Comment from Nate answered

Happy Friday! I hope that this message finds each of you

doing well. Thankfully, here in Santa Fe we have snow falling for the first time in awhile.

Today’s post is an answer to a question asked by Nate in the comments section. Here is what Nate asked:

“I haven’t bought anything yet, and I‘m now kicking myself a bit about it. My main problem is the lack of boldness. Having recently taken over my finances from my parents, I want to take a more active role and make some changes. How do I evaluate a company/mutual fund to determine whether I should own it? When people say: “look for good fundamentals,” what stats are they interested in? How much purchasing information can be gotten from stats on websites like http://www.fool.com/?

“I think now is the time for me to sell some bonds and buy some stocks, but I’ve never traded before and I’m a little scared of making mistakes.”

Specifically I wanted to address: “How do I evaluate a company/mutual fund to determine whether I should own it?”

This blog was created in anticipation of the publishing of a book designed to answer that very question. I sat down last year with the intention of writing an investment opus that would take you from where each of you are right now to investment expertise by the end. It was designed to teach interested readers how to conduct investment analysis for themselves and contained literally everything that I used to use on a daily basis. It was a hands on workbook. This book would have been sizable, at around 1,200 pages. So it wouldn’t have been for everyone, but the remarkable thing is that as I was meeting with publishers they each said that the public was not interested in such a book (!). I am not kidding. Yet, over the years the question I get most frequently from people is how they can conduct their own fundamental financial analysis.

As a blog writer I have a small quandary. Namely, a free-to-the-public blog is not the ideal place to start cranking out financial analysis lessons. Yes, there have been several technical posts about how to do this on your own, but it is very difficult to turn this medium into a teaching medium and still hope to profit from the sale of a book.

So what to do? I have been very tempted to just start posting the information in the absence of a publishing deal. Argh! For starters, Nate, let me answer your question generally. There is a set of skills that you need to acquire before doing your own financial analysis:

• The ability to see the world through the lens of investment opportunity.
• The ability to sift and evaluate news and know what information is important and which is not.
• The ability to read through source material such as a company’s annual report and SEC documents and determine what is important.
• The ability to evaluate a company’s past results.
• The ability to determine the present value of a business based on financial projections of future performance.
• The ability to evaluate the management of a business. This includes past performance, future goals for a business, and structures that are in place that will determine management choices. In other words, the incentive compensation plans put in place by boards of directors that shape management behavior.
• The ability to create an investment thesis that contains your reasons for having bought the firm. This allows you to remain objective in the face of a changing operating environment for the business.
• The ability to continually evaluate the news and understand how this affects company value.
• Knowing when to sell a business.
• How to construct a portfolio of investments.

For about half of these skills there are existing books that can walk you through the process. For the other half there is no book that addresses these skills; hence, the reason for my opus. To further expound on this process and to address Nate’s question generically…

To generate investment ideas pay attention to your interactions with businesses. Are you happy as a customer of theirs? How do you feel after interacting with that business? How do your friends, family and co-workers feel about this business? Another way to generate investment ideas is to read a lot of non-fiction, news-type information. The human mind naturally connects disparate pieces of information together to reveal opportunity. The more data (i.e. the more you read the news) you have then the greater number of, and better connections, you will make.

After you have found a business that you want to analyze then you need to read through the published financial documents of the business to evaluate risk and opportunity. The opus actually dedicates 200 pages to walking you through every paragraph of an annual report and providing commentary for the reader as to why a piece of information is either important or not. But remember, you are not supposedly interested in this type of analysis!

Assuming that you are still comfortable with the business at this point then you need to evaluate past results. Here you will need to have a little bit of an understanding of accounting, but you do not need to be a CPA. A great book for learning those basics of analysis, is: John Tracy’s “How to Read a Financial Report.” This is a short and straight-to-the-point book whose skills every investor should possess. After that, if you are ready for the really heavy lifting then turn your attention to “The Analysis and Use of Financial Statements” by White, Sondhi and Fried. This magnum opus has all of the information you need to evaluate financial statements. An evaluation of financial statements is really about an evaluation of management’s honesty and sobriety. Nothing more.

After that, you will need to have a grasp of how to evaluate the intrinsic value of a business. This is the single greatest skill missing from most investor’s repertoire. The thing that separates a great business from being a great investment is price. If you pay too high a price then you will never make any money by investing. A good book that teaches the skills necessary for valuing a business is: “Financial Management Theory and Practice” by Brigham and Gapenski. In particular, they have an excellent discussion on “additional funds needed” analysis. Another good book is Aswath Damodaran’s “Investment Valuation.” This latter book is not my favorite, but it is generic and broadly applicable.

There is a bible that unites each of the two previous skills and that is “Graham & Dodd’s Security Analysis: Fifth Edition” by Cottle, Murray and Block. This book is out of print, but superior to the recently updated 6th edition. Some of the information is out of date, but it is nonetheless very comprehensive.

After that you need a method for evaluating business news flow. And here is where you have been completely abandoned by the publishing industry. Remember, in their opinion, you don’t really want to know these skills. Sigh! There are skills that can be taught that will help you to reign in the overwhelm of news flow. But that is my proprietary information and I am still trying to cash in on that information. However, know that this blog is written using those principles and there have been sprinklings of the information throughout.

I am happy to answer further questions about these topics. Once the book gets published then I will be able to write more specifically about many of these topics. In the meantime, Nate, check out the posts I have made about evaluating the ability of a business to pay dividends, as well as, and more importantly, the posts about Price to Earnings (P/E) ratios.

With respect for each of you!

Jason