Get back to the basics for simple stock analysis and don’t miss these four warning signs of a bad investment

The investing public is divided into two camps, those that think you can beat the market by analyzing stocks and those that think it’s a waste of time.

The truth is, they are both right.

The fact that there are so many people analyzing and bidding on stocks means prices pretty closely reflect all the information available. That doesn’t mean you should give up and just pick stocks out of a hat or only invest in index funds.

Sticking to just a few stock market basics for analyzing stocks and avoiding the worst investing warning signs can help you reach your investing goals faster than you might think.

This is the 11^th in our series reviewing The Intelligent Investor, the most read book on investing ever written. We’re a little over half way through the book and have covered some great topics from understanding your investing needs to last week’s chapter on finding the best investment advisors.

Pick up your copy of The Intelligent Investor and follow along with the series. I’m using the 2003 edition with commentary by Jason Zweig, writer of the Wall Street Journal’s Intelligent Investor column.

Start on our first chapter review to learn how the intelligent investor can avoid hot stocks that could be ready to plunge.

Until now, the book has largely been about finding your own investing needs and planning for the bigger investing picture. Chapter 11 begins the second half of the book and the shifted focus to stock analysis and picking better investments.

The Real World of Stock Analysis

Stock analysis is a lot like an iceberg, if the analogy isn’t too overused.

Watching TV, you might get the idea that analyzing stocks is fairly basic. An analyst looks at some fundamental factors like sales and earnings growth then they look at how expensive the stock is relative to its earnings and other stocks.

And that’s it. That’s pretty much the extent of what they talk about on TV for stock analysis.

I’ve pasted below the proforma (forecasted) income statement I put together on a gold mining company, part of a stock analysis report I created when working for a venture capital firm a few years ago.

• To estimate sales, I needed to do a full industry analysis and estimate the price of an ounce of gold and other metals the company mined.
• Estimating operating costs meant looking at past performance and the potential for cost measures.
• Estimating depreciation and interest expense meant tying in balance sheet items like long-term assets and debt plus involving the statement of cash flows with capital spending.

And this is still a fraction of the work that goes into professional stock analysis. The full report was 24 pages long and included a look at management, a comparison of the gold reserves held by competitors, and how much the company could get in a fire sale.

Fortunately, most investors don’t need to go to this kind of detail for stock analysis. In fact, it’s reports like these that you can use to make your job easier.

We’ll keep our review of stock analysis, as Graham does in the book, to the most important concepts you need as an investor.

For more detail into the real world of stock analysis, everyone should check out the curriculum for the Chartered Financial Analyst (CFA) exams. Most libraries have the books in circulation. The CFA exams are three six-hour tests covering everything investment analysts need to know about asset management and analysis.

Each year includes a curriculum of a few thousand pages. The first year’s books are some of the best financial education you can find on stock analysis and money management.

Bond Analysis for Beginners

Graham covers a short section on bond analysis though Zweig doesn’t include any notes on the section. The reason is that most investors are probably fine with buying bond funds which offer instant diversification and reduce the need to value individual bonds.

In fact, unless you have more than $100,000 to invest in bonds, the fees to buy individual bonds are generally too high and you’re better off buying exchange traded funds (ETFs) holding bonds.

Don’t get the idea that bonds are an unnecessary part of your investing strategy though. These debt investments are critical to smoothing out the risk in the stock portion of your overall wealth.

How much of your money you invest in bonds depends largely on your age, usually ranging from about 15% up to 35% or more. If you have less than this in bonds, you’re setting yourself up for huge losses in the next stock market crash and all kinds of bad investor behaviors. Check out this series on investing by age to see how age affects investing in different assets.

It’s interesting that bonds are supposed to be the slow-and-steady investment but have surged over the past few years. It is definitely a part of your portfolio you don’t want to miss. For more detail on types of bonds and how to pick bond funds for your investments, check out my Step-by-Step Bond Investing on Amazon. An Amazon best seller in the bond investing category and a simple look at the investment for any type of investor.

