Chapter 18
IN THIS CHAPTER
Finding out why ignoring fundamental analysis might expose you to investment losses
Exploring past speculative bubbles to see which fundamental data provided warnings
Understanding why poor investment decisions are so difficult to recover from
Considering a few of the financial shenanigans companies might play and how to spot them
In many sports, simply not making mistakes can be the best way to win. In tennis, for instance, blunders you make yourself are called unforced errors. Too many unforced errors usually give your opponents an easy victory, even if they’re not all that good.
Reducing the number of errors you make is also important in investing. As you’ll discover in this chapter, making too many unforced errors in picking the wrong investments can sink your returns. Fundamental analysis, while not perfect, can be a vital tool in allowing you to avoid at least some colossal disasters.
Making big mistakes in investing can dig you into a hole that’s extremely difficult, if not impossible, to climb out of in a timely fashion. If fundamental analysis prevents you from making just one blunder, it’s well worth your time.
Part of the process of avoiding mistakes is steering clear of companies whose fundamentals aren’t sound for various reasons. Sometimes you might not know for sure a company is about to implode. But fundamental analysis can give you the tools that may signal to you, at least, something about the company’s financial reporting doesn’t smell right or displays some common red flags. By sticking with companies that have high quality of earnings, or reported results that accurately reflect the businesses’ health, you can go a long way in avoiding the many land mines that are so easy to step on.
It might seem like a marketing gimmick in a book about fundamental analysis to claim that not using fundamental analysis might be dangerous. Maybe the word dangerous is a bit strong. After all, you probably won’t die if you don’t read a company’s income statement or balance sheet before investing in it.
But, if you’re assuming the risk of picking and investing in individual companies, not having a knowledge of fundamental analysis can expose your portfolio to some trouble. Buying individual stocks because you believe the company’s prospects are strong may prompt you to pay sky-high valuations for untested companies with shaky fundamentals. That’s a recipe for poor returns, as you will see by reading this chapter.
By investing in individual companies, you’re exposing yourself to specific risk. This is the risk that is unique to a particular company. For instance, if there’s an outbreak of E. coli at a restaurant chain, that’s not a problem for other restaurants or companies in other industries. It’s a problem for just that restaurant — and its investors. Specific risk is very different from systematic risk, or risk faced by all companies.
For instance, if there’s a credit crisis, as there was in 2008, or a pandemic like in 2020, that’s a systematic risk that will (and did) hurt just about every stock. However, if you own a company that makes widgets, and it’s found that those widgets cause cancer, that’s a specific risk to that one company.
By using fundamental analysis to choose individual companies to invest in, depending on what else is in your portfolio, you may be exposed to specific risk. In other words, if a company you’re invested in makes a misstep, you will suffer a loss other investors won’t. Table 18-1 shows you how investment risk, measured by a statistical measure called standard deviation, is much higher when investing in individual stocks rather than a broad index such as the Standard & Poor’s 500.
TABLE 18-1 Individual Stocks Are Riskier by Nature
Stock | Average Annual Return | Annualized Risk (Standard Deviation) |
---|---|---|
Boeing | 14.4% | 31.5 |
McDonald’s | 13.9% | 20.7 |
IBM | 7.2% | 24.8 |
General Electric | 7.9% | 25.9 |
S&P 500 | 12.1% | 15 |
Source: Data from Index Funds Advisors (www.ifa.com
)
It’s easy to get enamored with a company and its stock. The typical story probably goes something like this: You might buy a pair of shoes, like them, and decide to invest in the company that makes them. Some fundamental investors believe it’s a good idea to invest in companies that make things they personally like or understand, for that reason. There’s no question that having an in-depth understanding of an industry, as discussed in Chapter 16, can be a vital part of fundamental analysis.
Investors, betting Zynga might be the next Electronic Arts, snapped up shares of the company in the months after they were first offered to the public in an initial public offering in December 2011. Shares jumped 45 percent in their first three months. For a while, the investment looked like a real winner, and investors chased the stock all the way up to nearly $15 a share by March 2012.
But investors who ignored the fundamental signs showing Zynga’s earnings growth wasn’t going to last suffered greatly. The stock began to falter in early 2012 and crashed to nearly $2 a share in late 2012. Eventually, in early 2022, rival video-game maker Take-Two Interactive bought Zynga for roughly $9.86 a share. That might sound great, but remember, that’s less than the company’s shares were worth ten years earlier. Basically, your investment was dead money for a decade.
One of the top reasons why you want to use fundamental analysis is that investment mistakes are incredibly difficult to recover from. Many times when companies start to stumble, they have a tough time regaining control. When you invest in an individual stock, you’re betting the company’s corporate governance, covered in Chapter 9, will be strong enough to kick out the failing management team before things get out of hand. But you also need to have faith the board of directors will bring in a qualified replacement to fix the company.
That’s just the business risk of making an investment mistake. Don’t forget the mathematical cruelty when it comes to digging out of an investment hole. Table 18-2 shows just how hard it is to make up for drastic losses.
