How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s

How the Wall street created the junk bond market investment fads?

In the early to mid-1980's, Wall Street firms pushed junk bonds on investors.

They touted the positive historical results of high-yield debt. 

There were major differences between the debts of fallen angels versus newly issued bonds from fragile companies.

Debt from fallen angels:

•  trades at a discount to par, 
• downside risk is reduced. 
• at the same time, the potential for capital appreciation is large. 

Newly issued debt from marginal companies 

• does not share in these above characteristics.

How Wall Street can create investment fads, only to leave investors much poorer when the tide goes out.

That didn't stop Wall Street from pushing this form of debt (newly issued debt from marginal companies), nor did it stop investors from ponying up and falling victim to these issues.

The number and size of junk bond issues grew, despite the fact that this asset class was untested by an economic downturn, which should have made investors cautious. 

Investors were happy to gobble up zero coupon bonds (where the interest accrues to the issuer but is not paid out until the bond comes due) despite the clear risks! 

It took the downturn of the early nineties to wipe out those who were too eager to pay for assets that were risky.



Faulty Logic using EBITDA propelled the Speculation

One way investors were prodded into purchasing such securities were valuation measures based on EBITDA. 

Rather than considering cash flow or earnings, companies were valued using this accounting measure which doesn't include depreciation expenses. 

A company paying its debts from EBITDA is slowly liquidating itself (as it can't make capital expenditures) and leaving itself susceptible to a credit crunch.

Such fads will undoubtedly occur in the future, and those who are able to avoid them will do well.

Read also:

• 
  
• Your investments using Mutual Funds or Money Managers
• Trading and portfolio management from a value investing point of view
• Value Investor's Opportunities in Distressed Securities
• Value Investing Opportunities in the Banking Sector
• Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions
• Where to look for Investment Opportunities
• Business value cannot be precisely determined. Make use of ranges of values
• Central elements to a Value Investing Philosophy
• The Philosophy of Value Investing and Why It Works
• Philosophy of value investing. Need to have clear strategies too
• How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s
• Understanding these changes in the investment world allows investors to earn superior returns
• What's good for Wall Street is not necessarily good for investors
• Speculators, Investors and Market Fluctuations

Understanding these changes in the investment world allows investors to earn superior returns

The changing scenario in the investment world

The investment world has changed over the last several decades.

From 1950 to 1990, the institutional share of the market rose from 8% to 45%.

During the same period, institutions comprise 75% of market trading volume. 



The short-term mindset of the institutional investors

The institutions are hampered by a short-term mindset.  

Here are some reasons.

1.   Money managers tend to be rewarded not on what they return to clients, but rather as a percentage of their assets under management. 

A larger base of cash actually makes it more difficult to generate returns.

Thus there is a conflict between what's best for the manager and what's best for the investor.

2.   Institutional investors are also "locked into a short-term relative performance". 

Frequent comparative rankings among institutional investors forces a short-term mindset, as a long-term view can quickly send a manager to the unemployment line. 

As a result, these managers act as speculators rather than investors.

They try to guess what other managers will do, and try to do it first!

Only the brokers, who benefit from frequent trading, win this, as short-term market fluctuations are random. 

3.   Institutional investors are also constantly compared (and comparing themselves) to index benchmarks. 

Due to this relative comparison, they tend to prefer being close to 100% invested, even if things don't look cheap on an absolutely basis, which hurts investors when stocks are expensive.

4.  Money managers rarely invest their funds along with their clients.

In this conflict of interest situations, it is clear that the management firm wins.

Economist Paul Rosenstein:

"In the build­ing practices of ancient Rome, when scaffolding was removed from a completed Roman arch, the Roman engineer stood beneath. If the arch came crashing down, he was the first to know. Thus his concern for the quality of the arch was intensely personal, and it is not surprising that so many Roman arches have survived."