Simple Stock Analysis for Beginner Investors

It’s funny to hear Graham talk about the Xerox Corporation as a growth stock with 32% annual earnings growth and all the speculative enthusiasm of the stock market. Shares of the photocopy leader jumped 15-fold in the four years after it began trading on the NYSE in 1961…

This millennium hasn’t been as kind to the stock. Xerox has struggled to move past its singular competitive product type and has under-performed the market.

Knowing a little about the photocopy industry could have helped you avoid losing money in Xerox over the past 16 years. More than picking individual stocks with stock analysis, investors benefit most from simply understanding the forces at play in different sectors and industries.

You don’t need all the price-to-earnings ratios, stock screeners and other measures. Understand how industries are developing and it will help you pick better stocks while avoiding the has-been companies that destroy value.

Any kind of industry or stock analysis must be done with a long-term perspective. Over the shorter-term, say up to a few years, investor sentiment is going to be the biggest factor that drives stock prices.

Just look at any stock market crash or bubble. Nothing really changes in the companies themselves but investor sentiment goes crazy and all rational analysis goes out the window.

Keep an eye on the industries and sectors in which you invest, shifting your investments infrequently to take advantage of low prices or advances in each.

That’s the big picture and close to all you really need to pick great stocks for your portfolio. Instead of writing out a laundry list of ratios and telling you to read 100+ pages of a company’s financial statements, stick to the basics and you will be better off for it.

4 Warning Signs of a Bad Stock Investment

There are some quick warning signs you can follow to avoid the worst stock investments. You don’t need to understand every line item in a financial statement but there are a few comparisons to make that will alert you to a potentially bad investment.

1) Earnings growing faster than operational cash flow over time. Compare the growth in Cash Flow from Operations (CFO) on the cash flow statement with growth in Net Income (earnings) on the income statement.

CFO is the true cash generating power of the company. Earnings are largely based on accounting tricks like when the company recognizes sales and expenses.

Managers like to manipulate things on the income statement to make earnings look better. It’s much harder to manipulate actual cash flow so cash flow growth that lags earnings is a sign that management might be using questionable accounting practices.

2) Free Cash Flow (FCF) growth and capital spending. FCF is the amount of operational cash flow minus the amount the company spends to maintain the business. This spending amount, called capital expenditures, includes things like acquisitions of other companies and product development. Without it, the company could lose its competitive advantage and see sales fall over time.

FCF then is the cash flow available to shareholders after ensuring continued growth in the business. You want to see that FCF is growing over time but not simply because the company is reducing its capital expenditures. Growing FCF and capex is a sign of a healthy company.

3) Compare the capital structure of the company to the industry and competitors. The capital structure is how much debt the company has compared to how much shareholders’ equity. Debt is a good thing in business because it provides money for growth without having to share the profits with more owners.

There is a limit to debt though just like in your personal finances. Look at how much debt other competitors in the industry hold as a percentage of equity. If one company has a very high percentage of debt while most others hold much less, it could mean the company is overextended. If sales fall, it may have trouble meeting debt payments or investors may get spooked at the very least.

4) What happened to the dividend payment during the last stock market crisis? This isn’t a common stock analysis measure but one I like to use to find strong companies that will stand the test of time. What was the company doing when everyone else was cutting their dividend to protect cash flow? A company with a long history of protecting or increasing its dividend means management is planning ahead and has investor return in mind.

One Last Thought on Stock Analysis

A lot of people will tell you stock analysis is a waste of time, that stock prices instantly reflect everything we know about a company. It’s called the Efficient Market Hypothesis and there’s some proof that it is at least partially true.

Armies of graduates from top schools pour over stocks every day to find value. Beyond that, billions of investors barter and bid on stock prices around their idea of a ‘fair’ price. All of this gets bid into prices and makes it nearly impossible to ‘beat’ the stock market.

But would we have that fair price were it not for all that stock analysis and bidding? It’s called ‘price discovery’ and it wouldn’t be possible without all that work. It’s a little of a chicken and egg conundrum but there is definitely something to be said for the efforts of hard-working analysts and investors.

So don’t give up on stock analysis. Investors like Peter Lynch and Warren Buffett have proven that you can outperform the market by following some simple stock market basics. We’ll take a closer look at earnings in next week’s chapter review. Don’t forget to pick up your copy of The Intelligent Investor and follow along with the review.

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