Company fundamentals

One widely used technique for filtering investment opportunities is top-down analysis. Using this approach, the investor begins by assessing which stock market sectors are likely to perform best. They will then identify which industries within that sector are likely to outperform and, finally, what companies within those industries are best placed.

Traders willing to buy into foreign share markets will also look at the wider global economies and take into account those which are likely to be the best performing and have the best prospects for their selected industries. With today’s globally integrated economies, many Australian companies have major overseas investments or are major exporters to international economies. Traders can obtain international exposure via these companies as well as by direct investment in international shares or managed funds.

Top-down selection often begins with choosing investment themes that the trader considers are likely to be major market drivers. These themes may vary according to the timeframe being considered. For example, an investor may consider that over the long term the aging population in economies such as Australia and the US will be a demographic theme creating above-average profit opportunities.

An example of a short- or medium-term theme would be where traders believe that the business cycle is bottoming and about to enter a gradual expansionary phase. In this case, they may weight their portfolio towards sectors that typically outperform in the early recovery stages of the business cycle, like finance and the consumer discretionary sectors.

Once you’ve decided on your investment themes and preferred industries, you’ll need to know what stocks are available in each industry.

Stocks in the top ASX are grouped into 10 sectors according to the Global Industry Classification Standard (GICS). Stocks in each sector are then grouped under sub-industry classifications.

The alternative is bottom-up analysis. This type of method is quite a bit more expansive in its nature than top-down analysis, but it’s likely to be used more commonly. Traders will use it to look for characteristics of what they believe to be ‘good’ companies. This may include things such as rates of growth, value (based on the P/E ratio) and, indeed, it could include such characteristics as being in a technical uptrend.

Bottom-up analysis can be used to assess a company’s value. A company may have strong profit growth prospects, but is the current share price a reasonable one to pay for that future earnings growth? Is the price too high for the level of risk involved or compared to alternative investments?

Either way, traders will probably want a well-weighted portfolio that won’t expose them too greatly to any one sector of the market. One lesson well learned from top-down analysis is that a downturn in one sector will probably have a negative impact on most companies within that sector.

The likely outcome for most retail traders is that they will incorporate some analysis that would be considered top-down, and some that would be considered bottom-up.

When you look at the company books, you’re confronted with pages of numbers to consider, and titles such as ‘Statement of Cash Flows’ and ‘Notes to the Accounts’. One of the most common ways for analysts to deal with this plethora of information is to condense it into more usable numbers by performing ratio analysis.

Traders use ratios to assess many aspects of a company, such as its profitability, earnings growth, dividend payments and risk profile.

Ratios are calculations that take the figures in company reporting and translate it into something that is much easier to use from a comparison perspective.

The basic building block of ratio analysis is the earnings per share. As the name implies, earnings per share is the amount of profit a company earns for each ordinary share it has issued. This calculation allows you to relate a company’s profit to its share price. Dividend per share is the amount of dividend paid per share.

One of the most popular ratios is the Price/Earnings ratio, or P/E ratio. This is quite a simple calculation but, again, it allows you to make a more effective comparison of different companies than you could using price alone. As the name implies, the calculation involves dividing the share price in cents per share by the earnings per share. The figure returned displays the multiple of the company earnings that you’re paying for based on the current share price. This can be very useful in making a comparison of relative valuations of two companies.

Below are some other key ratios to determine the financial strength of a company:
Debt to equity = Total debt/Total equity – Measures how leveraged the company is.
Times Interest earned = Operating income/Interest payments. – measures the ability of the company to at least service the interest portion of its debt
Current ratio = Current assets/Current liabilities – measures the ability of the company to meet near term obligations out of current resources.
A final word. When assessing companies, it’s just as important to assess the risk involved as the profit opportunity. In some cases you may decide that the risk involved in a company (for example, the volatility of its earnings record or the level of its debt and gearing ratio) may make it an unsuitable candidate for your investment portfolio. In other cases, you may consider the level of risk to be acceptable but you will assign a lower P/E ratio to it. There are dozens of different ratios available to traders to help you assess companies.

The outlook for companies already in your portfolio or that you’re considering buying will be influenced by economic, industry and company-specific news.

It can often be a very good idea to start by reading what the company itself has to say when it makes major announcements. In addition, most traders keep a watching brief on the financial press for news and commentary on companies.

One of the major periods of interest for fundamental analysts comes when companies are reporting their earnings. For most companies, company reporting will occur twice a year in a major form, but it will also happen intermittently during the year as the company updates its investors and the market as a whole. It is quite possible that these updates will impact the share price of the company as the market takes new information into account.

The reporting the company produces doesn’t only interest shareholders, because it shows the profitability of the company. Importantly, it allows analysts to see how close to reality their forecasts were. It allows them to make updates to their modelling in line with the results.

You may have seen brokers issuing upgrades or downgrades on company recommendations after results have been issued to the market. This occurs because brokers will change their own estimations based on this new information, and then amend their recommendations accordingly.

The report the market is most interested in is the full year report. It isn’t only the financial numbers that are of interest to the market. The company will give the market a lot of guidance at this time about where it’s heading and plans it has for the future, including things such as expansion or debt repayment. All these factors help you determine whether the company is an appealing investment for you right now, and also what needs to change for it to be attractive in the future.

The media generally gives a good summary of larger company reporting. If you invest in small companies, you’ll need to do more legwork yourself.

While the impact of changes in the economy isn’t always felt immediately (or even directly) by the share market, it is the economic information that serves to direct the mood of the market over the longer term.

One thing to remember about the share market as a whole is that it prices in what the market expects to happen in the future, not what happened in the past. This is why the markets don’t always respond the way you might expect when news is released.

For instance, if there’s been a release of economic data that shows a large fall in unemployment, the market may not necessarily react at all – particularly if this news had largely been anticipated. You may have thought this could spur companies like retailers, but the fact is that if the market as a whole had been expecting this news for weeks then prices will already have adjusted. Some people call this ‘buying the rumour and selling the fact’. This refers to people buying based on expectation, and then selling when the facts are released to the market.

Each month, a host of economic data is released around the world. Some pieces of data are very important in the immediate future, while others are of greater interest for highlighting trends that may be occurring in the economy. Depending on the timeframe over which you are trading, the impact of economic data can take an immediate impact or it may just be a blip on the long-term trajectory of your portfolio.

Regular items like employment, economic growth and inflation figures can all impact the share market. Possibly the most watched piece of data is the decision on interest rates. Although most people think of interest rates as impacting mortgage payments (which they do), they have an impact on the borrowing habits of companies, which can adjust things like estimates for company growth.