Read also:

• 
  
• Your investments using Mutual Funds or Money Managers
• Trading and portfolio management from a value investing point of view
• Value Investor's Opportunities in Distressed Securities
• Value Investing Opportunities in the Banking Sector
• Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions
• Where to look for Investment Opportunities
• Business value cannot be precisely determined. Make use of ranges of values
• Central elements to a Value Investing Philosophy
• The Philosophy of Value Investing and Why It Works
• Philosophy of value investing. Need to have clear strategies too
• How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s
• Understanding these changes in the investment world allows investors to earn superior returns
• What's good for Wall Street is not necessarily good for investors
• Speculators, Investors and Market Fluctuations

What's good for Wall Street is not necessarily good for investors.

How Wall Street does its business?

It has a very short-term focus. 

For example, Wall Street makes money up-front on commissions (not from long-term performance).

Therefore the Wall Street will always push for churn and will always push "hot" investments.

Is this business model fundamentally wrong?

Some argue that there is nothing fundamentally wrong with this business model. 

After all, many professionals make money in this manner without being responsible for the long-term results. 

It is, however, important that investors recognise this Wall Street bias, or they will be robbed blind.

This business model also encourages very short-term thinking, and a bullish bias. 

If stocks are going up, Wall Street is able to make more in the form of commissions. 

This bullish bias is seen in the percentage of stocks that are recommended by analysts versus those that are deemed "sells".

There are many examples of Wall Street's short-term bullishness that props up prices of various securities, but where those prices eventually fall dramatically. 

Take Home Message for Investors

Investors are advised to keep Wall Street's biases in mind when dealing with the Street.

Investors are to avoid depending on the Street for advice.

Read also:

• 
  
• Your investments using Mutual Funds or Money Managers
• Trading and portfolio management from a value investing point of view
• Value Investor's Opportunities in Distressed Securities
• Value Investing Opportunities in the Banking Sector
• Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions
• Where to look for Investment Opportunities
• Business value cannot be precisely determined. Make use of ranges of values
• Central elements to a Value Investing Philosophy
• The Philosophy of Value Investing and Why It Works
• Philosophy of value investing. Need to have clear strategies too
• How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s
• Understanding these changes in the investment world allows investors to earn superior returns
• What's good for Wall Street is not necessarily good for investors
• Speculators, Investors and Market Fluctuations

Speculators, Investors and Market Fluctuations

Speculators versus Investors

Mark Twain mentioned the two times in life when one shouldn't speculate: "when you can't afford it, and when you can!". 

Speculators buy in the hopes or assumptions that others will want to buy the same asset (be it a painting, a baseball card, or a stock) later.

Investors buy the cash flow the investment returns to its owner. (As such, a painting can never be an investment by this definition!)

Stock Market Bubbles

Bubbles in the stock market form due to faulty logic that first propels speculators to bid up prices followed by the inevitable bursting which destroys the wealth of many.

What determines whether an investor will make money in the market or not?  

The answer is his psychological make-up. 

If he does his own stock analysis and views the prices offered by Mr. Market as an opportunity to buy low and sell high, he will do fine. 

If Mr. Market's offering prices guide the investor's outlook of what the stock price should be, he should get someone else to manage his money!

Market fluctuations

Most market fluctuations are the result of day-to-day distortions between supply and demand of particular stocks, not of changes in fundamentals.

Investors who take advantage of these distortions by focusing on the fundamentals will be successful. 

Those who invest with their emotions are sure to fail in the long-run.

Read also:

• 
  
• Your investments using Mutual Funds or Money Managers
• Trading and portfolio management from a value investing point of view
• Value Investor's Opportunities in Distressed Securities
• Value Investing Opportunities in the Banking Sector
• Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions
• Where to look for Investment Opportunities
• Business value cannot be precisely determined. Make use of ranges of values
• Central elements to a Value Investing Philosophy
• The Philosophy of Value Investing and Why It Works
• Philosophy of value investing. Need to have clear strategies too
• How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s
• Understanding these changes in the investment world allows investors to earn superior returns
• What's good for Wall Street is not necessarily good for investors
• Speculators, Investors and Market Fluctuations

