Evaluating a company and evaluating a stock are vastly different. The idea that these separate evaluations are interchangeable has led many investors to financial ruin.
The first step in the evaluation of a company begins with an in-depth look at the big picture. This type of evaluation starts with a global, political, and economic perspective. For example, if Congress has approved a new budget with a large-scale increase in military spending as a reaction to geo-political happenings, an advisor should consider the impact this will have on the sectors of the economy that may be the beneficiaries of these expenditures. Once the sectors most likely to benefit from the current economic climate are uncovered, the advisor should identify the companies within the sector that show the most promise.
Also taken into account when doing this evaluation are a number of economic indicators. These indicators may include reports by Alan Greenspan and the Federal Open Market Committee, changes in the federal funds and discount rates, Beige Book Reports (to provide a more regionalized picture of the economic situation), and other indicators such as consumer confidence reports. The first part of evaluating companies is accomplished by an overview of economic conditions. Then an analyst examines all "hot" sectors and industries.
Once the broad company analysis yields promising sectors and individual companies are identified as potential investment opportunities, specific companies are evaluated by assessing their bottom line. Next, advisors analyze the balance sheet and the income statements. The idea is to ascertain how solid the fundamentals are of a given company. Even greater analysis is given to each of the measures to identify anomalous readings. For example, while analyzing losses, an advisor may investigate whether the losses represent a write-down of goodwill or writedowns of actual net losses.
The fundamental approach is key in identifying which companies may represent healthy prospects for growth. However, nothing is decided in a vacuum. It would be folly to purchase stock in a company that, while in possession of diligent management and healthy earnings, exists in a sector that has been hit by external forces beyond its control. Warren Buffett said it best, "The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage."
After the diligent analysis of the company comes the analysis of that company's stock. Again, just because the results of an evaluation of a company might be positive, does not mean that you should immediately buy that company's stock. There are times when analysis of a company and analysis of an individual stock provides different outlooks on whether to invest. This is why it is imperative to consider both the company and their stock when making any investment decision.
This approach analyzes the historical performance of both a stock and the market and attempts to apply these results to indicate future trends. Instead of analyzing the company's assets and liabilities and deriving an intrinsic value, evaluation of a stock looks at factors such as trading volume indicators, price movements over specified time periods, and strength of the stock relative to others in the market. Another item worthy of scrutiny when looking at the stock is how it trends against the S&P 500 index.
There are many more vital factors an advisor should consider when scrutinizing a stock in the evaluation process. One of these factors is the relative strength of a stock vs the movement of the stock market. An advisor should look for a stock that is displaying an upward price movement. For example, examine the slope of a stock's movement over the slope of the S&P 500's movement with an eye toward the disparity between the two as an indicator of strength.
Remember that none of these indicators are used to provide an evaluation of the business, product, or industry of the company. The concern is focused upon the trends, which indicate if others are buying or selling the stock. Investors can sometimes capitalize on the knowledge of others by focusing on volume indicators to arrive at our decision to buy or sell. In many instances, if a stock is trending up on heavy volume, this can indicate that the stock is a good buy. All of these measures rely upon past activity on the part of the stock to help forecast future movements.
At times, a company can have a fundamental analysis of an A+ with earnings above 95% of the industry, but does not have buying support or heavy volume. Thus the relative strength of the stock could be below 75% of other stocks on the exchange. This is disparity. Contrarian managers love to acquire these inexpensive stocks with good fundamentals. A company can have a fundamental analysis of a D-and possess relatively poor profit and loss statements, yet its individual stock can be moving upward on pure speculation, technological advancements, a buyout, or the creation of a new industry. The point is there is discrepancy between the fundamentals of the company and that of the stock. In this case, advisors see a potentially bad company, but a good stock. This is often an area of acquisition for trend managers or momentum managers, which is a questionable approach.
In practical application, both schools of evaluation are full of complexities and subtleties that challenge even the professional investors' and advisors' capabilities. The important idea to absorb is that a stock and a company must be evaluated separately, and the results of the evaluation should be combined to reach a conclusion about whether to take action.
John Valentine specializes in portfolio management
and in developing high-net-worth
strategies. He is the principal investment
advisor at Valentine Capital Asset Management
of San Ramon, Calif. He
welcomes questions or comments at 925-275-0200, or
visit www.vcrpg.com. Valentine Capital Asset Management
, Equity Research & Portfolio Evaluation,
and Securities America Inc are independent entities.
Securities offered through Securities America Inc, member
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America Inc as a firm does not make a market in, conduct
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Reprinted with permission from Valentine Capital's High
Net Worth Newsletter.