Fundamental analysis

I found this analysis of fundamental analysis. It struck me as interesting in that the person who wrote it, doesn’t particularly subscribe to fundamental analysis, but is pretty fair and objective, so I just wished to clarify some points that were done a disservice

Re: Is Value just a big bet on Financials? via Abnormal Returns.

The answer is either “yep,” or “it depends.” Let’s define some terms.

There are three types of analysis: Technical, Fundamental, and FundaTechnical. “Value investing” uses FundaTechnical analysis as it’s bedrock, and is predominantly quantitative in nature, although “value investors” will often through some qualitative junk into the trunk, talking about whether the company has a “moat” (WTF is a “moat?”) or has an easily understandable business model (that depends on who’s trying to understand it, don’t it?). But aside from the general taxonomy of where “value investing” fits, analysis-wise, in the greater realm of TRADING, we can get more specific with what “value investing” is: “Value investing” is simply a mean-reverting sentiment trade. It’s built on the premise that markets overreact, and beat down good companies past the point where (statistically, not necessarily specifically) it makes sense. Even the “cigar-butt” diversified quantitative trading strategy defined by Ben Graham is based on that central premise.

Lets try and extract the central premises from the paragraph.

*Value investing uses FundaTechnical as its bedrock
*Predominantly quantitative
*Value investing is a mean reverting sentiment trade

These would seem to constitute the central premises. FundaTechnical analysis is a new one on me. I had never previously heard the term. Initially I thought it might be a combination of a fundamental analysis combined with a chart pattern that suggested a top or bottom. Incorrect. There is a definition provided.

I believe that ramblings about “the economy,” whether “housing has bottomed,” “what is the yield curve telling us,” or if “Dr. Copper has lost his PhD” are patently useless. I also believe that debate about what amount of assets should be in cash/stocks/bonds is of limited efficacy in achieving long-term investment outperformance or eventual financial freedom.

Below are Fundamental, Technical, and FundaTechnical stock selection and screening criteria that are shown in academic literature, backtesting, and/or forward testing, to be effective in outperforming the market. I’ll let the pocket-protector crowd debate whether these factors are sources of Alpha or Beta, whether the Alpha is “portable,” or whether CrAPM version 4.45 can be expanded to include these considerations.

Fundamental Factors

Fundamental factors are those that relate to the underlying company, its management, financial performance, financial strength, and changes therein, without regard to the stock price.

* The accrual anomaly is well documented and is known to be international. Check for operating cash exceeding net income.
* Firms with low financing cash flow (normalized by relationship to assets) tend to outperform, again documented in academic literature.
* Cash flow ratios such as ability to cover interest payments have been documented as signs of solvency risk.
* Improvement in Current Ratio is one test of the Piotroski value screener.
* Improvement in Return On Assets is another test of the Piotroski value screener.
* Return On Invested Capital, ROIC, is cousin of ROA and used by many value gurus.
* Governance issues can create price shocks for long-term holders, hence the reading of Ks, Qs, and Proxies is part of fundamental analysis.

Technical Factors

Technical factors are those that relate to the stock price and its movement, volume, and trading characteristics.

* Price reverts from extremes, back to trend, over either short (days/weeks) or long (years) timeframes. Day and swing-trading robots can and have been built around this, and the long mean-reversion is the bread and butter of asset class investing, and to some extent, value investing. This technique is more reliable in stocks for mean reversion up (i.e. long-only strategies).
* Price tends to trend over medium time frames (weeks/months). Trend-following systems ride these price trends toward profitability.
* Suspicious levels of volume mark some, but not all, changes in trend. Extremely high volume always marks immediate or impending change.
* Companies with low float and low institutional ownership are more likely to make explosive up moves.
* Companies with high float and high institutional ownership, once momentum has stalled, are more likely to underperform and/or decline over time.
* The “days to cover” or shares shorted divided by the average daily volume, is a key indicator of the potential for a short squeeze and/or of a floor in prices should calamity befall.

FundaTechnical Factors

FundaTechnical factors are those include both Fundamental and Technical analysis.