Various Value Investing Strategies - a Review

Many value investing strategies to employ in the market place:  Stocks 1. Net-net of Benjamin Graham eg. Poh Kong in 2009 2. Deep value investing in secondary issues (but beware of value traps). eg. KAF before 2014 3. Buying blue chips at bargain at certain market sell down period. eg. 1998, post SARS, 2008/2009 4. Buying growth stocks at reasonable price (GARP). eg. PetDag in 2005 5. Special situations: Arbitrage, M&A, turnarounds, bankruptcy restructuring. e.g. turnarounds HaiO in 2005/6, GCB in 2009, Latexx in 2008, acquisition of MOX 6. Joel Greenblatt magic formula investing: Screen for stocks with high ROIC and high EY Bonds High quality bond with good yield sold at below par value. Low quality (junk) bond with good yield available at severely discounted value. eg. Plus Bonds before being redeemed by the government bailout, RBS bond yielding 8% available at a discount to par. Cash Stay with cash if you have nothing better to buy. Your default mode.

Teach yourself to THINK in PROBABILITIES and in MULTIPLE SCENARIOS.

Without question, Buffett's success is tied closely to number.

"One of the advantages of a fellow like Buffett is that he automatically thinks in terms of decision trees and the elementary maths of permutations and combinations."  (Charlie Munger)

Most people do not.

It doesn't appear that the majority of investors are psychologically predisposed to thinking in multiple scenarios.  

They have a tendency to make decisions categorically while ignoring the probabilities.

Thinking in probabilities

Thinking in probabilities is not impossible:  it simply requires attacking the problem in a different manner.

If your investing assumptions do not express statistical probabilities, it is likely your conclusions are emotionally biased.

Emotions have a way of leading us in the wrong direction, especially emotions about money.

But if you are able to teach yourself to think in probabilities, you are well on your way to being able to profit from your own lessons.

Not often will the market price an outstanding business or any other outstanding businesses substantially below their intrinsic value.

But when it does occur, you should be financially (have the CASH)  and psychologically prepared (have the COURAGE) to bet big. 

In the meantime, you should continue to study stocks as businesses with the idea that one day the market will give you compelling odds on a good investment.


"To the Inevitables in our portfolio, therefore, we add a few Highly Probables." (Buffett)

Bet Big when the Opportunity Presents.

It is not given to human beings to have such talent that they can just know everything about everything all the time.
But it is given to human being who work hard at it - who look and sift the world for a mis-priced bet - that they can occasionally find one.
The wise ones bet heavily when the world offer them that opportunity.
They bet big when they have the odds.
And the rest of the time, they don't.
It is just that simple.

Quote:  Charlie Munger

Asymmetric Loss Aversion

The pain of a loss is far greater than the enjoyment of a gain.

Many experiments have demonstrated that people need twice as much positive to overcome a negative.

On a 50/50 bet, with precisely even odds, most people will not risk anything unless the potential gain is twice as high as the potential loss.

This is known as asymmetric loss aversion:  the downside has a greater impact than the upside.

This is a fundamental bit of human psychology.



Applied to the stock market

It means that investors feel twice as bad about losing money as they feel good about picking a winner.

This line of reasoning can be found in macroeconomic theory, which points out that:

• during boom times, consumers typically increase their purchases by an extra three-and-half cents for every dollar of wealth creation, and
• during economic slides, consumers will actually reduce their spending by almost twice that amount (six cents) for every dollar lost in the market.

The impact of loss aversion on investment decisions

This is obvious and profound.

1.    Not selling our losers

We all want to believe we made good decisions.   

To preserve our good opinion of ourselves, we hold onto bad choices far too long, in the vague hope that things will turn around.

By not selling our losers, we never have to confront our failures.

2.   Unduly conservative

This aversion to loss makes investors unduly conservative.

Participants in 401(k) plans, whose time horizon is decades, still keep as much as 30 to 40 percent of their money invested in the bond market.

Why?  Only a deep felt aversion to loss would make anyone allocate funds so conservatively.

3.  Irrationally holding onto losing stocks, potentially giving up a gain from reinvesting

But loss aversion can affect you in a more immediate way, by making you irrationally hold onto losing stocks.

No one wants to admit making a mistake.

But if you don't sell a mistake, you are potentially giving up a gain that you could earn by reinvesting smartly.

Psychology and Investing

You must have faith in your own research, rather than in luck.

Your actions are derived from carefully thought out goals, and you are not swept off course by short-term events.

