Fundamental Analysis and Value Investing

Fundamental data

Earnings season is couple of weeks after the start of each quarter - Jan, Apr, Jul, Oct. Forget the fanfare, go for the numbers. 10-Q has these key things:

• Financial statements - Income statement, Balance sheets, Cash flow statements
• Footnotes - Noteworthy events
• Management Discussion and analysis of financial condition (MD&A) - Mgmt steps through financial results
• Controls and Procedures - Problems found in the way accounting done or presented
• Other info - Pending litigations, company selling additional stock, trouble with paying interest on debt etc.

Proxy statements include exec compensation, matters subject to vote, shareholder proposals and related-party transactions.

Financial Statements must be used to analyze 3 key things

1. Operating activities - this is how well a company is operating, i.e, converting a raw material into profit. It includes money going into R&D, marketing, profits made etc.
2. Investing activities - spending money to make money. Company might spend on buying better machines, bigger office, etc. Check if ROI is good, is the expansion (machine/building) being used
3. Financing activities - Borrowing money to fund operations.

Where to find

www.sec.gov Search IDEA or EDGAR databases

How to read financials

• Revenue - Total cash the business brought in by selling goods and services
• Cost of Goods sold - Money spent on producing the product, mainly in terms of raw material going into it
• Operating expenses - Cost of admin, R&D, marketing and other peripheral items to keep the business running
• Other income - Income from other assets, eg. sale of factory, or from legal settlements
• Other expense - Cost of severance, layoff, depreciation of assets (wear and tear)
• Earnings before interest and tax - (Revenue + Other income - Cost of Goods - Oper expenses - Other expenses)
• Interest expense - Money spent on interest for borrowed money
• Taxes - Govt. tax
• Net income - (Earnings before interest and tax - Interest expense - Taxes)

Track how these change Year over Year (YoY) to track the growth. Simple techniques to compare data:

1. Compare YoY change as a % value
2. Express data as a % of Revenue to compare how big each component is Eg. (Cost of Goods/Revenue)%
3. Compare net income and revenue YoY % changes
4. Dig into individual items if available to understand the business better

Extra Notes

1. Primary market is when a company sells to investors in an IPO. Secondary market is investors trading among themselves.
2. Bond is an IOU, stock is a piece of the company. Bond gets interest on the lent sum and principal. Stock rises or falls with the company's price in the secondary market. If company fails, bond holders get paid first.
3. When reading a 10K always watch out for statements from auditors: 'company may not be a going concern' means the company may not survive. qualified means the auditor has concerns on how the books are kept.
4. Historical PE is 15, rises to 20 when interest is low.

Exchange Traded Funds

ETFs provide a bucket of stocks and perform better than most actively managed funds. They are structured and traded like a stock - making it easy to buy, avoid capital gains until sale. They have low expense ratios and deliver consistently good performance.

Risk measurement

• Systemic risk

1. Market risk: Market moves up or down
2. Interest rate risk: If interest rates go up, value of bond ETFs will fall
3. Inflation risk: Inflation makes value of fixed income investments like bonds/cash dwindle
4. Political risk: In international stock where countries are unstable
5. Grand scale risk: Natural disasters

• Non-systemic risk - Individual stock investments with risks that are out of control. Rumor that kills the stock, CEO in scandal.

Higher systemic risk => higher historical returns, Non-systemic risk => zilch

Standard deviation - Calculate the mean and std dev for return % over the years.

• 66% of the time, the projected value will be between mean +/- std_dev
• 95% of the time, the projected value will be between mean +/- (2*std_dev)

Beta - Express the variation in a stock in terms of variation in a standard index like S&P500. Beta of S&P 500 is 1. If a stock has Beta less than 1 it is less volatile than S&P500, greater than 1 shows higher volatility. More volatile => More risk and rewards Formula to calculate Beta:

https://www.investopedia.com/ask/answers/070615/what-formula-calculating-beta.asp https://www.investopedia.com/terms/c/correlation.asp

Sharpe Ratio = (Total Portfolio Return - Risk-free return)/ Portfolio Std deviation

Risk-free return is the return from a short-term treasury bill where capital is not risked. It is the percentage of returns an asset/fund gives per unit of risk taken to invest. Higher the Sharpe Ratio better the return.

Treynor ratio = (Total Portfolio Return - Risk-free return)/ Portfolio Beta

By using Beta we measure Systemic risk instead of Total risk like with Sharpe.

Sortino ratio = (Total Portfolio Return - Risk-free return)/ Portfolio Std deviation of downside only

Calculate only downside risk.

Modern Portfolio Theory

Balance out ETFs with stocks that have negative correlation. Pick a portfolio that may have 2 high growth, high risk ETFs that move inverse of each other. With this, growth rate is high with lesser risk. This is theoretical. In reality, it is hard to find a perfect -1 correlation. Usually stocks and high-quality bonds have low correlation. The process of finding this mix is called the Efficient Frontier.

Portfolios are split in 2 ways:

• Style - International or Domestic and within it: Large-cap, mid-cap, small-cap, value, growth
• Sector - Healthcare, Tech, Energy, Financial, Utilities etc

Keep international ETF in non-retirement accounts. The foreign tax can be written off against U.S taxes if it is in a regular account but not in a retirement account.