Stock Market Success for Beginners

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ghjk bnm		Stock Market Success For Beginners bnmqwertyuiopasdfgzxcv wer g Maksim Pecherskiy
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Linköping University: Business Administration

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ISRN: LIU-IEI-FIL-G--08/00246--SE
Tutor: Dr. Emeric Solymossy

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Abstract

Bachelor thesis in Business Administration, Linköping University

Spring sem ester 2008

Authors: Maksim Pecherskiy and Stéphan Laouadi Tutor: Dr. Emeric Solymossy

Title	Stock Market Success For Beginners
Key words	Investing; Stocks; Stock Exchanges; Funda mental analysis.
Background and Problem discussion	The finance world is complicated and can be very intimidating to someone who knows nothing about it. This paper provides knowledge in a simple way for anyone who wants to enter this world by purchasing shares of stock. It provides general market knowledge and after looking at successful strategies of the greatest investors it proposes a strategy for investing in the stock market.
Purpose	The purpose of this paper is to see what worked for the best, and what worked historically, combine the data and come up with a strategy that may not work 100% of the time, but overall provides a positive return.
Methodology	This paper is based on internal and external secondary sources. We have used the inductive approach and most our data is qualitative.
Theories	Our theories are based on security analysis and mostly on Fundamental analysis.
Empirical Data	Our empirical data consists of strategies used by successful investors: Benjamin Graham, Philip Fisher and Warren Buffett. As well as internal reports from S&P and Reuters.
Conclusion	Our proposed strategy advocates investing in undervalued growth stocks with strong fundamentals for the long run.

Acknowledgements

We would like to thank Dr. Emeric Solymossy for his great ideas and helping us structure our ideas, Stefan's mom for the French wine and cheese to help us relax during our work, Charlotte Parkinson for providing us with some ideas using her knowledge of economics, Cecile Lauroa for letting us borrow the Methodology Book, Benji Greenberg for looking over our paper and providing his input based on his knowledge, and to Max's DePaul Professor Eric Greenberg for getting him interested in the topic and teaching him accounting.

Table of content

Abstract ii

A cknowledgements iii

Table of content a

Introduction 1

Background 1

Purpose 1

Problem Statement 2

Research Methodology 3

Nature of the Problem 3

Exploratory Research 3

Frame Of Reference 4

Data Collection 4

Analysis of Data 4

About the market 5

What is a stock? 5

Why, How and Where does A Company Sell Stock? 8

Investing 13

Market Philosophies 15

Evaluating Potential Investments 18

Growth Vs Value 18

Fundamental Vs Technical Analysis 21

Finding Information 55

Companies Themselves 55

Financial Publications 56

Internet 59

Other Medias 62

Personal experience 63

Successful strategies 64

Benjamin Graham 64

Philip Fisher 67

Warren Buffett 71

Proposed strategy 80

Introduction 80

Finding Stocks 82

Evaluating companies behind stocks 84

Other advices 91

Example 93

Bibliography 100

Appendix 104

S&P reports on Hansen Natural 104

Reuters report on Hansen Natural 110

Introduction

Background

Tony is currently a student at De Paul University. He is a third year student who is working toward his major in Information Assurance and Security Engineering, an information technology bachelor degree. He has been saving up his money for the past several years from working for several security companies because he has a lot of security knowledge and it's in demand. He has about $10,000 saved up and feels that he can do better things with it than keeping it in his Etrade account and getting only 5.05% annual return. He was thinking about investing in bonds, but he realized that he would barely be beating inflation using that approach. So he was wondering how to get started investing in stocks. He does not really have any knowledge of the stock market other than what he watches on the news about the S&P 500 and the Dow. He knows that S&P 500 tracks the 500 companies that represent the stock market, while the Dow tracks the top companies in the market. When he tried researching about how to invest, he was bombarded with a myriad of information that was dispersed all over the place and that he could not understand. This paper is for him.

Purpose

This paper is written with the beginning investor in mind. The current economic downturn has numerous banks and financial institutions in trouble and they are unable to provide decent rates of return on money that people put in the savings accounts of these institutions. The Fed has decreased the rate of return on Federal Savings Bonds and they barely beat the rate of inflation. But does the person that has no knowledge of finance or the stock market really stand no chance of profiting and getting returns that are better than the average 3% annually offered in an average savings account? Is the only way to profit in the stock market through sheer luck like gambling in a Las Vegas casino? Or is there a way to make informed buying and selling decisions that can provide a great return for the risk the investor chooses to take? Is it possible to take publicly available information and analyze it to make informed and confident stock valuations and purchases? And is it possible to follow in the strategies of investing of the great gurus like Buffet and make a profit? If so, is the only way to do it by reading hundreds of boring 1000 page books that an accountant would not understand, much less Tony, the average no-knowledge investor?

This paper provides a way for Tony to understand the stock market but only to the point of getting him off on the right track in investing. We try to suggest what works and what doesn't and try to take the best from some of the greatest investing gurus. We try to set him on a path to a strategy that will keep him out of trouble in the stock market while providing a decent return. Of course, we can't guarantee that, because the only thing sure about the market is that it will fluctuate. However, we can see what worked for the best, and what worked historically, combine the data and come up with a strategy that may not work 100% of the time, but overall provides a positive return. That is the purpose of this paper.

Problem Statement

By writing this paper we try to answer the two main questions that have driven us to pick this topic. We know that there is more than one way to make money in stocks and in the market in general. However, what we focus on in this thesis is how to make money by finding, buying, and holding stocks of good, solid companies, and how to obtain the most return for the risk taken. Therefore, or main problems are:

· How does the beginning investor make money through capital appreciation of stocks of companies on major stock exchanges?

· How does the beginning investor obtain the most return for the risk that he or she undertakes while investing?

Research Methodology

Nature of the Pro blem

Originally, we were interested in doing something with the stock market and the finance sector in general. Since we had a level of knowledge in economics and finance, and because of the general economic condition of the United States, we first decided to look at the relationship between stock market fluctuations and the economy. However, we quickly found that issue to be outside our scope of knowledge, and decided to look into the causes of market fluctuation. This led us to contemplate the reasons behind the fluctuation of stocks in general, posing a question of what makes price go up or down every single day. Naturally, we became interested on how people make money in the stock market. We began to research, and got bombarded with an overwhelming supply of information, very few of it providing us with a clear picture of the world of investing. We needed to narrow down our audience to see at what level we would be writing this paper. Eventually, we decided to write this paper to Tony, mentioned in the background, who is a beginning investor and knows nothing about the market or stocks. We decided to keep one question in mind above everything else. How does one make money in stocks? We started looking at some of the world's greatest investors such as Buffett and Graham. Eventually, after further refinement and research, we came up with our problem statement. Based on the insights from some of the most successful investors, how does one understand the market, and find and research successful stocks which provide a decent rate of return compared to the amount of risk the investor can afford?

Exploratory Research

After contemplating our problem, we came to understanding that the nature of it is unstructured. The reason we came to this conclusion is because the problem seemed to be not well understood. It's obvious that the stock market and all the stocks on it fluctuate on a daily, even a minute basis. However, what causes them to fluctuate, and more specifically what causes some investments to double or triple in value while others fail miserably, seemed to be a mystery. Furthermore, we wanted to look at how people that have successfully beaten the market over the years were able to know which stocks would succeed and which would fail. Knowing that the solution would not be simple, and the answers could be numerous, we knew we had to look at several sources and several ways of investing to come to our conclusions. We also knew that the direction of our research could change based on our findings. Therefore, we chose to utilize the Exploratory Research methodology. By examining and analyzing strategies of successful investors as well understanding how to find a great company that stands behind the stock symbol by using ratios and fundamental valuations, we hope to arrive at our proposed strategy.

Frame Of Reference

We know nothing of stock valuation or market fluctuations. We do understand however that the people who have successfully beaten the market over a long period of time have had a system for doing so that worked. We hope to provide a theoretical strategy based on our observations and the recommendations of the world's greatest investors as well as valuation books that will try to beat the market. We do understand and assert that this strategy would be theoretical and only a conclusion of our research and deductions. In addition, we do understand that the market can be irrational and unpredictable and that this strategy will not guarantee a positive return percentage all the time. However, we do believe that by picking companies with solid fundamentals and holding them for long periods of time will provide a great way to earn a good amount of return in the stock market.

Data Collection

Since we are using the exploratory model, most of our data comes from secondary sources. We have used several internal and external sources. External sources used for this paper include books and articles, while internal sources consist of stock research reports from the Standard and Poor Corporation as well as Reuters Research Reports.

At first we were building from our existing knowledge of finance, however that turned out to be insufficient. In order to find more information, we turned to libraries, such as the LIU library and the DePaul University library. We have been able to obtain several books that described the investing style of some great investors as well as several books on analysis of different securities. We used these to build our knowledge of valuation formulas, as well as to provide information about the strategies of the great investors. We have also turned to the internet for sources. There are several investing websites which were especially helpful for explaining different ratios and what they mean and how they should be looked at.