* Various measures of “cheapness” have been found to be predictive of long-term outperformance. Arguably the most effective in the literature is the ratio of current price to book value, although ratios of price to sales, free cash flow, cash on hand, earnings, and doubtless others have been used and are effective. This is essentially a mean-reversion play with a long time horizon, filtered by a fundamental sign of company strength.
* Growth At a Reasonable Price measures (GARP) are similarly FundaTechnical. The basis of PEG is the Price to Earnings Ratio divided by the Projected Growth in Earnings. A free cup of nothing to the first person who can identify the Technical measure in that formula.
* Dividend Yield strategies are FundaTechnical. Yield is projected dividend divided by price. High-yield stocks, as a group, tend to outperform the indices.

We now have a lot more information with regards to definitions, and what factors the original premises were based on.

Within the first set of definitions with respect to Fundamental analysis we have this statement; Fundamental factors are those that relate to the underlying company, its management, financial performance, financial strength, and changes therein, without regard to the stock price.

This is simply incorrect. All the identified factors in the analysis are in relation to the price to be paid. This is absolutely fundamental to the analysis.

Turning now to the question of FundaTechnical analysis, it seems that it constitutes simply selection through financial ratios, that through historical data support the mean reversion theories that constitute strategies employed within financial markets.

Returning to the three central premises identified initially.

*Value investing uses FundaTechnical as its bedrock
*Predominantly quantitative
*Value investing is a mean reverting sentiment trade

I would argue that value investing can, the lazy man approach, indeed use FundaTechnical analysis as its foundation for selecting common stock candidates. It is predominantly quantitative. It is based on mean reversion of the financial ratios. The sentiment aspect is a little more difficult to quantify, but I can see where he is coming from.

True value investing however while utilising financial ratios as a measurement tool, goes far further in the analysis, digging to check the validity of the ratios and trying to understand the drivers of the ratios. As a simple example, P/E ratios, a highly followed metric can provide low or high P/E’s based on changes within either metric.

As an example, Resource based stocks [BHP] are currently displaying low P/E’s due to massively high commodity prices currently. Their earnings rising faster than their share prices, thus driving a low P/E. Additional analysis of their inventory accounting can add interesting insights, by way of example companies can choose FIFO or LIFO accounting.

Balance Sheet.
BHP utilizes FIFO accounting for Inventory.
FIFO, in an environment of rising prices, leverages net profit.
FIFO in an environment of stable, or falling prices, causes losses on Inventory.
Therefore, unless prices for Inventory continue to rise, net profits will fall.

This is simply one example of analysis based on financial ratios. What I am really saying is that financial ratios, the FundaTechnical analysis are simply a starting point for the analysis.

In summary, the conclusions drawn and inferred with regard to value investing and value investors is flawed, somewhat biased, and hints at the authors dislike of the methodology.

I’ll include a long analysis of BHP that I completed sometime ago as an example that illustrates a lot of the definitions that have been discussed. We also have the benefit of hindsight to evaluate the value of the analysis.

I should also like to point out that the analysis is a starting point in evaluating risk, and devising a risk managemet strategy. The analysis does not constitute a methodology or strategy in-of-itself.

And the previously posted analysis;

Current Price $39.91
Code BHP
Yield 1.1%
Market Capitalization $128150
TCI Price Target $18.70 to $13.80
Investment Sector Industrial Metals & Minerals
Price/Earnings ratio 18.73
Recommendation Watch List

INDUSTRY STATISTICS

Market Capitalization: 360B
Price / Earnings: 15.6
Price / Book: 5.2
Net Profit Margin 16.7%
Price To Free Cash Flow -87.0
Return on Equity: 32.6%
Total Debt / Equity: 0.5
Dividend Yield: 1.5%

Resources, commodity prices have been at historic highs just recently. With prices for the producers of commodities currently so high we must take into account the “cyclical” nature of the businesses involved.

We must ascertain whether the P/E ratio is derived from high earnings due to high prices received for production, or, a low purchase price available for the aggregate earnings over a number of business cycles.