TABLE 18-2 Digging Out of a Hole Is Hard To Do
If Your Loss on a Stock Is … | To Break Even, You Need a Return Of … |
---|---|
10% | 11.1% |
20% | 25% |
30% | 43% |
50% | 100% |
90% | 900% |
From time to time, stock investors lose sight of the fundamentals. Bubbles, or periods of time when prices of investments get overinflated compared to their fundamental value, are a reality in a market economy. When the public is allowed to set the prices on assets in a free-for-all auction, it’s inevitable that sometimes prices in the short term are pushed to levels that are difficult to justify with reason.
Sometimes the entire stock market enters a bubble. Sometimes a particular part of the stock market gets bubbly. And sometimes, just a few stocks or types of stocks see their prices shoot up to the stratosphere. Having the self-control to avoid these investments with inflated prices is extremely difficult, because everyone around you who is buying them keeps making money. But fundamental analysis can provide a few things to watch out for as a warning prices might be getting ahead of themselves.
When investors start to lose their discipline and begin chasing stocks, you might start to notice P-E ratios are getting inflated. The long-term average for P-Es (based on operating earnings) since 1988 has been 18, so when you notice a company’s P-E get dramatically higher than that you’ll want to take notice. You’ll want to analyze a stock’s valuation, including its P-E and PEG ratios, to get an understanding of how rich the price is.
A stock’s dividend yield, or annual dividend divided by the stock’s price, can give you a heads-up on a stock that may be part of a bubble. When a stock’s dividend yield drops well below the average in its industry, or what’s paid by other companies, you might start to wonder whether investors are paying up too much for promises. Similarly, you might be suspicious if one company is the only one in an industry not to pay a dividend.
The more investors pay up for a stock, the more the dividend yield drops, because the denominator of the calculation gets bigger. This mathematical reality makes the dividend yield a decent indicator to pay attention to. You can look up dividend yields paid by other companies to see what the norm is.
Don’t assume, though, when the market’s — or a stock’s — dividend yield gets unusually high that it’s a screaming buy. When a stock’s dividend yield gets very high, that may be a signal companies in general — or the specific company — is about to cut the dividend or run into some serious financial difficulties.
TABLE 18-3 When Dividend Yields Sag, Watch Out
Year | S&P 500 Dividend Yield |
---|---|
2021 | 1.8% |
2020 | 2.1% |
2014 | 2.3% |
2010 | 2.3% |
2007 | 2.0% |
2000 | 1.0% |
1990 | 3.5% |
1980 | 4.5% |
Source: Data from S&P Dow Jones Indices
If you ask an investor and an accountant how much a company is worth, they’d approach the question very differently. The accountant might start counting up all the assets, or things the company owns, and subtract all its liabilities, or things it owes. By subtracting the liabilities from the assets, the accountant would come up with the book value of the company. That, the accountant would attest, is the company’s value.
Investors, though, approach the valuation question very differently than accountants. Investors might try to figure out how much someone else would be willing to pay for the company. The price at which a company would sell, the investor might say, is how much the company is worth.
When you see a company’s price-to-book soar, it can be a tip-off its stock is in a mini-bubble. GameStop, for instance, was a “meme” stock that could do no wrong in the eyes of many individual investors in early 2021. Investors were enthusiastic about the video-game seller’s plans to expand into new areas like digital collectibles and digital downloads. Investors drove the company’s average price-to-book ratio of just 1 in the third quarter of 2020 to a high of 68 in the first quarter of 2021, as shown in Table 18-4. Investors, though, found out the hard way that buying pricey stocks can be dangerous.
TABLE 18-4 GameStop’s Price-to-Book Told the Story
Quarter | Price-to-Book (Based on Average Quarter-End Book Values) | Stock Price at Quarter End |
---|---|---|
September 2020 | 0.94 | $2.55 |
December 2020 | 2.6 | $4.71 |
March 2021 | 22.2 (high of 68.2) | $47.46 ($86.88 at the high) |
June 2021 | 25.0 | $53.54 |
September 2022 | 7.0 | $26.86 |
Source: Data from S&P Global Market Intelligence
Shares of GameStop started to crack in January 2021, losing nearly half its value by the end of the quarter — a big shock for investors because all the online boards where the stock was being hyped promised it would head “to the moon.” Things got downright ugly by late 2022 when the stock crashed another 40 percent, down to roughly $27 a share.
When you start noticing shares of money-losing companies shooting up to the stratosphere, like GameStop, it’s time to be on bubble watch. A company’s fundamental value is based on its earnings and cash flow. So, if a company doesn’t have any earnings, it doesn’t have any fundamental value. If your fundamental analysis work tells you a company could justify its valuation — that’s one thing. But if you don’t think a company can ever generate profits, you should steer clear even if the stock is rising.
Despite all the protections provided to investors, buying stock is still largely a buyer-beware endeavor. That’s especially the case when buying a large stake in a single individual company. If the company’s management makes a mistake, whether honestly or dishonestly, shareholders may end up paying the price.