For explaining core earnings, we looked at primary sources from Standard and Poor's in a document describing the reason for creating these measurements. In order to collect our primary data, we have also used S&P reports to collect different ratios and key fundamentals. We have used the inductive way of collecting data. We have first observed and researched, looking at some major ways of investing that exist, then took general conclusions from our research and created our theory.

Analysis of Data

In analyzing data, we have tried to concentrate on what are the similarities between the investing styles of the great investors that we have researched. We have also looked at internal documents from the S&P for an explanation of core earnings in order to understand their importance and implementation. For evaluation by formulas, we have tried to pick the most important formulas and to try to organize them first by the financial statement, and then, in our strategy by importance so that the investor who has less time on their hands will be able to skip the highly detailed and in depth valuations that our strategy proposes. From the information we have gathered, we have taken the main points and provided them in this paper. We have tried to limit the formulas that we use to only the most important ones and ones essential for analyzing companies' performance. For the investors, we took out their main philosophy and investing strategy and summarized them here. We have departed from data, and using the qualitative information we have gathered and analyzed, we have created a theory.

About the market

What is a stock?

A company's operations are financed in one of two ways. The first way is by loans from major lending institutions such as banks and credit agencies or though sales of bonds. The other way for a company to raise money to fund its operations is through sales shares of stock or equity. Shareholders are essentially owners of small pieces of the company, because that's what a share of stock is. Therefore, the management of the company is responsible to the shareholders, because they are essentially owners of the company that they are managing.

Why Invest in Stocks?

So why invest in stocks? They are volatile, risky, and the investor could lose if the market crashes. The answer is actually quite simple. Stocks allow the investor to own successful companies, and stocks tend to be the best investments over time. And, if the investor is not a speculator and does his or her due diligence and research, stocks can really pay off.

Table 1 below shows the average total return of stocks measured by the S&P 500 Index and AAA Corporate Bonds shown by Moody's Seasoned AAA Corporate Bond Yield Index over five decades.

Table 1- Percentage Return

PERCENTAGE RETURNS
STOCKS		BONDS
		Per Year*	Total	The 1950s
486.5%		19.4%	11.3%	The 1960s
112.1%		7.8%	19.2%	The 1970s
76.8%		5.9%	81.7%	The 1980s
398.1%		17.4%	238.3%	The 1990s
432.3%		18.2%	131.9%	* Compounded

Compiled Using Data from FRED and Yahoo Finance

It's easy to see that every 10 year period, stocks have outperformed bonds, and by quite a lot. Even during the 1980s when one of the great recessions happened and the 1990s when the dot com bubble burst, stocks on average seemed to provide a way better return than bonds.

Types of Shares

However, not all shares of stock are created equal. There are two types of stock offered by the company in order to finance its operations. Even though most beginners will deal with common stock, it is necessary to understand both types:

Preferred Stock

The first type of stock is preferred stock. If the company goes bankrupt and after all the creditors get paid off, the holders of preferred shares get first claim on whatever is left over, followed by the holders of common stock. Preferred stockholders usually get paid dividends, and if there's still money left over after paying dividends to the preferred stockholders, the corporation will issue a dividend to pay the common stockholders. Furthermore, preferred stock shares usually do not have voting rights.

The exact definition and rights of preferred stock vary from company to company, but the best way to think of this of preferred stock is a financial instrument that is similar to a bond (fixed dividends) and equity (stock price appreciation).

Common Stock

The stock that is most often traded on the markets is common stock. Corporations usually issue a lot more shares of common stock than they do preferred. Holders of these shares maintain control of the company through a board of directors, and have voting rights on corporate policy. However, they are on the bottom of the list if the company goes bankrupt and gets liquidated, right after the creditors, bondholders and preferred stockholders. However, common shares most often outperform preferred shares in the long run.

Making money in stocks

So how can stocks return gains on the money Tony invests in them? There are several ways:

Capital Appreciation

The first is capital appreciation, or when the price of the stock goes up. Therefore, the capital that Tony has invested into the security has increased in value, because the value of his shares has increased. The capital appreciations part of the investment includes all of the market value exceeding the original investment or cost basis.

Dividend

The other way to make money is by holding stocks that pay dividends. Dividends are a distribution of a portion of a company's earnings to a class of its shareholders. The distribution of dividends and how much is decided by the company's board of directors. It's most often quoted in the terms of the dollar amount per share such as $.50 per share. For example, if Tony is the owner of 10 shares of Disney, and they decide to issue a dividend of $.50 a share, he will receive a total dividend of $5 for the shares that he is holding. Not all companies pay dividends, but generally the well established, slow growth companies. High growth companies usually reinvest their dividends in order to maintain high levels of growth and don't pay out their investors.

Declaration Date

This is the date on which the next dividend payment is announced by the board of directors. This announcement will include the dividend size, ex-dividend date and payment date. Once this announcement has been made, the dividend becomes a declared dividend and it is now the company's legal liability to pay it. Ex-Dividend Date

This is the date on which the security becomes traded without a previously declared dividend. After this date, the seller, and not the buyer of the stock will be entitled to the announced dividend. It is usually two business days before the record date.

Record Date

This is the date on which the shareholder must be holding the security in order to receive the declared dividend. On this date, the company records who the holders on record are and makes sure that they receive the dividend. Even if the shareholder sells the stock after this date, he or she will still receive the dividend. Payment Date

This is the date on which the dividend payment is finally made. Only the shareholder who bought the stock before the ex-dividend date and were still holding it during the record date will receive the dividend distribution.

Extra dividends

These are a non-recurring distribution of the assets of a company, determined by the board of directors to shareholders. These are unusually large in size and are not on the usual payout date. These dividends are often declared following strong earnings results as a way for a company to distribute the really good profits of the fiscal cycle to the shareholders.

Stock Splits

A stock split is a corporate action where existing shares are divided into two or more shares. Even though the number of shares increases, the value of each share decreases proportionally. This is in order to keep the company's market capitalization (explained further) the same, since no real value has been added because of the split. For example if Google is currently trading at $580 a share, and has 33.74 Million shares outstanding. The company decides to do a 2:1 split. The stock price becomes $290 a share and they now have 67.48 Million shares outstanding. In each case, 290 * 67.48Million and 580*33.74 million provides the same number for market capitalization. In addition, if an investor is the owner of 100 shares before the stock split, he or she is the owner of 200 shares after. Companies may do this in order to decrease their per share price so that different kinds of investors would invest in it. For example, since Tony only has $10000 to invest, he can only buy 16 shares of Google, and if the stock goes up by $100, he will only make $1600. However, if he buys after a 2:1 split for Google, he can buy 32 shares, and if those shares increase by $100 a share, he or she will make $3200. Therefore, in order to attract smaller investors, companies may want to perform a stock split.

Stock splits also go the other way. A company can also reduce the number of shares trading on the market by doing a reverse stock split. This can be done to increase the company's Earnings per share, even though nothing has really changed. It's usually a bad sign if the company has to reverse stock split as they may do so to make their shares look more valuable or even to avoid being delisted.

Why, How and Where does A Company Sell Stock?

Selling stock to rais e money

In order to raise money to fund its operations, a company has two main choices. The first choice is debt. This involves going to a bank or lending institution and borrowing money at a certain percentage and pay it back over a certain period of time. Another choice is to go into debt by issuing bonds where the company pays the bondholders back at a certain percentage for a certain amount of time. The other option is to finance its operations by selling shares to investors. A share is essentially a part of the company, and therefore entitles the shareholders to a certain percentage of the company's profits.

In order to go public, a company has to go through an investment bank and make an IPO or an initial public offering to the primary stock market. Afterwards, these shares go to a secondary market such as NYSE or Nasdaq. This allows the company to sell shares to millions of investors therefore using their capital to fund its operations.

Primary market

The primary market is where new issues of stock are first offered. Companies, governments, and other entities obtain money by either debt or equity securities. The primary markets are facilitated by underwriting groups which usually consist of investment banks. They will set a beginning price range for a given security and then oversee the sale directly to investors. The issuing company receives cash proceeds from the sale which are used to fund operations and fuel growth. Once the initial sale is complete the security begins to trade on the secondary market.

Secondary market

The market that is on the news every day is the secondary market where shares are traded between different investors and institutions. Before, the secondary market used to be a large trading floor with different investors yelling out orders to buy and sell. However today, thanks to computers, all the trades are done almost real time by computerized systems and the floor now only exists in virtual reality. The main markets that show up on the news every day are NYSE which the New York Stock Exchange, AMEX and NASDAQ. One of the largest difference between primary and secondary markets is that in the primary market, the prices are set beforehand, while in the secondary market, the prices are only determined by market forces such as supply and demand.

All those symbols streaming during CNN Financial news are called ticker symbols, and each corporation's stock has one. It's an arrangement of characters which are usually letters to represent a security that's being publicly traded on an exchange. When a company becomes publicly traded, it gets to pick a ticker symbol for its stock. It's useful to know that stocks trading on the NYSE usually have three symbols, and Nasdaq stocks have four letter symbols.