To date the earnings have risen on high prices, and this has already more than been reflected within the prices asked for within the industry. This can further be illustrated within the low current dividend yield.

Purchasing this industry implies continued growth within China & other developing nations.

Is this current growth rate sustainable?

There will be many opinions upon that crucial question, but, the answers are all speculative, and if wrong, could find a very nasty correction in the prices of resource stocks. This has already happened in May, and currently the question remains, after the correction, have the prices become cheap, or undervalued?

The unequivocal answer is no. They are still as a sector overvalued.

CAPITALIZATION

Market Cap (intraday): 116.89B
Enterprise Value (19-Jun-06) 129.64B
Trailing P/E ( intraday): 15.08

The Capitalization structure of BHP is an unqualified good.
The debt, constituting both funded debt & Bank debt is a very small component of the Capitalization.

Further, the Pension & Operating Leases component is currently showing a surplus from my estimations.

Income Statement
Revenue 32.20B
Revenue Per Share 10.64
Qtrly Revenue Growth 9.70%
Gross Profit 10.09B
EBITDA 13.08B
Net Income to Common 7.80B
Diluted EPS 2.56
Qtrly Earnings Growth 55.10%

The coverage of Interest payments is excellent, and poses little risk to holders of debt, or of equity.
We can see the result of the current high prices of commodities reflected within the two ratios of “revenue growth” and “earnings growth”.

A 9.70% growth in Revenue, contrasted with a 55.1% growth in Earnings. Should commodity prices weaken, and commodity prices are very cyclical, we would see a significant shrinkage within earnings as a result, with a concurrent shrinkage in Revenues.

Due to the lack of leverage within the Balance Sheet, and the high percentage of Common, the expectation would be for a low volatility within the share price. This until just recently was the case. It has not been the case over the past two years.

There has also been a significant improvement to net profit due to a reduction in production costs, quite possibly due to economies of scale. There has additionally been a significant improvement within Selling General & Administration, costs falling. These are both positives, but sustainability is a concern.

Balance Sheet
Total Cash 1.65B
Total Cash Per Share 0.546
Total Debt 10.47B
Total Debt/Equity 0.495
Current Ratio 1.092
Book Value Per Share 6.98

Cash is lower currently than one would like to see. This in of itself is not a major problem, as of course the ability to borrow cash would be forthcoming, and undoubtedly, BHP, would have a credit revolver available.

The Current Ratio however is not high enough to qualify BHP as “Investment Grade” currently.

Inventory & Receivables display no red flags, and pass muster.
The collections of Receivables is possibly a little low, but is consistent, this will be monitored.

BHP however does not pass muster on the return generated on assets. With the current high prices that are being paid for commodities, a return of $0.97 on each invested $1.00 is indicative of a low return business.

Cash Flow Statement
Operating Cash Flow 10.04B
Levered Free Cash Flow 8.27B

Cash-flow analysis throws up some interesting areas.
Depreciation is the problem child. As a percentage of Revenues, Depreciation has fallen from an aggregate of 8.9% to 6.6%. This will after Tax, flow to the bottom line, improving net profit growth, this is some $0.13 cents per share.

Capital Expenditures have fallen quite significantly, some $0.77 per share from the aggregate.
Depreciation compared to Capital Expenditures has also decreased.
Depreciation to Cash from Operations……..fallen.
Depreciation as a percentage of Net Assets………..fallen

What we are left with does not look confidence inspiring currently, especially as we are not even purchasing a bargain, thus we have no margin of safety.

We have reduced Capital Expenditures, thus pumping up net profits.
We have reduced Depreciation being charged against Net Assets, pumping up profits.
In short, there may very well be reduced investment, or more importantly reduced, or inadequate spending on maintenance to pump up earnings.