You understand the true elements of risk and accept the consequence with confidence.

In the business world, you can find huge predictable patterns of extreme irrationality.

This is not talking about predicting the timing, but rather the idea that when irrationality does occur, it leads to predictable patterns of subsequent behaviour.

You should pay serious attention to the intersection of finance and psychology.

The majority of investment professionals have only recently paid serious attention to this.

Your own understanding of this will be valuable in your own investing.

The Psychology of Investing. Emotions affect people's behaviour and ultimately market prices.

The emotions surrounding investing are very real.  These emotions affect people's behaviour and ultimately, affect market prices.

Understanding the human dynamic (emotions) is so valuable in your own investing for these two reasons:

1. You will have guidelines to help you avoid the most common mistakes.
2. You will be able to recognise other people's mistakes in time to profit from them.

We are all vulnerable to individual errors of judgement, which can affect our personal success.

When a thousand or a million people make errors of judgement, the collective impact pushes the market in a destructive direction.

The temptation to follow the crowd can be so strong that accumulated bad judgement only compounds itself.

In this turbulent sea of irrational behaviour, the few who act rationally may well be the only survivors.

To be a successful focus investor:

• You need a certain kind of temperament.
• The road is always bumpy and knowing which is the right path to take is often counterintuitive.
• The stock market's constant gyrations can be unsettling to investors and make them act in irrational ways.
• You need to be on the lookout for these emotions and be prepared to act sensibly even when instincts may strongly call for the opposite behaviour.
• The future rewards focus investing significantly enough to warrant our strong effort.

The importance of high ROE when selecting your stocks for the long term (Warren Buffett)

In his newsletter to Berkshire Hathaway's shareholders in 1987, Warren Buffett wrote a brilliant piece on his focus on return of equity in his selection of his companies.  Here are some of his notes.


1.   Only 6 out of 1000 had ROE > 30% during previous decade

In its 1988 Investor's Guide issue, Fortune reported that among the 500 largest industrial companies and 500 largest service companies, only six had averaged a return on equity of over 30% during the previous decade.  The best performer among the 1000 was Commerce Clearing House at 40.2%.

(Comment:  6 in 1000 is 0.6%)


2.  Only 25 of 1,000 companies had average ROE > 20% and no year with ROE < 15%, in last 10 years.

This Fortune study also mentioned that only 25 of the 1,000 companies met two tests of economic excellence -

• an average return on equity of over 20% in the ten years, 1977 through 1986, and 
• no year worse than 15%.

These business superstars were also stock market superstars:  During the decade, 24 of the 25 outperformed the S&P 500.

(Comment:  25 in 1000 is 2.5%)

3.  Companies with durable competitive advantage

These companies have two features.

• First, most use very little leverage compared to their interest-paying capacity.  Really good businesses usually don't need to borrow.
• Second, except for one company that is "high-tech" and several others that manufacture ethical drugs, the companies are in businesses that, on balance, seen rather mundane.  Most sell non-sexy products or services in much the same manner as they did ten years ago (though in larger quantities now, or at higher prices, or both). 

The record of these 25 companies confirms that making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics.  

(Comment:  About 20 of 1,000 companies in KLSE, that is, 2%, are investable for the long term.)

4.  Quoting Buffett from his 1987 letter to shareholders of Berkshire Hathaway:

"There's not a lot new to report about these businesses - and that's good, not bad.  Severe change and exceptional returns usually don't mix.  Most investors, of course, behave as if just the opposite were true.  That is, they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change.  That prospect lets investors fantasise about future profitability rather than face today's business realities.  For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be."

Reference:

http://www.berkshirehathaway.com/letters/1987.html

Qualitative and Quantitative factors in Valuation of Stocks or Companies.

Both qualitative and quantitative factors are used in the valuation of stocks or companies.

From an extreme perspective:

1.  Qualitative analysis method:  "Buy the right company, do not consider the price."

2.  Quantitative analysis method:  "Buy when the price is right and do not consider the qualitative factors of the company."


Of course, in reality, both factors are considered when valuing and buying a stock or company.

A great company can be a bad investment if you overpay to own it.