Types of secondary markets

Centralized markets

A centralized market consists of a market structure where all orders are routed to a central exchange such as a trading floor. The quoted prices of different securities trading on the market show the only price that's available for the security available to investors. NYSE is considered to be a centralized market.

Over the counter markets

An over the counter market or OTC market is a network of brokers and dealers with no centralized exchange. Usually stocks will trade on such an exchange because they do not meet the listing requirements of other exchanges. Even though Nasdaq operates as a network of dealers communicating by computer systems, it is a very large stock exchange with listing requirements and is therefore not referred to as an OTC Market.

Exchanges

Exchanges are marketplaces where securities and other financial instruments are traded. The main function of an exchange is to coordinate fair and orderly trading as well as to provide information about the price of those securities to investors in an efficient manner. An exchange can be considered a platform where investors trade securities with one another and where economic concepts such as supply and demand are clearly exemplified. Exchanges do not have to be a public trading floor, but could exist in a virtual world where all the trading is coordinated by computers. Many famous exchanges are located around the globe such as NYSE in New York, Tokyo Stock Exchange in Tokyo, and NASDAQ which is an exchange fully run on computer systems.

In order to be listed on a specific exchange, a company must meet certain requirements such as regular financial reports and a certain amount of market capitalization.

NYSE

The New York Stock Exchange or the «Big Board» is considered to be the largest exchange of equities in the world judging by the total market capitalization of the securities that are listed on it. Even though it used to be a private organization, it became a public entity in 2005. Its parent company is called NYSE Euronext after it acquired the European Exchange in 2007.

At first, NYSE relied only on the floor trading system, having all the trades yelled by investors and then executed. Today however, more than half of all the transactions that happen on this exchange are conducted by electronic means, and floor trading is used for only high volume institutional trading.

The beginnings of the NYSE go back to 1792. Because of its long history and high reputation, some of the most prominent and well known companies of the world are listed on it. Foreign corporations can list on it as well as long as they adhere to specific SEC rules known as listing standards.

NYSE opens for trading Monday through Friday 9:30 AM to 4:00 PM Eastern Time. It also shuts down for nine holidays out of the year.¹

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Nasdaq

NASDAQ or National Association of Securities Dealers Automated Quotation is a computerized exchange that provides the ability to trade for more than 5000 actively traded over the counter stocks. This exchange is only a few decades old, dating back to 1971 when it became the world's fist electronic stock market. While stocks listed on the NYSE are comprised of three letters generally, the stocks on NASDAQ tend to be listed in four or five letter symbols. However, if the stock is a transfer from the NYSE, then it could have a three letter symbol while trading on NASDAQ.² Usually, stocks on Nasdaq tend to be high tech and carry a little bit more risk than those on NYSE. It's home to tech giants such as Microsoft, Intel, and Cisco.

AMEX

AMEX is the third largest exchange in the United States and has now merged with Nasdaq. It is located in New York City and now handles roughly 10% of all securities traded in the US³. Before Nasdaq, it used to be a strong competitor to NYSE, but now it carries a lot of small cap stocks, and ETFs.

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3 IBID

The Market

What is commonly referred to as the market is where shares are traded and is more specifically the equity market. It is one of the most vital areas of the market economy since it provides companies with access to capital to finance their operations and it lets investors own a piece of the companies and therefore realize potential gains based on the company's future performance.

Indexes

An index is best understood as a statistical measure of change in economy or a securities market. In the case of the financial markets, an index acts like a portfolio with securities that represent a particular portion of the market. The index is usually expressed as a change from a base value in percentages.

Since investors cannot directly invest in a whole index, and the only way to do that is by individually selecting stocks in the index and adjusting them accordingly, index mutual funds and index-based ETFs (See Below) allow investors to buy securities that represent the broad market segments. It is important to remember that the index does not reflect the individual stocks, but rather acts as a barometer for market sentiment. Stocks change in price due to many different factors, and stocks will not necessarily stop going up in a bear market.

Main Indexes

Dow Jones

The Dow Jones Industrial Average, also known as the DOW, is a price-weighted selection and average of 30 significant stocks traded on Nasdaq and NYSE that are thought to represent the market as a whole. Also known as the DJIA, this is what is used to gauge whether the market has gone up or down and where it is headed. It is the oldest and most watched index in the world. A concept that is important to understand is the Dow Theory that states that prices tend to move with positive correlation to each other. This is a very detailed theory and is well out of scope of this paper; however, it is worth summarizing. Under this theory, if the Dow Jones Industrial Average moves in a certain direction, it's not an indication of a trend. However, if the DJIA and the Dow Jones Transportation Average move in the same direction, it could indicate an emerging trend. It is what technicians use to gauge market sentiment and movement.

Nasdaq 100

The Nasdaq 100 is composed of 100 largest and most actively traded companies on Nasdaq. While it includes many different industries, it generally does not include financial institutions since those usually trade on NYSE.

S&P 500

The Standard and Poor's 500 index is comprised of 500 stocks chosen for their market size, liquidity and industry grouping as well as several other factors. It is designed to be an indicator of US equities. It is one of the most commonly used benchmarks to gauge the US market. Since it contains so many companies and in so many broad ranges, many people consider it to be the definition of the market.

Exchange Traded Funds

ETFs or Exchange Traded Funds are securities traded on the stock exchange with a specific symbol just like any other company. However, ETFs track an index or a commodity, or several assets like an index fund. By owning an ETF, an investor can use the diversification of an index fund, as well as the ability to sell short, or leverage a specific index fund. For example, one of the best known ETFs is SPDR (Spider) which tracks the S&P 500 and trades under the sym bol SPY.

Market Sentiment

It's in the news all the time. «This bear market this» or «This bull market that.» These metaphors came from the different way the animals use to attack their opponents. The bull swipes his horns up when attacking, while the bear swipes his paws down. They describe current market sentiment and how investors feel about putting money in the market in general. The two main descriptions are «Bear Market» and «Bull Market.»

Bear Market

A bear market is a market condition in which the prices of the securities on average are falling or are expected to fall. Usually, a downturn of 15 - 20% in different indexes is considered the beginning of a bear market. Usually, investors are pessimistic or scared, and are pulling their money out of the market causing stock prices to fall.

Bull Market

It's the exact opposite of the bear market. Whereas in the bear market the prices of securities are falling, the prices of securities in a bull market are on the rise. Also generally defined as a climb of 15-20% in different indexes is the beginning of a bull market.⁴ Usually investors in such a market are optimistic, investor confidence is up, and so are stock prices.

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Investing

In order to invest in the market, an individual needs to go through a broker who will charge a fee or commission for execution of trades ordered by its clients. Whereas before, only the wealthy could afford a broker and therefore access the stock market, the birth of the internet allowed for the subsequent birth of discount brokers on the internet. These brokers allow investors to trade at a lower cost, but they don't provide investors with personalized advice. Many brokers will charge under $10 per trade and some will go even lower. Thanks to discount brokers, almost anyone can trade in the stock market.

Brokers

Brokers come in two different flavors. The first kind is the full service brokerage firm. These are the largest and most known brokers in the country and they spend millions of dollars a year on advertising to make sure of that. The problem with these brokerages is that they are expensive and they are biased. Such large firms usually have an investment banking division that helps companies make IPOs. It's not hard to see that it may pose a conflict of interest when the other part of the company is dedicated to advising people on what to invest in. Therefore, they may guide the investor to buy shares of a company that they put to market just to keep a good banking relationship with that company. Furthermore, they are very expensive with fees upwards of a $100 per trade. A trade may cost a lot of money and their advice is usually misleading.

The second kind of brokerage firm, and the most appealing one to use, is the discount brokerage firm. They do not have investment banking divisions, but even if they did it would not matter anyways because they don't give their investors any advice. They provide a trading platform to stay competitive and may help the investor by giving them reports from third parties, but the only reason they really exist (in the mind of the investor) is to execute his or her orders to buy or sell. Here, a trade may cost around $7 to $10, so it's more affordable. In addition, they make commission the same no matter what stock gets traded, so they are not interested in giving the investor any recommendations.

Types of orders

In order to invest intelligently and successfully, the investor needs to put all the tools available to him or her to use. Different orders that the brokerage performs are some of those tools and are instrumental in executing trades under specific conditions.

Market Orders

When a market order is placed, it is an order to purchase shares of stock immediately at the next available current price. It guarantees execution, and also carries with it a lower commission, because all the broker has to do is buy or sell. However, placing a market order with a stock that has low average daily volume can be dangerous. In such a situation, the ask price can be a lot higher than the bid, causing a larger spread, and therefore making the shares cost a lot more than originally quoted.

Above the market Orders

An order to buy or sell at a price that's higher than price the security is currently trading. An example of such an order can be a limit order to sell, a stop order to buy, or a stop-limit-order to buy. Momentum traders will often place such traders above the resistance level in the hopes that once a price breaks through the resistance level, it will continue in an upward trend.