All sorts of shenanigans, both those that are pushing the limits and those that are outright fraudulent, often leave investors feeling cheated and caught off guard. Many investors, feeling there’s no other recourse, may band together to sue a company or its management team in a securities class-action lawsuit.Table 18-5 shows how the number of federal securities class-action suits tends to spike amid a bear market for stocks, such as in 2001, 2008, and 2020. Notice, too, how lawsuits have dropped off in 2021 as the stock market continued a strong leg higher.
TABLE 18-5 Shareholder Ire Follows the Stock Market
Year | Number of Securities Fraud Class-Action Lawsuits |
---|---|
2021 | 211 |
2020 | 318 |
2019 | 402 |
2018 | 402 |
2017 | 411 |
2016 | 271 |
2015 | 208 |
2014 | 168 |
2013 | 166 |
2012 | 151 |
2011 | 188 |
2010 | 175 |
2009 | 165 |
2008 | 223 |
2007 | 177 |
2006 | 120 |
2005 | 182 |
2004 | 239 |
2003 | 228 |
2002 | 265 |
2001 | 498 |
Source: Data from Stanford Securities Class Action Clearinghouse
The temptation to cook the books, or make financial statements look better than reality, is very big. Management teams running companies have a tremendous amount at stake when it comes to the financial results. One disappointing quarter could erode investors’ confidence in the company’s plan and knock the stock price down. Because executives and members of the board of directors often own big chunks of company stock, they don’t want to see the value of their holdings fall. A vast majority of executives’ pay is often tied to their company’s stock price. If the stock falls, they just took a massive pay cut.
Financial smoke-and-mirrors used by management teams can be very difficult for investors to detect, unless they get tipped off and know exactly what to look for in the financial statements. The ability for management to manage earnings, or tweak financial statements to make them look more positive, is a huge issue fundamental analysts must contend with.
There’s no shortage of troubling things that fundamental analysts need to look for. You need to look for deterioration of the business or profitability, which is the traditional aspect of financial analysis. But you’ll also want to look for suspicious trends that just don’t smell right. I spotlight a few of the more common warning signs you need to be particularly vigilant to watch for.
If you start seeing the accounts receivable item on the balance sheet skyrocket to the point where it’s outpacing revenue growth, that can be a bad thing. The accounts receivable line item grows when a company sells product to a customer, and accepts an IOU in exchange. If you see accounts receivable growth outpacing revenue growth, you might wonder if the company is pushing product onto customers to boost revenue. The way a company decides when to book revenue, called revenue recognition, may have a profound influence on its results.
Revenue recognition abuse was especially a problem during the dot-com boom — those were fun times for fundamental analysts, as you’ve probably gathered by now. For instance, Internet software company PurchasePro in late 2000 reported a $13.2 million quarterly jump in accounts receivable to $23.4 million. That should have caught fundamental analysts’ attention, because the company’s revenue was just $17.3 million for the period. The company a year later restated results, and the Securities and Exchange Commission ultimately accused company executives of committing fraud.
When you think of a company’s assets and read about them in Chapter 6, actual property the company owns that can be touched or seen probably comes to mind. But those types of assets, called tangible assets, are only one part of what a company owns. Companies also have what are called intangible assets, or items believed to have value that cannot be seen or touched. When intangible asset values are inflated, fundamental analysts might believe a company to be worth more than it is in reality.
One commonly used trick by companies is the so-called big-bath restatement. When a company is about to report a poor quarter, it makes the quarterly report really bad. A company’s management writes down the value of assets or pays some expenses ahead of time, which makes the current results look horrendous. But by getting all this bad news out, the company sets itself up for the illusion of a better future. Best of all, some investors automatically look past one-time charges, assuming they’re just unusual events. But the fact is, these restatements can have a profound effect on inflating a company’s future profit growth.
Accounting rules are supposed to make a company’s financial statements reflect reality and give investors an accurate picture of how the business is performing. For instance, companies are expected to book revenue when a sale is made, not necessarily when cash is received on the sale. Booking revenue this way ensures the revenue is matched up with the costs incurred to generate that revenue.
But this accrual accounting technique, while of merit, can open the doors to manipulation. Companies can push the limits of accounting by padding the financial statements with revenue and earnings that have no connection whatsoever to cash actually received or spent. Companies that do this are considered to have earnings of low quality. The statement of cash flows is a fundamental analyst’s best weapon in finding and steering clear of companies with low-quality earnings. I give you complete instructions on how to perform this quality of earnings detection analysis in Chapter 7.
If the bear market and credit crunch that began in 2007 taught investors anything, it’s the danger of borrowing too much. Investors learned the same lesson. Some companies, including Bear Stearns and Lehman Bros., had so much exposure to debt, or leverage, they were unable to hold themselves together when business turned south.
While entirely legal, piling on debt can also distort some of the popular measures fundamental analysts consider when evaluating companies’ profitability. Return on equity, a commonly used financial ratio used to measure the effectiveness of a management team, is especially vulnerable to distortion from the use of debt. You can read about return on equity, and how it’s skewed by debt, in Chapter 8.
Again, nothing is illegal about borrowing, and I’m not suggesting at all that it is. Debt can be a critical portion of a company’s total capital structure, because it tends to be cheaper to borrow than to issue stock. But it’s a crime for a fundamental analyst not to pay attention to the effect of a company’s debt.