Also, a lousy company can be a value trap though you paid a very low price to own it.

My personal approach.

1.  The company has to always satisfy the qualitative criteria first, namely, the right company of the highest quality.

2.  Having passed the qualitative hurdle, then it has also to satisfy the quantitative criteria, namely, the right price.

That is Quality first, then Price!

A Dividends-and-Earnings (D&E) Approach - Finding the Value of Non-Dividend-Paying Stocks

What about the value of a stock that does not pay dividends and is not expected to do so for the foreseeable future?

The D&E approach can be used.

Value of a share of stock
= Present value of future dividends + Present value of the price of the stock at the date of sale.

Using the above equation, simply set all dividend to 0.  

The computed value of the stock would come solely from its projected future price.

The value of the stock will equal the present value of its price at the end of the holding period.



Example:

Stock XYZ pays no dividends.
Investment period 2 year holding period.
Estimates this stock to trade at around $70 a share at end of this period.
Required rate of return 15%.

Using a 15% required rate of return, this stock would have a present value of
= $70 / (1.15^2)
= $52.93

This value is the intrinsic value or justified price of the stock.

So long as it is trading for around $53 or less, it would be a worthwhile investment candidate.

A Dividends-and-Earnings (D&E) approach to Stock Valuation

A Dividend-and-Earnings approach

One valuation procedure that is popular with many investors is the so-called dividends-and-earnings (D&E) approach, which directly uses future dividends and the future selling price of the stock as the relevant cash flows.

The value of a share of stock is a function of the amount and timing of future cash flows and the level of risk that must be taken on to generate that return.

The D&E approach (also known as the discounted cash flow or DCF approach) conveniently captures the essential elements of expected risk and return and does so in a present value context.


Value of a share of stock
= Present value of future dividends + Present value of the price of the stock at the date of sale.



The D&E estimates the future stock stock price by multiplying future earnings times a P/E ratio.

Because the D&E calculation does not require a long-run estimate of a stock's dividend stream, it works just as well with companies that pay little or nothing in dividends as it does with stocks that pay out a lot of dividends.



Finding a viable P/E multiple is critical in the D&E approach

Using the D&E valuation approach, we focus on projecting 

• future dividends and 
• share price behaviour 

over a defined, finite investment horizon.

Especially important in the D&E approach is finding a viable P/E multiple that you can use to project the future price of the stock.

This is a critical part of this valuation process because of the major role that capital gains (and therefore the estimated price of the stock at its date of sale) play in defining the level of security returns.

Using market or industry P/E ratios as benchmarks, you should establish a multiple that you feel the stock will trade at in the future.

The P/E multiple is the most important (and most difficult) variable to project in the D&E approach.



Estimates required

Estimate its future dividends
Estimate its future earnings per share
Estimate a viable P/E multiple
Estimate its future price ( = P/E multiple x future earnings per share)
Estimate your required rate of return

Using the above estimates, this present value based model generates a justified price based on estimated returns.

You want to generate a return that is equal to or greater than your required rate of return.




Example

Company ABC
Our investment horizon - 3 years
Forecasted annual dividends  Yr 1 $0.18       Yr 2 $0.24      Yr 3  $0.28
Forecasted annual EPS           Yr 1 $3.08       Yr 2  3.95       Yr 3  $4.66
Forecasted P/E ratio                Yr 1 20.0         Yr 2 20.0        Yr 3  20.0
Share price at year end of        Yr 1 $61.60     Yr 2 $75.06    Yr 3  $93.20

Given the forecasted annual dividends and share price, along with a required rate of return of 18%, the value of Company ABC stock is:

Value of a share of stock
= Present value of future dividends + Present value of the price of the stock at the date of sale.

Value
= {[$0.18/(1.18)] + [$0.24/(1.18^2)] + [(0.28/(1.18)^3]}    +     [$93.20/(1/18^3)]
= {$0.15 + $0.17 + $0.17}    +    $56.72
= $57.22

According to the D&E approach, Company ABC's stock should be valued at about $57 a share.


Comments on the above example:

1.  Assuming our projections hold up and given that we have confidence in the projections, the present value figure computed here means that we would realize our desired rate of return of 18% so long as we can buy the stock at no more than $57 a share.