Below the market Orders

An order to buy or sell the security at a price that's lower than the current price. An example would be a limit order to buy, a stop order to sell, or a stop-limit order to sell. This can be used to limit losses by some investors who will want to sell a security after it has hit a certain low price point.

Trade execution

Limit Order

An order that instructs the broker to buy or sell a number of shares at specific price or better. The investor can also limit the length of time the order can be outstanding before it's no good. These can often cost more than market orders, but are sometimes worth the higher price if used to limit losses, or purchase shares at a low price the stock hits for only a few minutes.

Example: Tony has decided he wants to buy 100 shares of Coca-Cola but he is willing to pay no more than $30 per share. He sets a Buy Limit order at $30 for 100 shares. If the price of the stock drops to $30 or below, the order will become a market order and execute but only a price of $30 or below. If the price never reaches that point, the order will not execute.

Stop Order

An order to buy or sell a security when its price passes a certain point. This gives the investor a larger probability of hitting an entry or exit price that he or she wants. Once the price passes that point, the order becomes a market order. Investors usually use this when they know they will be unable to monitor their portfolio for a certain period. However, they are not a guaranteed the transaction will happen at the price the trader wants. If the stock drops down really quickly or jumps, the investor's stock will be sold or bought at a very different price than what the investor expected.

Example: Tony has bought a stock for $20 that is now trading for $70. He wants to sell it at $60, therefore locking in a 200% gain. He places a stop order to sell at $60. The order will execute at the best price it can after the price hits $60 or lower.

Stop Limit Order

This order combines the features of a stop order with those of a limit order. This order will be executed at a specified price or better after a given stop price has been reached. In other words, once the stop price has been reached, the order becomes a limit order instead of a market order, therefore giving greater assurance that the order will be filled at the price desired by the investor.

However, the downside is that the trade may not be executed if the stock reaches the stop but does not hit the limit.

Example: Going back to Tony and his stock that he wants to lock in a 200% gain on. If he places a stop limit order to sell at $60, and the price hits $60, the order will only execute at a price that is $60 or higher, unlike the stop order which will execute at any price after the price point has been hit.

Market Philosophies

Before talking about investing and different strategies that exist, it is necessary to undertake a certain philosophy about how the market functions, therefore bringing about some basic assumptions.

The Efficient Market Hypothesis

The efficient market theory was published in the 1970s by Eugene Fama. It is a theory that states that all share prices at any given time are the result of all available information. It makes the assumption that people analyze information in the same way, that they are rational, that all information is available to everyone at the same time, they react to it instantaneously, and that there is an infinite number of investors who want to sell or buy a given stock at any given time.

There are three levels of this academic theory. The first version is called «Weak Form Efficiency» and asserts that all information from the past is already included in the current price. This goes against the tenets of technical analysis, because this says that future price movements cannot be predicted based on past price fluctuation patterns.

The second version is called «Semi-Strong Form Efficiency,» and it states information that can only be obtained from insider trading can benefit investors with an edge in the market.

Finally, the third version is called «Strong Form Efficiency» and states that all information about a stock is already reflected in its price, and its impossible to gain an edge through fundamental or technical analysis. Therefore, it is impossible to «beat» or outperform the market over the long term.⁵

This paper's philosophy of the market

This paper will be written on the assumed rejection of this hypothesis because due to the information that we have read, we do not believe it to be true. Investors like Warren Buffett and Benjamin Graham have consistently beaten the market over the long term as well as many others. This brings to assume that the market is inefficient which leads us to three main investment methodologies.

· Behavioral Finance

· Investing Based on Technical Analysis

· Investing Based on Fundamental Analysis

Details of Behavioral Finance are out of the scope of this paper because it deals with psychological aspects and we have no background with psychology. We do accept that numerous studies have been made that explain market anomalies based on the lack of investor rationality, and we will use that fact further in our paper.

5 Investopedia.com

We also believe that investing based on technical factors carries greater risk than what an average beginning investor may want to undertake, therefore the details of investing based on technical analysis will be excluded from the scope of this paper. In addition, the average investor will not likely have an extensive knowledge of the mathematics and charting needed to perform technical analysis with a certain range of confidence. However, we do recognize that certain technical phenomena and combinations of technical and fundamental factors may help to make rational decisions for investors and we will discuss those in some details in our valuation and strategy sections.

We will propose a strategy for investing based on fundamental factors of companies behind the stock. From our research we have concluded that people that have managed to successfully beat the market have been able to do so in this manner. From our research, we firmly believe that by picking companies with strong fundamentals, it is possible to outperform the market. This leads us to a further breakdown of the Fundamental Analysis I nvestment Methodology as follows.

· Income Investing

· Speculation

· Value Investing

· Growth Investing

Income Investing is based on finding companies with good fundamentals that will pay a good amount of dividends. However, the most an investor can obtain from dividends on average is about 5-6%, and dividends are not guaranteed, so if a company is not doing well, they may cancel several dividend payments. A missed dividend in one quarter can decrease the gains to around 4%. In addition, the price of the company's stock could fluctuate which would also affect the income of the investor. Therefore, we believe that the risk of being invested in the stock market is too great for the small amount of gains that the investor would receive compared to a savings bond. We recognize that some investors would prefer this method because of its decreased volatility compared to other investing methodologies, but we would like to point out that income investing is out of the scope of this paper.

Speculation is a much more risky strategy than income investing, as well as any of the other strategies mentioned above. "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."⁶ We believe that speculation carries more risk than a beginning investor would like to take on in addition to not having enough experience to speculate. Therefore, speculation is out of scope of this paper.

6 Benjamin Graham, Security Analysis(18)

Value investing, described further in this paper involves finding undervalued companies with good fundamentals and holding onto them for a long time. Benjamin Graham, considered to be the father of value investing was successful in the market over the long term as well as several others who followed this methodology. We will further focus on this methodology in order to develop our strategy.

Growth Investing, also described further in this paper focuses on finding companies with reasonable potential for growth in the long term. Investors such as Philip Fisher used this methodology to become successful in the market over the long term. We will apply this methodology as well to the development of our strategy.

To summarize, our strategies and our theories will assume that:

· The market is inefficient

· All information is not available to everyone at the same time

· That investors do not react to information instantaneously,

· That a large percentage of investors are irrational and emotional because a large percentage of them are human⁷

· Investors Make Mistakes

· It is possible to outperform the market over the long term.

· Stocks of companies with strong fundamental factors will perform well in the long run

7 A certain percentage of investments are performed by computers who process market information and react to it instantaneously based on pre-set guidelines.

Evaluating Potential Investments

Evaluating a potential investment can be a daunting task for a beginning investor. There are different styles of investing such as growth and value investing. Furthermore, analyzing investments themselves can be done through technical or fundamental analysis. In addition, there are many ratios that can be looked at and compared in order to make educated decisions about whether the company the investor is buying will go up in price and is a profitable investment over time. This chapter will provide a sort of «investor's toolkit» for evaluating investments.

Growth Vs Value

In order to fully explain stock classification to the beginning investor, it is necessary to clarify the main strategies that traders use to succeed in the market. These strategies are not set in stone, but are rather guidelines and philosophies used by different investors. Even though this section will not go into full detail on stock picking strategies, it is necessary to introduce them in order for the reader to understand different valuation principles.

Value Investing

Value investing is perhaps one of the most widely known methods to pick stocks. When a person who is new to investing thinks about trading stocks, value investing undoubtedly comes to mind. The strategy was formalized by Benjamin Graham in the 1930s in his books Security Analysis and The Intelligent Investor. Some of the better known value investors include Warren Buffet and Benjamin Graham.

The main premise of value investing is the rejection of the Efficient Market Hypothesis. ⁸ After all, if the market always assigns the correct value to stocks, it is impossible to ever buy stocks that are undervalued. Rather, value investors follow the mindset of Benjamin Graham who believes that the market is irrational and will not always price a company's stock correctly, but will often undervalue it or overvalue it. In fact, one of his most popular followers, Warren Buffet said, «In the short run the market is a popularity contest. In the long run, it is a weighing machine.»⁹

Based on this philosophy, value investors look for good, solid companies, that for one reason or another are selling really cheap compared to their intrinsic value and not historical prices. Value investing is a strategy of buying stocks whose intrinsic value is higher than the price that the market has assigned to it. It's important to note that this does not refer to the actual stock price. Some may confuse value investing with just buying stocks because they are cheap ($5 a share rather than $300). This is not the case. Value investing is based on the understanding of the fact that when you purchase a stock, you are purchasing a part of a living, breathing and operating company. The value investor sees stock ownership as a means to owning a part of a company, rather than just gambling on a stock hoping it will go up. The performance of the stock, and the price of the stock in the market will undoubtedly eventually be based on the performance of the company. One of Buffet's most known phrases is that «time helps great companies and destroys mediocre ones.»¹⁰ Therefore, it is necessary for the value investor to assess how good of a company it is that he or she is buying. When

8 Investopedia.com

9 Robert Hagstrom, The Warren Buffet Way( 103)

10 Robert Hagstrom, The Warren Buffet Way( 147)

buying a computer, the customer has to look at its processor, how much memory it has, how big it's hard drives are and many other factors in order to assess its future performance. In comparison, the value investor must look at numerous key measurements of the company's performance in the past in order to assess whether this is a good company to own a part of. These measurements will often be found on the Balance Sheet, Income Statement and Statement of Cash Flows which every publicly traded company must provide quarterly, as well as many other places such as the Shareholder's Report, company website, or the company's Investor Relations department as well as the internet. This paper goes into detail on how to locate them in a further section. These values include everything from how the management runs the company, to how much debt the company has, to how much money it earns annually, and many other different factors. A value investor's job is to look at all these values, known as fundamental measurements, and make a decision as to how much the company is worth, or its intrinsic value. It's worth noting, however, that different investors will judge intrinsic value differently. If two investors were given the same information, they may come up with two completely different estimates of intrinsic value. Once the intrinsic value is known, the investor will compare it to the current market price, and if the stock is trading lower than what the investor believes its worth, he or she will purchase shares. Therefore, he or she is usually not interested in the day to day price fluctuations of the stock because he or she knows that he or she has picked a solid company that is posed to perform well.

