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Tuesday, October 11, 2016

How to conduct quick and effective Fundamental Analysis

Many passive long-term investors have a special focus on dividend paying companies. A starting point for many is the Dividend Aristocrats list (companies that have paid and increased their dividends for at least 25 consecutive years), and the Dividend Kings (50 or more years). These are usually large-cap companies that have a moat, solid business models, and in general, conservative and prudent management. They have successfully stood the test of time. They have successfully dealt with technological changes, demographics shifts, and several ups and downs of typical business cycles. The assumption is: although not exciting, our money should be safer there while we get paid (via dividends) to wait for consistent capital appreciation.

However, just because a company is a Dividend Aristocrat or a Dividend King, doesn't mean your investment will always be good if you carelessly initiate it at any point in time. An overvalued business that trades at 30 times earnings (PE Ratio = 30), may grow its earnings perfectly fine year after year and you may still lose money if there is normal PE compression that takes the ratio from 30 back to its normal historical average of 20. For this reason, it is important to invest making sure we are not overpaying, and thus endangering our capital. Furthermore, investors tend to disregard the fact that many companies have dropped out of these lists over the years. So, there is no guarantee that any one of them will preserve elite status into eternity.



Using MorningStar to quickly assess Over/Undervaluation

MorningStar is a free resource that you can leverage to quickly assess whether the company you want to invest in is over or undervalued.

I personally prefer to use MorningStar.ca. For some reason I find the overwhelming information over at MorningStar.com harder to visually interpret. You would think both sites should be nearly identical, but nop. Not at all. So, anyways, you may find MorningStar.com more comfortable to work with, I just happen to like MorningStar.ca better, and so this post will be focused on it.



Valuation

Once you type your symbol at the top of the page and click "Go", you get tons of information.
The first thing I do is I go to the Valuation tab. In this example I am going to be analyzing Emerson Electric Co (symbol: EMR)

By comparing the values on the first column with those on the fourth one, we get a quick idea about whether Emerson is overvalued or not. We want to see the values on the first column being smaller than those on the fourth column. In the case of the Dividend Yield %, we want to see a greater value on the first column, which is generally the result of a reasonable stock price as investors sometimes tend to over-bid on the "safe" stocks, which sky-rockets their price and makes the dividend yield % smaller.

In the above case, we can conclude that Emerson is not over-valued at the moment. Even though Price/Book is higher than its historical average, there is definitely no significant over-valuation based on the other aspects.

So, we now have two valuable pieces of information:
1- Emerson is a Dividend King. Solid, stable business, reliable dividend payer in the past.
2- Emerson is not over-valued at the moment in respect with its own historical averages.

This alone, is enough for many passive, income oriented, long-term investors to avoid overpaying. However, with just an extra step you can quickly decide whether the business should be part of your core investments, or whether you are better of perhaps considering other strategies here.



Key Stats
 
By switching over to the Key Stats tab you get what I consider vital information about the operations of the company over the years.

(Click on image to enlarge)
There is a lot to digest here, but I mainly focus on the four highlighted aspects.

First, Revenue. As we can see, from 2011 to 2014 revenues were flat. They went down in 2015 and currently, the Trailing Twelve Months revenue (TTM) is pointing to even more decline. These are hard dollar numbers that cannot be camouflaged through "financial engineering".

If you look at Earnings Per Share (EPS), even though the TTM is lower, there has been a consistent increase since 2012. A naive investor would look at increasing Earnings per Share and would think the company has been doing perfectly fine. However, Revenue (hard earned dollars) told us earlier that was not the case. The company has been actually making less money in dollar terms. How can Revenues be flat to declining and yet EPS increasing?

The answer is: financial engineering. "Share buy backs" and other more advanced accounting practices. By reducing the number of shares in circulation, the Earnings (dollars) are divided by a smaller number, which results in a higher Earnings Per Share. This is crucial information to understand.

Finally, we have the Dividends (per share) and Payout Ratio. We know this is a Dividend King, so it is a given that dividends will have increased over all these years. But here we see the magnitude. We can specifically see how much this dividend is growing year after year. We can also see the Pay Out Ratio (how much of the earnings is being paid out to investors as dividends). We want to see Pay Out Ratios that are not drastically increasing year after year, as it is a sign of dividend growth not being supported by actual earnings growth. A company that is unable to increase Revenues, will tend to have higher and higher Pay Out Ratios if it wants to keep growing the dividend payments to its investors. Eventually, if Revenues don't grow, the company becomes unable to keep increasing the dividends and sometimes even paying them at all. That's where dividend cuts usually come.



Verdict

We now have all the information in our hands:

1- EMR is a Dividend King. This implies a historically stable business with a commitment to rewarding shareholders through dividend increases. Good.

2- EMR is not overvalued at the moment. Good.

3- EMR revenues trend is questionable and even though the company has increased dividends in the last few years, it is doing so through very small increments percentage wise, obviously constrained by flat to declining Revenue. Bad.

With all this information in hand we can now make a more informed decision.


Would I invest in this company?

- Not as a core investment that I am willing to hold for the next ten years. I believe my hard-earned dollars will not be working as effectively through this investment in the long run as they could potentially do in others.

- That being said, I can consider investing in the company as a shorter-term play, especially in environments where everything else looks over-valued. If opportunities are scarce and nothing in my watch list is fairly priced, I am willing to put my money to work on a Dividend King that is not over-valued. However, I will have no problem taking my gains and abandoning the position once valuation goes back to above historical norms. I will be collecting decent dividends, and at the same time, I will be willing to generate extra income in this position via Covered Calls without concerns of my shares eventually getting called away, as I don't see this company as a core, long-term holding in my portfolio.


Finally, I wanted to point out that Morning Star displays its own unique rating in the form of stars. The best rating a company can receive is 5 stars.


It is important to understand that a high rating does not mean that it is a great company with a great business model. According to Morning Star, their "proprietary" rating system is mostly based on how over-valued or under-valued a company is. A 4 star rating could be a not so good business with bad management and flat revenues that simply happens to be more under-valued than necessary, whereas a 1-star rating may be a fantastic company that just happens to be way too over-priced. So, be careful about making your investment decisions solely based on the MorningStar rating. As a rule of thumb, I only use it to avoid investing in anything with less than 3 stars, no matter how wonderful the company is.

You can also conduct this type of analysis and consult other type of information via Reuters. Simply go to finance.google.com, enter a ticker symbol there, scroll down and click where it says "More from Reuters >>"



You can spend as much time as you want analyzing the fundamentals of a company, but there is a point of diminishing returns where your extra efforts do not represent a much greater edge. There is always the chance for an investment to fail, no matter how hard you dissect the numbers, because in the end, the future is always unknown. However, the past is all we have. So, we better take advantage of it somehow. I prefer to use a simple, yet solid approach to conduct my business when it comes to long term investments and this one has served me decently well over the years.

I hope you enjoyed today's piece.
Cheers,
LT

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