2.  If Company ABC is currently trading around $41, we can conclude that the stock at present price is an attractive investment.  Because we can buy the stock at less than its computed intrinsic value, we will earn our required rate of return and then more.

3.  Note:  Company ABC would be considered a highly risky investment, if for no other reason than the fact that nearly all the return is derived from capital gains.  Its dividends alone account for less than 1% of the value of the stock.  That is only 49 cents of the $57.22 comes from dividends.

4.  If we are wrong about EPS or the P/E multiple, the future price of the stock would be way off the mark and so too, would our projected return.

A little COMMON SENSE goes a long way to Improve Investment Results! The mistakes of some investors may be the profit opportunities for others.

Investors' decisions are affected by a number of psychological biases that lead investors to make systematic, predictable mistakes in certain decision-making situations.

These mistakes, in turn, may lead to predictable patterns in asset prices that create opportunities for other investors to earn abnormally high profits without accepting abnormally high risk.


Here are some of the behavioural factors that might influence the actions of investors:

1.  Overconfidence and Self-Attribution Bias
2.  Loss Aversion
3.  Representativeness
4.  Narrow Framing
5.  Belief Perseverance
6.  Familiarity Bias


Using Behaviour Finance to Improve Investment Results

Studies have documented a number of behavioural factors that appear to influence investors' decisions and adversely affect their returns.

By following some simple guidelines, you can avoid making mistakes and improve your portfolio's performance.

A little common sense goes a long way in the financial markets!


1.  Don't hesitate to sell a losing stock.

If you buy a stock at $20 and its price drops to $10, ask yourself whether you would buy that same stock if you came into the market today with $10 in cash.  

If the answer is yes, then hang onto it.

If not, sell the stock and buy something else.


2.  Don't chase performance.

The evidence suggests that there are no "hot hands" in investment management.

Don't buy last year's hottest mutual fund if it doesn't make sense for you.

Always keep your personal investment objectives and constraints in mind.


3.  Be humble and open-minded.

Many investment professionals, some of whom are extremely well paid, are frequently wrong in their predictions.

Admit your mistakes and don't be afraid to take corrective action.

The fact is, reviewing your mistakes can be a very rewarding exercise - all investors make mistakes, but the smart ones learn from them.

Winning in the market is often about not losing, and one way to avoid loss is to learn from your mistakes.


4.  Review the performance of your investments on a periodic basis.

Remember the old saying, "Out of sight, out of mind."

Don't be afraid to face the music and to make changes as your situation changes.

Nothing runs on "autopilot" forever - including investment portfolios.


5.  Don't trade too much

Investment returns are uncertain, but transaction costs are guaranteed.

Considerable evidence indicates that investors who trade frequently perform poorly.




Implications of Behavioural Finance for Security Analysis

Behavioural finance can play an important role in investing.

The contribution of behavioural finance is 

• to identify particular psychological factors that can lead investors to make systematic mistakes, and 
• to determine whether those mistakes may contribute to predictable patterns in stock prices.

If that is the case, the mistakes of some investors may be the profit opportunities for others.

See the above 5 common sense rules on how to keep your own mistakes to a minimum.

Valuing companies with little or no earnings or with very volatile and highly unpredictable earnings.

Companies with no earnings or very volatile and highly unpredictable earnings

Some companies, like high tech startups, have little, if any, earnings.

If they do have earnings, they tend to be quite volatile and therefore highly unpredictable.

In these cases, valuation procedures based on earnings (and even cash flows) are not much  help.





Price to Sales ratio or Price to Book Value ratio

Investors turn to other procedures - those based on sales or book value.

While companies may not have much in the way of profits, they almost always have sales and, ideally, some book value.

Investor Mistakes (Short-lived Growth)

So called value stocks are stocks that have low price to book ratios, and growth stocks are stocks that have relatively high price to book ratios.

Many studies demonstrate that value stocks outperform growth stocks, perhaps because investors overestimate the odds that a firm that has grown rapidly in the past will continue to do so (Short-lived Growth).