For example, Tony is thinking about which companies are good to add to his portfolio. He decides to look at SBUX, a Starbucks stock that has been trading for around $40 a share until recently when it fell to $15. He is wondering if SBUX's price fell because the market has undervalued it, or because there is something wrong with the company. He spends a few days researching the company, looking at P/E ratios, statements of Cash Flows, and many other different quantitative factors. He also looks at the recent news about the company, recent changes in management and other qualitative factors.

He then makes a decision that to him, Starbucks is worth $45 a share, because it's a good solid company and has a bright future and bright expansion plans. He sees now, that he can get a bargain because the price fell to $15 a share, so he buys. He doesn't really care to look at day to day market fluctuations and he is not biting his or her nails off because he is afraid he will lose his or her investment. He knows he has bought a solid company. In two weeks, he checks to see that the stock has risen back up to $40 dollars.

He then decides to take a look at some of the other stocks in his portfolio and sees that a company with a stock symbol of WINS, which he bought for $7 a share has fallen to $4 a share. He is wondering if he should buy more. He re-evaluates his or her stocks, taking his time to do research, only to find out that the management changed in the company for the worse. He decides to sell his stock so that he won't lose any more money. The company eventually bankrupts. In this case, the price fell, but it was the market's reaction to a change in management for the worse. The market has evaluated the price of the stock correctly.

Growth Investing

Growth Investing, on the other hand is a little bit different cup of tea. The best way to explain growth investing is to put it into direct contrast with value investing. Value investors are focused on the current price of the company and its current intrinsic value, always shopping for a bargain. Growth investors, on the other hand are interested in the future potential of the company they are looking at, while not really putting much emphasis on the current price. They don't mind paying more for a company than its intrinsic value, because they believe that the company will grow way beyond their valuations anyway.

For example, growth investing could be compared to a team manager trying to recruit Michael Jordan. The manager would have to pay Jordan a lot of money, but as long as he or she keeps winning games and putting people in the seats, it's worth it. In addition, if he or she trains more, he or she can get better. However, value investing on the other hand looks for players that are good but don't have Jordan's hype. Therefore they would have to pay them less, and get a great player at a bargain price. However, there is always the possibility that they get what they paid for and the player really is bad.

Growth investors are interested in growth stocks and those tend to be companies that grow a lot faster than others. It makes sense then for growth investors to be primarily concerned with younger companies that have a lot of potential for growth. They base their philosophies on the theory that growth in earnings and revenues will make the stock price go up. Growth investors realize all of their profits through the increase of the stock price rather than dividends paid out to them, because the companies they invest in usually do not pay dividends.

For example, Tony's wife, Tanya is a growth investor. He or she decides to look at shares of Google. They are currently trading for around $530 a share, up from about $430 last quarter before the company's earnings report came out. She wants to buy several shares of the stocks because after evaluating the company, she strongly believes that the company can go up in price even more, or perhaps the stock will split. She ignores Tony's advice to wait until the share price drops a little bit, and makes the purchase. Google continues to go up in price and Tanya makes money, making sure to tell Tony that she was right.

Other types

There are two other major types of investing that are worth mentioning but merit no further discussion in this paper due to its scope. The first is income investing where the investor picks companies based on their dividend yield and the income from the shares comes not from capital gains, but only from dividends. The other type is called speculation and is where investors look at chart patterns and have very little interest in the company they are buying. This is a very risky way to trade and requires looking at stock price changes on minute to minute levels.

Fundamental Vs Technical Analysis

There are two generally accepted ways to look at stocks and determine whether they are worth purchasing or not. This chapter will concentrate mostly on Fundamental analysis, as this is the main underlying factor behind most of the successful strategies that were researched. However, technical analysis is also very useful to know and should not be neglected. Both ways of analyzing stocks should be included in a successful investor's strategy because both provide information about the stock and its price movements that should not be missed.

Fundamental Analysis is a term for a technique for looking at a security such as a stock or a bond and analyzing its value by looking at certain underlying factors behind that specific security. As discussed before, a purchase of a stock is a purchase of a certain part of a living breathing corporation. Successful investors have always performed fundamental analysis in order to determine how much a security that they are looking at is worth. Investopedia calls it the cornerstone of investing. It does however merit to say that a growth investor and a value investor will look at different aspects of the company's fundamentals differently, each will undoubtedly perform fundamental analysis in order to know what he or she is putting his money into. By looking at certain fundamentals of a company, industry or a whole economy, the investor can make educated guesses as to the well-being of the company he or she is looking at. Some questions answered by fundamental analysis include

· Is the revenue growing?

· Is it making a profit?

· How does the company stack up against competition?

· How is the industry the company is in is doing?

· How deep is the company in debt?

· How free is the cash flow through the company?

· Is there evidence of «creative accounting»?

· And many more.

However, all these questions really boil down to one specific question. Should I put money into this stock and is this a good investment which will make my money work for me?

The real purpose of doing any kind of fundamental analysis for any security is essentially finding out the security's intrinsic value. Essentially, this is based on the rejection of the Efficient Market Hypothesis because after all, if the market were always correct in its pricing, there would be no reason to look for undervalued stocks. This essentially brings another assumption: In the long run, the market will reflect the fundamentals of the company and price the stock accordingly. According to Warren Buffet, «In the short term the market is a popularity contest; in the long term it is a weighing machine."¹¹ The trouble is however, that the long run may be just a few weeks or a few years and knowing the exact time frame is impossible. The other problem is that one doesn't know if his valuation of the intrinsic value is correct. As previously mentioned, there is no correct way to determine intrinsic value, and different investors will come up with different valuations.

Technical analysis, on the other hand is at a completely different range of the spectrum. While fundamental analysis is concerned mainly with the value of the company behind the stock, technical analysis looks more at the price and volatility patterns of the stock rather than the company behind it. Technical

11 Robert Hagstrom, The Warren Buffet Way( 103)

analysts are generally interested in the price movements of the stock on the market. Essentially it studies supply and demand and by the direction of the charts, technical analysis attempts to determine where the stock will head. Technical analysis assumes that the price of the stock will always reflect all the information about the company and the market that the price moves in trends, and that price movements repeat.

Another main way that technical analysis differs from fundamental analysis is the time horizon. Technical analysts will look at data in months, weeks, days, hours and minutes in order predict future price movements. They are often called swing traders because they do not hold on to a stock for a very long time. Fundamental analysis however focuses on a time frame of years, looking at num bers from financial statements of the past five years in order to determine the value of the company. In addition, things like management, brand recognition, and other qualitative factors that fundamental investors look at can only be analyzed by looking at historical data from years ago. The fundamental investor will hold on to a stock for a number of years, because he or she believes that in the long run, the market will reflect the intrinsic value of the stock.

Fundamental Analysis

Here, this paper will focus on fundamental analysis, or analyzing the company behind the stock. When performing fundamental analysis, there are two types of factors that comprise the fundamentals of any given company. The first and the most obvious type that one might expect to look at are the quantitative factors. These are capable of being measured and expressed in numerical terms. Examples of these can be Assets, Liabilities, Revenues, Expenses and many other factors found on the financial statements of a company as well as on the internet. Qualitative factors, on the other hand, include everything else. Things that cannot be measured such as the efficiency of management, brand value, future outlook, patents, proprietary technology, competition, and everything else about a company that cannot have a specific number assigned to it. Qualitative factors are the largest reason why when two different investors are given the same figures, they can come up with two drastically different valuations of the company. These factors cannot be measured, but comprise a large portion of the intrinsic value of the company.

Qualitative Fundamental Factors

10k and 10q

Before discussing qualitative fundamental factors, it is important to mention these annual reports of a company's performance that have to be submitted either yearly (10k) or quarterly (10q) by publicly traded companies to the SEC. The 10k usually contains company history, organizational structure, and much other information not contained on the annual earnings report. The 10q discusses the company's financial position and performance. These can both be pulled up from the EDGAR database at secinfo.org along with the annual report and other SEC filings by companies¹².

