Fundamental Equity Analysis

1
Fundamental Equity Analysis

• Chris Argyrople, CFA
• Concentric Investment Management LLC

2
Humor Caution DLJs Springsteen Theory of the
Dow

• DLJ noted in their April 17, 2000 research report
  that
• The Dow outperformed the NASDAQ after leg 2 of
  the Springsteen Tour
• Conclusion
• 1) The Boss Rules
• 2) Humor is Acceptable
• 3) SOMETIMES IT IS MUCH TOUGHER TO DISCERN WALL
  STREETs BS THAN IN THE SPRINGSTEEN EXAMPLE

3
Why Take this Class?

• Develop Rigorous Analytical Approach Towards
  Evaluating an Equity
• Integrate Concepts from Corporate Finance,
  Accounting, and Strategy
• Profit
• Improve Thinking Skills

4
Where is the Market Going??

• I have no idea where the Dow or SP will trade in
  the next year
• Long Term earnings will drive stock prices and
  earnings have risen about 9 per year over time
• This Class Forecast Results for Individual
  companies, not the market
• IT IS A STOCKPICKERS MARKET GOING FORWARD, SO
  YOU ARE IN THE RIGHT CLASS

5
Allocate 1,000 between these 3

• Company A P/E ratio 15, consensus growth
  estimate 17, analyst dispersion around consensus
  of 12, payout ratio 0.
• Company B P/E ratio 2, consensus growth estimate
  0, (20 analysts all in agreement), payout ratio
  100.
• Company C P/E ratio 10, consensus growth
  estimate 30 (20 analysts all in agreement),
  payout ratio 0.

6
Course Goals

• Be able to thoroughly analyze a company
• Learn how to Integrate all knowledge into a
  portable toolkit for analysis
• Help Train the Next Peter Lynch -)
• NOTE The great student will take the science to
  a higher level than the teacher

7
How/What Will You Learn?

• Learn from Yourself, about Yourself
• Learn from Classmates (dont minimize)
• Learn from Professor
• TURN MISTAKES INTO LEARNING
• My Goal / Deliverable
• Students can prepare a professional securities
  analysis by end of session
• Destination is gt Interim Progress

8
My Finance Philosophy

• Models are Important
• Analysis augments Thought
• Accounting is Important
• Details are Key, but stop when you reach
  diminishing returns.

• Logic and Thoughtfulness are more important than
  modeling
• I would rather be Warren Buffet than Fisher Black
• Strategy is Equally important as Finance

9
Two Approaches to Research

• Traditional MBA
• Do some ratios
• Quick Answers

• This Class
• Sleuthing
• Thought Logic
• Analytical Models

EASY WAY
CORRECT WAY
10
What to Expect

• Hard Work
• Boring Data Gathering and Data Entry.
• Modeling COMBINED with Logic. The Models will
  not give you the answer. I could give you a
  model right now, and you would not know what to
  do with it.

11
What I Expect

• Lots of Hard Work
• Plenty of Participation
• Debate and Differing Viewpoints
• More Hard Work
• I Expect you to be Good at Both the Modeling and
  the Thinking. These are 2 different things.
  Example How do you Calculate this E(r)?

12
About The Markets

• Market Timing is nearly impossible
• The Last 15 Years have been Incredibly easy to
  make money
• The Next 15 Years will be Stockpickers Markets
• Thus, Fundamental Analysis
• Quant models face a difficult future because, by
  definition, quant models eliminate efficiencies
  they exploit

13
Characteristics of Good Analysts

• Intelligence
• Cant be Taught, BUT it can be offset by other
  factors
• Buffet is rumored to be a genius
• Geniuses can see what others dont
• Work Habits Work Smart Hard, Focus
• Independent Thinking / Guts to Act
• Experience Training
• Learn from Mistakes, Be Open Minded
• Passion For the Work

14
MODEL BUILDING

• EDGAR (Elec. Data Gather. Retrieval)
• Data Entry -- actuals from 10Ks 10Qs
• Try to Pick Companies / Industries that have lots
  of data -- Data drives good fundamental models.
  Dont want to multiply last years revenue by 6.

15
Pick A Company / Industry

• Pick Industries where Data is Available
• Maybe you work in that industry
• Want to Drive Revenue with Fundamental Data
• Pick Something you Like
• At my Firm, we like High Fixed Costs, Operating
  Leverage, Data Availability
• DONT WASTE TOO MUCH TIME CHOOSING A COMPANY
  WILL LEARN FROM Your Firm, Classmates, Prof.