Price to Sales ratio

Price to Sales ratio


P/S = Market price of common stock / Sales per share


Sales per share equals net annual sales (or revenues) divided by the number of common shares outstanding.

Many bargain hunting investors look for stocks with P/S ratios of 2.0 or less.

They believe that these securities offer the most potential for future price appreciation.



Very low P/S multiples of 1.0 or less are especially attractive

Especially attractive to these investors are very low P/S multiples of 1.0 or less.

Think about it:  With P/S ratio of, say, 0/9, you can buy $1 in sales for only 90 cents!

So long as the company isn't a basket case, such low P/S multiples may well be worth pursuing.




High P/S aren't necessarily bad.

While the emphasis may be on low multiples, high P/S ratios aren't necessarily bad.

To determine if a high multiple - more than 3.0 or 4.0, for example - is justified, look at the company's net profit margin.

Companies that can consistently generate high net profit margins often have high P/S ratios.




Valuation rule to remember:

High profit margins should go hand in hand with high P/S multiples.

That make sense because a company with a high profit margin brings more of its sales down to the bottom line in the form of profits.

Price to Book Value Ratio

Price to Book Ratio

P/BV ratio
= Market price of common stock / Book Value per share

Unless the market becomes grossly overvalued (1999 and 2000), most stocks are likely to trade at multiples of less than 3 to 5 times their book value.

There is usually little justification for abnormally high price to book value ratios - except perhaps for firms that have abnormally low levels of equity in their capital structures.

Other than that, high P/BV multiples are almost always caused by "excess exuberance."

As a rule, when stocks start trading at 7 or 8 times their book values, or more, they are becoming overvalued.




Investor Mistakes (Short-lived Growth)

So called value stocks are stocks that have low price to book ratios, and growth stocks are stocks that have relatively high price to book ratios.

Many studies demonstrate that value stocks outperform growth stocks, perhaps because investors overestimate the odds that a firm that has grown rapidly in the past will continue to do so (Short-lived Growth).

The Market as a Leading Indicator

Investors use the economic outlook

• to get a handle on the market and 
• to identify developing industry sectors.

It is important to note that changes in stock prices 

• normally occur before the actual forecasted changes become apparent in the economy.

Indeed, the current trend of stock prices 

• is frequently used to help predict the course of the economy itself.

Investors in the stock market tend to look into the future to justify the purchase or sale of stock.

If their perception of the future is changing, stock prices are also likely to be changing.

Therefore, watching the course of stock prices as well as the course of the general economy can make for more accurate investment forecasting.

Fundamental Analysis Advocates versus Efficient Market Advocates

Fundamental Analysis Advocates

The concept of security analysis in general, and fundamental analysis in particular, is based on the assumption that at least some investors are capable of identifying stocks whose intrinsic values differ from their market values.

Fundamental analysis operates on the broad premise that some securities may be mispriced in the marketplace at least some of the time.

Fundamental analysis may be a worthwhile and profitable pursuit:

• if securities are occasionally mispriced, and 
• if investors can identify mispriced securities.

To many, those two premises seem reasonable.



Efficient Market Advocates

However, there are others who do not accept the assumptions of fundamental analysis.

These so-called efficient market advocates believe

• that the market is so efficient in processing new information that securities trade very close to or at their correct values at all times. and 
• that even when securities are mispriced, it is nearly impossible for investors to determine which stocks are overvalued and which are undervalued.

Thus, they argue, it is virtually impossible to consistently outperform the market.

In its strongest form, the efficient market hypothesis asserts the following:

1.  Securities are rarely, if ever, substantially mispriced in the marketplace.
2.  No security analysis, however detailed, is capable of identifying mispriced securities with a frequency greater than that which might be expected by random chance alone.

In recent years, stock markets have been extremely volatile in the U.S. and around the world.

October 2007 to March 2009

From October 2007 to March 2009, U.S. stocks lost more than half their value, and in many markets around the world, the results were even worse

Those declining stock values mirrored the state of the world economy, as country after country slipped into a deep recession.

U.S. firms responded by cutting dividends.  Standard &Poor's reported that a record number of firms cut their duvidend payment in the first quarter of 2009, and a record low number announced plans to increase their dividends.