Company Level

Business Model

When Warren Buffet invests in a stock, he makes sure to treat the investment as though he were buying the whole company.¹³ And anyone buying a whole company would like to know its business model, and understand it. The business model gives the answer to the most important question - how does the company make money. It's possible to get a good overview of the business model by looking at the company's website or checking out the company's 10k filing (described below). In addition to looking over the business model, it's necessary to understand it. Buffet talks about a circle of competence, by which he means knowledge of a particular sector. He does not invest in tech stocks not because he is afraid that they are too volatile, but rather because they are out of his circle of competence - he does not understand them. If an investor cannot understand a company's business plan, he does not know what the drivers are for future growth, and investing in it could be extremely risky.

12 Can be found at secinfo.com

13 Robert Hagstrom, The Warren Buffet Way

Competitive Advantages

The competitive advantage of a company is also extremely important. If the company does not differentiate itself from its competitors, what is there to keep it in business? It can't get more market share, and therefore is stifled in growth. Michael Porter, a Harvard Business School Professor says that very few companies can compete successfully if they are only doing the same things as their competitors. He argues that sustainable competitive advantages can be obtained in several ways:

· Unique position in the market place

· Clear tradeoffs and choices vs. competitors

· Activities that are tailored to the company's strategy

A high level of integration across activities (The activity system)

· A high degree of operational effectiveness¹⁴

Signals of these factors can be seen in news reports, and also the investor can get clues to these by looking at the financial statements (discussed below).

Management

What good is a great business plan when the management is a bunch of crooks, or they are stupid enough not to implement it correctly? Every investor needs to know a lot about the management of the company. While individual investors can't really get a face to face meeting with managers like analysts that work for multi-million dollar funds can, it is possible for the average investor to get a good feel for management in several different ways.

Conference calls are hosted quarterly by the CEO and CFO of the company. The first portion of the call is dedicated to reading off financial results, but the really juicy part is the question and answer part. This is where the line is open and different analysts can ask questions from management. The answers here can be revealing, because analysts know what to ask. But the more important part is how the management answers. Are they answering like politicians or are they straightforward about their answers.

In addition, the Management and Discussion portion of the annual report is where the management gets to be honest about the company's outlook and is fully at management's discretion. A good thing is to look at some annual reports from several years ago and compare them and see if the management has followed up on what they have said and if the changes they wanted to make have been implemented.

If the people who run the company have a material interest in its success, they are more likely to work harder to make it succeed. The investor should look for a large stake in the company to be owned by insiders. It is especially crucial for small cap companies as management is crucial in the success of the company, and the investor should look for management to be invested in the company. In addition, it is worth noting that while insider buys are worth looking, insider sells are worthless information, unless several key executives are selling at the same time. The reason for this is that people sell stock all the time to finance their child's education, make a down payment on a house, or many other different reasons.

14 Michael E. Porter, Cynthia A. Montgomery, Strategy: Seeking and Securing Competitive Advantage. (182)

Industry Level

Assessing the company in relation to its industry can help the investor to obtain an understanding of different external factors affecting the company and how in control the company is of those factors. Customers

Some companies only cater to a few customers, while others serve millions. A big red flag comes up when a business relies on only a few customers for a large portion of its sales simply because of the question, what if they go away? For example, if a company has the government as its sole customer, what will happen to the company when there is a policy change and the government no longer requires the company's product?

Market Share

The market share of the company can tell the investor a lot about the company itself. If the company possesses most of the market share, the investor can judge the stability of the company in the industry. In addition, companies that hold a large amount of market share have an economic safety guard against competitors and because of economies of scale they are capable of absorbing costs a lot better and still maintaining the lead.

Industry Growth

If the industry where the company operates has a bleak outlook, how can the company grow? This factor needs to be carefully considered before investing in any company.

Competition

Some companies have one or two competitors while others can have hundreds. Companies with hundreds of competitors can have a harder playing field compared to those with only one or two.

Regulation

Is the company's product regulated? For example in the pharmaceutical industry, the FDA has to approve any drug before it reaches the market. This can take years and billions of dollars. This needs to be considered in the attractiveness of the investment.

Several Guidelines for Performing Fundamental Analysis / Looking At Ratios

When performing fundamental analysis, it's important to keep several things in mind regarding ratios and other numbers. The first and one of the more important things is that ratios are best looked at as a long term trend. Even though it's useful to compare a ratio to a universally accepted standard, or the industry, a ratio compared over five or ten years can tell a lot more about a company. In addition, as previously mentioned the validity of some numbers found on the financial statements often needs to be questioned and adjusted in order to get a clearer picture. It is the investor's job as a detective to provide him or herself with a clear picture of the company he or she is buying. Furthermore, it is important to look at a number of different factors and ratios that reveal important facts about the company's risk and its potential because there is no indicator that will tell everything. Fundamental analysis becomes a valuable tool when the investor begins to review trends, each developed from tests of different ratios. It is also important to understand that goals need to be set by the investor for him or herself in terms of ratios. For example with the P/E ratios the investor may want to make a goal to sell when the ratio hits a certain point because at that point the company is not worth holding or could go down.

Quantitative Fundamental Factors

In order to understand quantitative fundamental factors, it is necessary to understand where they can be found. Most of these factors can be found in a company's financial statements. However, at the first look, these can be extremely intimidating due to the extremely large amount of different numbers and definitions on each. The three most important financial statements of a company are the income statement, balance sheet, and statement of cash flows. These can be found in either the investors packet along with the annual report and can be obtained by calling investors relations, or by simply looking up the company in a financial website such as Google Finance and looking at these electronically. Following is a brief description of each statement and some of its most important sections.

Balance Sheet

The balance sheet is a representation of assets, liabilities and equity of a company at any given point in time. All balance sheets, at the beginning say «As Of DATE.» This is important to understand because a balance sheet is a snapshot of the company's financial situation at that given point in time. It does not track changes over periods of time, but is rather a clear picture of one point in time in the day of the company's life. The premise of the balance sheet is that well, it balances. The businesses financial structure balances in the following manner:

Assets = Liabilities + Stockholders Equity

Figure 1 - Balance Sheet

Source: Stock Market Investor's Pocket Calculator (113)

Assets

The resources that business owns or controls at the time specified on the balance sheet. These can range anywhere from the stapler on the secretary's desks, to the trucks that transport machinery, to the computers that the IT department manages, and the building where it's based to the liquid cash that's available in a company's bank account. They are further broken down into categories called current assets, long term assets, and other assets.

Current assets

They are either cash, or can be easily converted to cash within the nearest 12 months. This section of the balance sheet contains three very important items crucial to company analysis. These include cash, inventories, and accounts receivable.

Cash

Generally, investors are attracted to companies with a large amount of cash on their balance sheets, believing that cash offers protection from hard times and the ability for a company to quickly take advantage of emerging business opportunities. And a growing cash account over several business cycles indicates that cash accumulates so quickly that management doesn't know where to put it. However, if a balance sheet's cash account seems to hold an abnormally large amount of cash over several business cycles, a question should pop up in every investor's mind as to why the money is not being put to good use. Is the management too short sighted to do anything with it? Has it run out of investment opportunities? These are questions that need to be asked by every critical investor.

Inventories

Products that the company is keeping in warehouse and is ready to sell. It is good to know if the company has too much money tied up in inventory that it cannot move or is hard to move. If the company is not selling what it has in stock at the warehouse, they cannot make the cash to pay bills and make a profit. Receivables

Anything that is owed to the company. Finding out the speed at which a company collects debts owed to it can tell a lot about how efficient the company is financially. The collection period should not be growing longer because that would mean that the company could be letting its customers stretch their credit in order to increase its sales, but is not actually generating cash. If when it's time to pay back, the customers don't have the cash to pay because of a bad economy for example, the company could wind up in trouble.

Long term assets or non-current assets

They are capital assets minus accumulated depreciation. These could be fixed assets such as buildings, machinery, and property. Unless the company starts liquidating, these are not very important.

Other Assets

That includes any tangible or intangible assets such as goodwill, prepaid assets such as insurance and

others.

Liabilities

Liabilities and Shareholders' Equity comprise the other side of the balance sheet equation. They represent the total value of the financing that the company has used to acquire those assets. If liabilities were used, then the money to acquire assets came from loans and the company owes money to banks or other lending agencies. These are also further subdivided into current liabilities, and non-current liabilities.

Current Liabilities

Current liabilities are debts that the firm must pay off within the nearest twelve months. These can include payments owed to suppliers and other immediately payable expenses.

Non-Current Liabilities

Non-Current Liabilities are debts that need to be paid off in over one year. These are usually debts to banks and bondholders.

Investors should look for a small amount of debt that is preferably decreasing over the reporting cycles. The company should have more assets than liabilities in order to be able to pay them all back and not go bankrupt.

