Google Finance: www.google.com/finance
• MarketSmith: https://marketsmith.investors.com
• Morningstar: https://screen.morningstar.com/StockSelector.html
• MSN Money: www.msn.com/en-us/money/stockscreener
• Zacks Investment Research: www.zacks.com/screening/stock-screener

If online screening interests you and you want to know more, more details about stock screening tools are available in my Investing Online For Dummies, 10th Edition (Wiley) book — yes, another shameless plug.

Building this sample screen requires taking these steps:

1. Log into the screening system. You can try Morningstar’s screening tool at https://screen.morningstar.com/StockSelector.html.

2. Set your first criteria. Here you tell the screener to only find the companies with the largest market capitalizations. You can review what market capitalization is in Chapter 3.

   In the fourth row of the screen titled “Minimum market capitalization,” you can instruct the screener to filter its results for companies with market values of $10 billion or more.

3. Set the second criteria. Here you want to limit your list to companies with stellar return on equity of 15 percent. Scroll down in the screening tool to the Company Performance section and change the “Return on equity (ROE) greater than or equal to:” field to 15 percent.
4. Set the third criteria. To limit your search to large core companies — those you might find in the Standard & Poor’s 500 — go to the Stock Basics section of the screen and change the “Morningstar equity style box:” field to “Large Core.”
5. Run the screen. To see the results of your screen, just scroll all the way to the bottom of the screen and choose the Show Results tab. You’ll get a list of companies that would be a good place to start for further analysis.