March 2009 to April 2011

From March 2009 low, the U.S. stock market nearly doubled ovee the next 2 years, hitting a post-recession peak in April 2011.   The run up in stock prices coincided with an increase in dividend payouts.

Of the 500 firms included in the S&P 500 stock index, 154 increased their dividend payment in 2010 or 2011, compared to just 3 firms which cut payments over the same period.

April of 2011 to April 2012

The good news for stocks didn't last very long.  In the spring of 2011, concern about a looming economic crisis in Europe sent U.S. stocks lower again.   The S&P 500 Index fell by more than 17% from April to August in 2011.  The market largely recovered its losses over the next year.

Dividend Aristocrats

Throughout this volatile period, some companies managed to increase their dividends each year.   Standard and Poor's tracks the performance of a portfolio of firms that it calls "dividend aristocrats" because these firms have managed to increase their dividends for at least 25 consecutive years.

Including household names such as Johnson & Johnson, Exxon Mobil and AFLAC, the dividend aristocrat index displays ups and downs that mirror those of the overall market, but at least investors in these firms have enjoyed consistently rising dividends.

Future Value is an Extension of Compounding

A simple concept.

It is never too early to begin saving for retirement.

If you placed $2,000 per year for the next 8 years into an account that earned 10% and left those funds on deposit, in 40 years the $16,000 that you deposited would grow to more than $480,000.  When investing, time is your biggest ally.

Time is on your side.

Why understanding fundamental analysis is important for investing in stocks?

Fundamental analysis:

Why understanding FA is important? 

FA cannot offer you the magic keys to sudden or instant wealth. If that were true, the Professors of Finance will all be fabulously rich! What FA can do is to provide sound principles for formulating a successful long-range investment program. FA are proven methods that have been used by millions of successful investors.

The motivation for investing in stocks is obvious. It is to watch your money grow.

Why then, for every story of great success in the market, there are dozens more that don't end so well!!!!

More often than not, most of those investment flops can be traced to:

1. Bad timing
2. Poor planning
3. Failure to use common sense in making investment decisions.



Intrinsic Value

The entire concept of stock valuation is based on the idea that all securities possess an intrinsic value that their market value will approach over time.

Security analysis consists of gathering information, organizing it into a logical framework, and then using the information to determine the intrinsic value of common stock.

Given a rate of return that's compatible with the amount of risk involved in a proposed transaction, intrinsic value provides a measure of the underlying worth of a share of stock. It provides a standard for helping you judge whether a particular stock is undervalued, fairly priced or overvalued.



Main message

The aims of fundamental analysis are to determine the asset's intrinsic value and its future growth potential.

Income Stocks

Income Stocks

Income stocks are appealing simply because of the dividends they pay.

These issues have a long history of regularly paying higher than average dividends.

Income stocks are ideal for those who seek a relatively safe and high level of current income from their investment capital.



Growing dividends protect from effects of Inflation

Holders of income stocks (unlike bonds and preferred stocks) can expect the dividends they receive to increase regularly over time.

Thus, a company that paid, say, $1.00 a share in dividends in 1997 would be paying just over $1.80 a share in 2012, if dividends had been growing at around 4% per year.

Dividends that grow over time provide investors with some protection from the effects of inflation.



Major Disadvantage: some have Limited Growth Potential

The major disadvantage of income stocks is that some of them may be paying high dividends because of limited growth potential.

Indeed, it is not unusual for income securities to exhibit relatively low earnings growth.

This does not mean that such firms are unprofitable or lack future prospects.

Quite the contrary:   Most firms whose share qualify as income stocks are highly profitable organizations with excellent prospects.

A number of income stocks are among the giants of U.S. industry, and many are also classified as quality blue chips.




Risks

By their nature, income stocks are not exposed to a great deal of business and market risk.

They are, however, subject to a fair amount of interest rate risk.

Examples

Many public utilities are in this group, such as:

• American Electric Power,
• Duke Energy,
• Oneok,
• Scana,
• DTE Energy, and 
• Southern Company.

Also in this group are selected industrial and financial issues like:

• Conagra Foods,
• General Mills, and
• Altria Group.