Shareholder's Equity

If the acquisition of assets financed by liabilities means borrowing money from banks and other lending institutions, the acquisition of assets financed by shareholder's equity means using the money gained from stock sales to acquire them. It can be determined by the following formula,

Equity = Total Assets - Total Liabilities

Paid-In Capital

This is the amount that the shares were worth when they were first sold. As discussed previously, the markets that the average investor purchases from are secondary, and the prices of the stocks of those markets do not affect a company's bottom line. Paid-In Capital discloses how much money was made from the stock sales by the company.

Retained Earnings

They are the amount of money that the company has gained from selling its stock that the company has used to reinvest in itself instead of paying it back to shareholders in the form of dividends. An investor should look how well the company puts this money to use and how it generates return on this money.

Income Statement

The income statement is where all the juicy numbers are located that always show up in the news. Figures like revenues, expenses, profits and earnings per share and expressed on this statement. The main reason for analyzing the income statement is for an investor to figure out if the company is making money. Unlike the balance sheet, the Income Statement begins with «For The Period Ending... Date.» This is to specify that the income statement is a record of a certain amount of time in the company's life. If the balance sheet is a picture, then the income statement is a short film. The main formula that governs the income statement is:

Profits = Revenue - Expenses
Figure 2 - Operating Statement

Source: Stock Market Investor's Pocket Calculator (136)

Revenue

Revenue or its synonym, sales, is how much money a company has made over a certain period of time covered by the income statement. This number is the main driver for the profitability of a company. However, since profit, or earnings equal revenues minus expenses, it is good for the expenses to be going doing while the revenues are going up.

COGS - Cost Of Goods Sold

This can be the sum of several different accounts. These can include merchandise purchased for sale or manufacture, the cost of shipping, salaries and wages that are paid out to employees that are in positions directly related to revenues, and changes in inventory levels from the beginning to the end of the reporting period. It is important to understand the difference between costs and expenses. Costs should follow revenues very closely, as they are essentially the cost of generating those revenues. So when revenues go up, the costs will most often go up as well.

Gross Profit

This is the number obtained when subtracting costs from revenues. This number should also vary along with sales. A gross profit that fluctuates wildly from one period to the next could mean a merger or acquisition, a new product, a sale of an operating unit, or a change in an inventory valuation method. Further research should follow such a phenomenon.

Expenses

Unlike costs, expenses do not vary alongside revenues. This category includes all the money leaving the company that is not in direct relation to revenue production. It is very important to note the difference between costs and expenses. The relationship between costs, expenses, profit margin and revenues is demonstrated Figure 3.

Figure 3 - Operating Statement with Controlled Expenses

Source: Stock Market Investor's Pocket Calculator (138)

As can be seen from the graph above, as revenue varies, the costs vary alongside them, while expenses stay relatively unchanged. This assumes that expenses are controlled. When revenues increase, so does profit margin, making more money for the company that the expenses are not eating up. However, consider the following graph with uncontrolled expenses.

Figure 4 - Operating Statement with Uncontrolled Expenses

Source: Stock Market Investor's Pocket Calculator (139)

This chart represents a company who is unable to successfully manage its expenses, one of the usual reasons for this phenomenon being lack of good internal controls.¹⁵ The level of expense rises over time

15 Michael C. Thomsett, Stock Market Investors Pocket Calculator

eventually turning profit margin into loss. The profit margin is shrinking when revenues are on the rise and when they are falling, which is not a good thing for any company. A company with a relationship like this between profit, revenues and expenses should be avoided at all costs by any investor.

Expenses can also be further broken down into two categories called selling expenses and administrative costs or overhead. Selling expenses are related to the generation of sales but not directly, like costs. Overhead can include rent for the office, wages of employees not directly related to revenue generation, office supplies and electricity. These usually recur each year.

Operating Profit.

This section discloses the profit made from operations which will be the same or close to core earnings as defined by S&P (Discussed Later). This number may often not be reliable, because even with GAAP it is possible for companies to distort this number by creative accounting.

Other Income and Expenses

This is a series of additional adjustments from the non-core section. For the income part, these can be profits from sale of capital assets, currency exchange adjustments, or interest income. For the expense part this could be losses from sale of capital assets, currency exchange losses and interest expenses.

Pretax Profit

After subtracting expenses and adding income from the other income and expenses section to operating profit, this is the number that is determined. This is the value used to report net earnings.

Provision For Income Taxes

This is the amount set aside by companies to pay income taxes. This value can change based on what country or state the company operates in, its tax liability changes and other such variables.

After Tax Profit

This is the final net profit or loss, and the value used to calculate Earnings per Share (Discussed Later). The problem with this measure, however is that since this bottom line is subject to many nonrecurring and non-core adjustments and other factors, the investors cannot compare two different companies on the same level using EPS.

The income statement can provide some valuable knowledge inside a company. Increasing sales shows a sign of good fundamentals, rising margins can indicate increasing efficiency and expense control. It's also good to compare the company with its industry peers and competitors to see how other companies fare against the one you are researching.

Statement Of Cash Flows

This statement shows how much cash moves in and out of the company over the quarter or year. This is also calculated for a specific period like the income statement, but there is a big difference. Accrual accounting requires companies to record revenues and expenses when the transactions occur, not when cash is exchanged, and this type of accounting is used on the income statement. For example, when the company shows a net income of $20 Million on the income statement, that does not mean that he cash account on the balance sheet will increase by $20 Million. The cash flow statement is more straightforward, and when it shows $20 million cash inflow, the cash account on the balance sheet is exactly what changes. It shows the

company's true cash profit. It shows the investor how the company is able to pay for its future growth and expansion.

As a matter of fact, every investor should look for a company that can produce cash. Just because profit shows up on the income statement does not mean that the company won't get in trouble later because it does not have enough cash flow.

Figure 5 - Statement Of Cash Flows

Source: http://financial-education.com/

The cash flow statement is subdivided into three different sections. The following paragraphs will discuss them in more detail.

Cash flow from Operating Activities

This section provides the investor with information on how much cash moves in and out of the company from the sales of goods and services and from the amount needed to make and sell those goods and services. Net positive cash flow is always preferred, but high growth companies, such as technology companies will show negative cash flow in this section during their first several years. Also, changes in this section offer a forecast of changes in net future income.

Cash Flow from Investing Activities

This section shows how much cash the company spent acquiring capital and any other equipment necessary in order to keep the business running. It also includes mergers and acquisitions, and monetary investments. It's good to see a company reinvest in itself by at least the rate of depreciation expenses yearly. If that doesn't happen, the next year it could show artificially inflated cash flows which would be fake.

Cash Flow from Financing Activities

This section describes the moving of cash associated with outside financing. These can be the sales of stock or bonds or bank borrowings. Also, paying back debt to a bank or dividend payments and stock repurchases are all reflected here.

Reliability credibility core earnings

Before further discussing how to analyze the financial statements presented above, it is necessary to make a distinction between what is reported on the financial statements and what the real numbers may be. When financial statements are prepared, they must follow GAAP, or generally accepted accounting principles which were standardized by the SEC in order to avoid accounting scams by companies. In addition, the Sarbanes- Oxley Act passed after the Enron scandal prevents the same accounting firm that does the auditing of financial statements to do consulting for the company. Discussing this further is outside the scope of this thesis, but it will suffice to say that the numbers on the financial statements may not always tell the whole story, and the investor, in his or her analysis must dig deep and find the true numbers often by him or herself.

Standard and Poor's Corporation developed the concept of «core earnings,» or earnings from a primary product or service and excluding nonrecurring items¹⁶, and at the time it was estimated that the corporations under the S&P 500 index had their earnings overstated by 30% the first year the adjustment was calculated.¹⁷ Therefore, it stands to reason that using the core net profit and core net worth as a reliable means for calculating the formulas and ratios that will be described below will provide a clearer picture of a company's financial situation. Things that can be excluded from financial statements that are GAAP approved are stock options granted to executives or employees which can be huge if cashed in. Contingent liabilities such as lawsuits that have not been lost yet but will most likely be also escape the financial statements. Core earnings adjustments account for these and therefore make sure that the financial statements tell the actual position of the company excluding any one time revenues and including hidden expenses. This allows the investor to look at the financial statements and compare trends of how the company is doing and how it may grow in the

16 S&P Core Earnings FAQ

17 «2002 S&P Core Earnings,» Business Week Online, October 2002; through June 2002, reported profits for the 500 corporations totaled $26.74 per share versus a core net profit of only $18.48, a reduction of 30%.

future. These data can be found in the S&P's stock reports service, (APPENDIX) which most brokers will provide.

It also stands to reason that a big difference between core earnings and reported earnings may serve as a big red flag, because companies with such a large difference could be using shady accounting practices. Well managed companies tend to have a low core earnings adjustment in most years. However, in some cases, when a unit has been sold off or an acquisition made, sometimes the adjustment may be large. Also, companies with low core earnings adjustments tend to report lower than average volatility in stock price.