Examination from a different perspective reveals nothing that allays any concerns.
%growth in Capital Expenditures = 30.7%
%growth in Plant Property & Equipment = 24.3%
%growth in Depreciation = 9.8%

When we compare this to the following;

%growth in Revenues = 22.8%
%growth in Gross Profits = 34.3%

It would seem that the Depreciation charge is being inappropriately rated. This is always a red flag, and may pose problems further down the road. At current prices, it is certainly enough of a question to apply prudence to the investment decision.

The Depreciation or Depletion charge carries an extra importance within the purchase of the common stock of a resources business. The Depreciation charged by the business cannot be the depreciation charge utilized by the individual investor, as of course, the business charges depletion at purchase price, and so must the investor.

Utilizing a pessimistic outlook, and diminishing productive capacity after seven years, the investors return would calculate to 4.5%. This is inadequate, and provides no margin of safety at all.

Utilizing a generous twenty years on productive capacity, we still have only a 6.7% return. For this return, a lot of things would need to move in the investors favor.

MANAGEMENT

Looking at hidden Cash-flows we can identify a discretionary Cash-flow of $295.9 million, or $0.09 per share within Selling General & Administration. This in of itself is generally a positive, as these cash-flows may well be available to the business in harder business cycles.

There is however a discretionary Cash-flow within Capital Expenditures also, calculated to be approximately $593.8 million, or $0.19 per share. Under the present question marks present regarding the Depreciation charge, I am not willing to look at this as a positive, if; in point of fact maintenance spending has suffered.

SUMMARY

BHP is considered a “Blue Chip” business, or share. In my opinion, the business is profitable, but has a very low return. It has some serious question marks in regards to the Depreciation charges and related questions regarding the outcome of Capital Expenditure spending.

At the current price, it is too expensive, and returns accruing to the investor, purchased at these prices will reside almost entirely on speculative outcomes. Will commodity prices remain at 25 year highs? Will China & other developing nations continue their extreme growth rates?

From BHP’s 2005 Annual Report;
*Petroleum +38.9%
*Aluminium +26.5%
*Base Metals [Copper, Lead, Zinc, Gold, Silver, Uranium Cathode] +221.8%
*Carbon Steel [Iron Ore, Magnesium, Metallurgical Coal] +127.8%
*Diamonds + Specialty -7.9%
*Energy Coal +206.9%
*Stainless Steel +47.7%

Are these types of increases sustainable?
This question must be addressed in two stages;
*Macro-view, viz. global supply/demand dynamics
*Balance Sheet, viz. Accounting policies.

Balance Sheet.
BHP utilizes FIFO accounting for Inventory.
FIFO, in an environment of rising prices, leverages net profit.
FIFO in an environment of stable, or falling prices, causes losses on Inventory.
Therefore, unless prices for Inventory continue to rise, net profits will fall.

Looking at the percentage increases within Inventory pricing, can you envisage further increases of a similar, or increasing magnitude?

If not, then, as prices stabilise and weaken, so FIFO will impact net earnings.
We can calculate this from the Depreciation charge.

Therefore, from a Balance Sheet analysis, we can surmise that the earnings growth could have a fatal flaw that is currently under-appreciated.

From a macro-perspective;
The US & China are symbiotic economies currently.

China can only consume 42% of their own output [this is a very small consumption]
They thus rely on the rest of the OECD bloc to take the surplus production.
The US accounts for some 68% of the 58% surplus.
Walmart alone accounts for 30% of the US 68%

Now supposing China did not cycle the FX surplus back to the US via the purchase of Treasuries? Could, would the US continue to purchase Chinese manufacturing output?

Protectionism is very strongly on the rise through Congress & Senate working parties, you need only look at various mergers that were blocked recently.

Trade tarriffs, etc are again a fact of global trade, thus, should China NOT support the US consumer, the US consumer would possibly be denied the opportunity to purchase from China just in case they would still wish to, or could afford to.

China is still a managed economy.
It is managed locally with great inefficiencies and wasted capital.
In China, it has led to massive overinvestment in manufacturing assets in sectors already suffering from oversupply. Investment in fixed assets — everything from steel mills to cement plants to oil refineries to highways — grew by 30% in the first half of 2006.