16
The Class Will Cover
1) Cash Flow Methodology Valuation 2) EVA TM,
Economic Value Added Model c Stern, Stewart
Co. 3) Strategic Management Valuation 4)
Industry Analysis
17
What Moves Stock Prices?

• Rank These Items
• Press Releases
• Earnings Growth
• Buyers in the Market
• The Big Boys Mutual Pension Funds
• Announced Stock Buyback
• Splits
• Dividend Increases
• Change to a New Economy Business Plan

18
Pattern Recognition is Key in Stockpicking

• Pay attention to patterns in the markets
• Always think WHAT MOVES STOCKS?
• What happens to Financials, Homebuilders,
  Retailers when interest rates rise?
• Why are falling same store sales GREAT for retail
  stocks?
• Need Many Mental Models To a Man with a Hammer,
  Every Problem Looks Like a Nail, Charlie Munger
  -- You need to draw on many experiences for
  successful investing

19
Introduction to Valuation

• THE VALUE OF ANY INVESTMENT EQUALS THE PRESENT
  VALUE OF THE FUTURE CASH FLOWS TO THE BUYER
• This holds for all Investments ? Stocks, Bonds,
  Real Estate, Beanie Babies etc.
• i correct discount rate that reflects the risk
  of the cash flows

20
DCF Valuation

• Discounting future cash flows to a present value
  is called DCF Valuation
• DCF Valuation is ALWAYS CORRECT given the
  following assumptions
• You can correctly forecast the Future (even many
  years out)
• You use the correct discount rate

21
Problem with DCF Valuation

• In 1977, I was in 8th Grade
• Experts told us
• The Russians will take over America
• Oil was going to 100 a barrel
• Computers will take jobs away from humans
• By 1990 the 4 Day Workweek !
• If you can Predict the Future, then use DCF and
  Drop this Course

22
Reasons for Fundamental Research in an Efficient
Market

• KEEP YOUR JOB (1 Reason)
• Develop E( r ) Forecasts
• FIND OCCASIONAL INEFFICIENCIES ATTRACTIVE
  SITUATIONS (this is the real 1 Reason)

23
My Recommendation

• Do Lots of Fundamental Research
• When you have no alpha, diversify and keep costs
  low (index)
• When you have alpha, throttle it. Remember, you
  are in school so you can get a high paying job.
  If you are worth the pay, you will reap the
  excess returns from your best ideas. Implement
  your best ideas in a big way. Are your Ideas
  Worth the Paycheck?

24
The Buffett Method

• Put all your eggs in one basket, and watch that
  basket very closely.
• Concentrated Positions (never less than 9 stocks)
• Intense Research, Lots of Knowledge
• Note A good Portfolio will be
• Industry Diversified
• Maybe have 30 stocks

25
Homework Due

• Pick a company -- Domestic USA only
• Build an equity model
• At least 2 full years of historical data ( 8
  quarters Income Cash Flow Statem)
• Full Year Forecast for Current Year (quarterly)
• Short writeup and investment thesis
  recommendation (Buy or Sell)
• Hand in on-time Hardcopy PLUS Optional email of
  model

26
Homework (continued)

• Use trailing and forward ratios to formulate your
  investment thesis recommendation
• Only most recent quarterly Balance Sheet (for
  now)
• Dont worry youll get plenty of practice !

27
Textbook is Optional

• The textbook is Optional but recommended
• Distributed in class
• Price 65 cash / check / your good word
• Must order text via email
• Length continually varies, but approximately 280
  pages

28
About the Instructor

• Adjunct Professor (not full-time)
• New Analyst 10 years at Fundamental
• B.S. Engineering, Rensselaer Polytech
• M.S. Finance, M.I.T. Sloan
• 2 years Equity Quant Acadian Asset Mgt
• 4 years Corp. Finance Ford Motor Co.
• 1.5 years Asst. Port Mgr Atlas Investm.
• 4 years Analyst PAR Capital Mgt
• Co-Founded Delta Partners in April 1999
• Co-Founded Concentric Investments January 2005
• Analysis of this Career.

29
Instructor (continued)

• Internships Travelers (foreign equity quant)
  Colonial (bond trader)
• Willing to stay late after class to answer
  questions
• Have difficulty finding people jobs, but you can
  always ask (my contact list is finite, but the
  students regenerate yearly)