Although the reported profits of China’s largest industrial enterprises climbed 28% in the first half of 2006 over the same period in 2005, companies in some sectors have seen profits squeezed, sometimes to the vanishing point.

According to government numbers, 80% of the profits in the Chinese economy went to companies in the oil, power, coal and nonferrous metals sectors. The other 30 sectors of the economy shared just 20% of corporate profits.

Profits in the Steel sector dropped by 20% in the first half of the year. The problem is overcapacity. Too many steel companies have added too much capacity, driving down the price they can charge for their product.

Cheap money in plentiful supply has produced a real estate boom in China, too. Higher prices pull more money into real estate, of course. In the first six months of 2006, real estate investment climbed 24.2% over the same period in 2005. According to the National Bureau of Statistics, 1.41 billion square meters of housing were built from January through June 2006, up 21% from 2006.

China needs GDP growth north of 7% a year just to stay even with the number of new job seekers thrown up by its massive population every year.

A purely rational economic analysis would say that if Chinese textile makers can’t compete after the yuan is appropriately revalued, then the least-efficient companies in the sector should go out of business and the jobs should flow to countries, perhaps Vietnam, where lower labor costs would allow textile makers to make a profit.

That would mean shipping jobs out of China, however, and advocating that is political death in a country that needs to create 20 million jobs a year to keep the population governable by the Communist regime.

Therefore, it would seemingly be economic suicide to dampen demand from the US via refusal to fund the deficit in trade. The second part of the equation being, how much of the infra-structure, & productive assets belong to US Corporations via their FDI investments?

Just because the profits are not being repatriated due to tax reasons, does not mean the profits are not accruing to Corporate America.

With such a large component of listed Australian stocks having their earnings seemingly dependent upon Chinese demand, how will Australia weather a recession in China?

China has huge reserves of coal.
They are switching their power generation from oil & imported coal to home produced coal. This will impact the price of coal, particularly if they become net exporters.

Iron ore, with a steel glut already, and getting worse, demand from China will decrease, again, not promising for BHP.

China is the margin economy.
Prices are always set at the margin.
The margin is currently evolving.
In the longer term, I see prices returning to the equilibrium.

So what are those prices?
From RIO’s Annual Report;

Alumina
Low price $250
Current price $420

Aluminum
Low price $55
Current price $90

Coking Coal
Low Price $45
Current price $130

Thermal Coal
Low price $35
Current price $55

Copper
Low price $75
Current price $160

Diamonds
Low price $150
Current price $200

Gold
Low price $350
Current price $550

Iron Ore
Low price $35
Current price $80

Iron Pellets
Low price $45
Current price $120

Molybdenum
Low price $5
Current $30

Silver
Low price $5
Current $7

“Should prices fall to circa $8.00 then there will be enough value available to warrant an investment with “Fair Value” calculated at the range of $18.70 to $13.80 per share.”

Therefore, intrinsic value is in a range between $13.50 – $18.70.

For an UNDERVALUATION I recommend buying at least 50% below this range. At $8.00, BHP would enter the undervaluation, or bargain area.

BHP released their financials early last week. Having now had a chance to read through them in-between Jury service, there are some interesting things going on.

BHP have two separate share repurchase programs that have currently been announced. The August program, a $3.0B program, is more or less complete now.

142Million common shares were repurchased at a cost of $2.957B or circa $20.82/share. Does this represent management’s assessment of value?

Ignoring whether this was good value or not, the allocation of cash-flow went;
$286M………………………….Share Capital
$2.559B……………………….Retained Earnings

So, we can count these earnings twice?

The first time, the earnings are earned via Revenue, flow through the Income Statement, ending up on the bottom line as Net Profit.

That Net Profit if not paid out in dividends, would then rightly be recorded as Retained Earnings.

However, that is not what happened.

Assuming cash was paid for the share repurchase program, out of Net Profit, the shares were repurchased, placed in the Treasury, awaiting cancellation. [Previous Treasury shares have been retired]

Meanwhile, the cash used for the purchase has been recorded as….Retained Earnings. At this point we have the same cash showing up in three different places;
*Net Profit [Retained Earnings]
*Treasury shares [Share repurchase]
*Retained Earnings [Share Repurchase via Treasury shares]

Now, if the shares are not retired [cancelled] and are stored in the Treasury, they should not be recorded under Retained Earnings, they however remain an asset that can be resold. Should this happen, then the proceeds will be recorded under Financing Cashflows, and the proceeds placed in Current Assets as cash.

If the shares are retired, then, the asset is destroyed, in effect, a Return of Capital.
The advantages of this strategy is that future earnings are divided over a smaller share base, thus earnings per share will rise.

In either case, these are not retained earnings.
Currently BHP are counting their earnings three times…a little optimistic.

Earnings were also reported without including “Exceptional Items”.
Exceptional Items totaled……………………………………. $259M
Not an insignificant sum. The general rule is, are the items normal business?
In the case of BHP I would say that they are, thus they should be included.

They were;
*Impairment of South African Coal operations
*Newcastle steelworks rehabilitation [maintenance]

Capitalised Interest……………………………………………$353M
This one is a disgrace. Capitalising interest boosts net earnings. With a company claiming such a successful earnings period, capitalising interest is particularly egregious.

Taxes.
BHP have been utilising Tax Loss carryforwards to reduce Taxable income [no figure supplied]
This company has lost money?

Deferred Taxes……………………….+53.6%
BHP has accelerated depletion for tax purposes. In a resource business this is important. If you purchase on the basis of shareholder figures, you are guaranteed to overpay by the Deferred Tax figure. Again, simply a ploy to boost per share earnings by subterfuge.

Revenues/Inventories/Receivables.
So if we take Revenues of $47.47 and subtract the contribution made by higher prices we come to $40.37 Billion which is a 3.2% increase in Revenues. Now Inventories and Receivables rose by 20.6% and 22.4% respectively.

If you accept that Revenues rose due to advantageous pricing as opposed to increased sales of production [which is the case] then this figure is confirmed by the increase within the Inventory. It is also interesting to note that if Revenues hide the sold production, Receivables suggest that BHP is financing their customers purchases. In this “high demand” era, why is that?

BHP is a highly cyclical company. BHP is a “Pricetaker” not a “Pricemaker” thus, in weak commodity price cycles, BHP can indeed lose money.

Therefore BHP has certainly boosted Net Income by;
Tax + Exceptional + CapInt………………………………………$612M + ?
Retained Earnings………………………………………………….$2.957B
Total………………………………………………………………..$3.569B+

Liquidity [Working Capital]
Total Current Assets……..$8776………………$11087
Total Current Liabilities…..$8661………………$10249
Net Current Assets……….$115.0……………..$838.0
Current Ratio……………….1.01………………..1.08

For a “Blue Chip” Investment, BHP does not come close to passing the working capital liquidity test [minimum = 2.0] It is almost 100% below the cut-off point minimum.

This, especially in a contractionary credit cycle is vital. We have seen $10B Hedge Funds go bankrupt in the space of 5 days. I’m not suggesting BHP is a Hedge Fund, just that liquidity is vitally important and if you don’t have it when you need it, bad things happen.

BHP does have a newly negotiated $3.0B credit revolver…but were you expecting your rock solid investment ever requiring emergency bank lending?

In addition BHP debt is increasing in the time of plenty;

BHP have issued new debt, and placed a Shelf Registration for future debt.
This of course underlines the fact that the cashflow from Net Earnings, ahem, has been spent.
Future Working Capital requirements exceeding cash on hand etc, will be financed via this new issued debt and the debt registered, and already sold.

$788M Floating rate due 2008
$788M 4.375% due 2014
$875M Floating rate due 2009
$625M 5.125% due 2012
$750M 5.4% due 2017

Those “Floating” rates, could seriously impact future earnings…..if of course they are not capitalised or re-financed.

So what were the real, or adjusted earnings?
Adjusted figures………………………………$1.894B

Not quite the headline grabbing BHP version.