Looking At Ratios

A ratio or a percentage tells the investor nothing. It's just a number. They become much more powerful in comparison with those from previous years or compared against industry and competitors to judge a company's strength and growth. The real key to determining value of a company is whether the key ratios that judge its performance have been growing and if it's outperforming the industry on average. Furthermore, because of the sheer number of comparisons that can be made between different factors influencing the company, it is up to the investor to judge what ratios can be used and when. Tracking all of these ratios can be impractical and time consuming, and for the investor who has other things to do is just plain stupid. For example, in retail intensive industries, it's worth looking at inventory indicators while the number rarely matters in the financial sector or the software industry. Think of the following section as a toolkit rather than an analysis sheet for evaluating companies, and then when planning and researching investments, use the tools that will provide the best picture.

Return On Equity

ROE answers the question of how well did the company but its capital to work in order to make money. Since corporations are responsible to their shareholders, who want to gain a better return on the money they invested in that specific company rather than investors who invested in its competitor. Return on equity measures how well the company put the money that investors gave it to work. The basic formula for return on equity is as follows:

P/E = R P = Profit For A One Year Period E = Shareholders' Equity R = ROE or Return On Equity

However, there are some flaws with the formula that come from its assumption. It assumes that the dollar value of capital did not change during the year. However, the value of capital stock may change due to new issues, retirement of stock or mergers and acquisitions.

This ratio is very useful when comparing the company to the rest of the industry. Also ROE growth over several years can be of great importance in showing how well the company has managed the money invested in it.

Where It Can Be Found: This number can also be found on a number of stock screeners and financial sites such as Yahoo! Finance and Google Finance as well as the Scottrade stock screener.

Balance Sheet Analysis

Working Capital Tests

These next several ratios help to identify growth potential or upcoming problems on the balance sheet. It is important to understand that with all ratio analysis, it is the trend that counts and not only the latest ratio itself.

Current Ratio

The Current Ratio is a comparison between balances of current assets and current liabilities.

A/L = R A = Current Assets L = Current Liabilities R = Current Ratio

The answer is a single digit and a popular standard for the current ratio is 2 or better. However, in many well-capitalized companies with good management, a ratio of 1 or above is acceptable as long as earnings are consistent. For example, Altria and Merck are great examples of companies that do well with current ratio lower than 2. It should stay consistent when looked at over the years, and should be better or the same as the industry. Consistency is very important in this ratio because controlled fundamental volatility is a great sign,¹⁸ and comparing it to the industry will give the investor a picture of how well the company is doing compared to the competition.

Where It Can Be Found: This number can also be found on a number of stock screeners and financial sites such as Yahoo! Finance and Google Finance as well as the Scottrade stock screener.

Quick Assets Ratio

The same as the current ratio, but it excludes current inventory values.

(A - I) / L = R A = Current Assets I = Inventory L = Current Liabilities R = Quick Assets Ratio

In companies with widely fluctuating inventory levels such as retail stores whose inventory levels change due to sales cycles, comparison of the current ratio may be unreliable. The quick assets ratio provides a better tracking history in this case. An acceptable ratio is 1 and consistency is key¹⁹. Also, comparing it to the industry and seeing the trend over the years will provide the investor with a picture of how the company manages cash which does not include inventory.

Where It Can Be Found: This number can also be found on a number of stock screeners and financial sites such as Yahoo! Finance and Google Finance as well as the Scottrade stock screener.

18 Michael C. Thomsett, Stock Market Investors Pocket Calculator

19 IBID

Cash Ratio

This is the most conservative test of working capital, and tests the highly liquid assets to current obligations.

C + M / L = R C = Cash M = Marketable Securities L = Current Liabilities R = Cash Ratio

Since cash and marketable securities are available immediately as liquid assets for paying off debt, this ratio demonstrates the highest level of liquidity. If a declining trend is evident or the ratio approaches the 1 level, working capital becomes a concern. ²⁰ A company should be able to pay off its debts easily from its liquid assets. Also, comparison to the industry and competition will provide a picture of how the company is doing against those that are competing against it.

Where It Can Be Found: This number can also be found on a number of stock screeners and financial sites such as Yahoo! Finance and Google Finance as well as the Scottrade stock screener.

Working Capital Turnover

This is the average number of times a year working capital is replaced.

R / A - L = T R = One Year's Revenue A = Current Assets L = Current Liabilities T = Working Capital Turnover

The result is expressed as a number of turns. This shows how many times the working capital has generated its value in revenues. As part of a bigger long term trend, it shows how effectively management controls its funds.

Where It Can Be Found: While most financial websites will not have it, brokerages a lot of times provide a research report for a stock compiled by Reuters which will provide this number. If not, it can be calculated.

20 Michael C. Thomsett, Stock Market Investors Pocket Calculator

Accounts Receivable Tests

The accounts receivable account is a current asset account representing the balance of the money owed to the company by its customers. Since not all customers pay their debts, there is a reserve account for bad debts. Since in accounting, every credit must be offset by a debit, credits to the reserve account are offset by a debit to the expense account. In other words, increasing reserve for bad debts results in a larger expense for bad debts. When certain accounts receivable are identified as bad debts, they are removed from the asset and from the reserve. The net asset includes the bad debt reserve and the asset account.

The company bases how much it wants to place into the reserve by recent history of bad debts. The reserve is only an estimate.

Bad Debts to Accounts Receivable

This formula tests the corporate policy regarding reserve requirements and is expressed as a percentage. This should remain fairly level even when receivable levels grow.

B / A = R

B = Bad Debts Reserve

A = Accounts Receivable

R = Bad Debts to Accounts Receivable Ratio

Where It Can Be Found: Most stock screeners and financial websites will not include this number and the investor will have to calculate it himself.

Accounts Receivable Turnover

This is a way to compare receivable levels to credit-based sales. The relationship between the two accounts should be consistent, and if accounts receivable is increasing at a greater rate than credit sales, working capital could be in danger.

S / A = T

S = Credit Sales

A = Accounts Receivable

T = Accounts Receivable Turnover

Where It Can Be Found: While most financial websites will not have it, brokerages a lot of times provide a research report for a stock compiled by Reuters which will provide this number. If not, it can be calculated.

Average Collection Period

This is a very important test of how the company is managing the money that is owed to it. According to many studies, the longer that the money is owed to a company, the more chance it has of not getting paid back. In addition, during times when revenues are expanding, companies sometimes relax collection efforts and internal controls. If historically, the period for collection has been 30 days and all of a sudden spikes up to 45, there is a problem in collection procedures, and even if the company is doing good does not mean it should relax and stop collecting the money owed to it.

R / (S / 365) = D

R = Accounts Receivable

S = Annual Credit Sales

D = Average Collection Period

Where It Can Be Found: This must be calculated

Inventory Tests

Inventory is a current asset and is the value of the goods the company holds for sale. When looking at retail organizations or other organizations with significant inventory levels, inventory turnover is important to determine how fast the company is selling its products and effective management is at controlling inventory levels so that storage and maintenance costs are not running up.

Average Inventory

In order to determine this, average inventory needs to be calculated. The reason for this is because companies like retail stores or manufacturing companies may maintain different levels at different times throughout the year due to customer demand or sales cycles. To calculate average inventory this is the formula.

Ia + I^b + I^n / N = A I = Inventory value a, b = periods used in calculation N = total num ber of periods A = Average Inventory

Where It Can Be Found: This must be calculated

Inventory Turnover

The number obtained from the previous formula is obtained to obtain inventory turnover which estimates how often the entire inventory is sold and replaced. This reflects the management's efficiency at keeping inventory levels and the best level so that it does not tie up cash and storage costs, or if it's too low it becomes hard to fill orders and revenue is lost.

C / A = T

C = Cost Of Goods Sold

A = Average Inventory

T = Turnover

For most companies, 4 to 4.5 turnovers is an average year.²¹ However, if the turnover begins to decline over the years, it may be a sign that too much inventory is being kept on hand.

Where It Can Be Found: While most financial websites will not have it, brokerages a lot of times provide a research report for a stock compiled by Reuters which will provide this number. If not, it can be calculated.

Capitalization

Capitalization is a description of how a company funds its operations. This is a combination of two sources: equity and debt. The makeup of capitalization is very important to a company and its investors. It varies widely among companies in a single sector or industry and even between two stocks that may otherwise look the same. A higher debt ratio may demand a higher level of interest payments. In addition, the trend over the years of the capitalization is very important and a negative trend should provide a serious red flag.

Debt to Total Capitalization Ratio

Any investor must ask the question of what amount of capitalization comes from equity and how much comes from debt. If debt rises over time, the company will have to repay it in the future plus the ever growing annual interest that debt carries with it. For shareholders this threatens dividend growth and hampers a company's ability to grow. In addition, a company with little or no debt can't go bankrupt and get liquidated.

D / C = R R = Debt Ratio D = Long - Term Debt C = Total Capitalization

The answer the formula provides is the percentage of capitalization that debt is. Obviously, the smaller this number, the better the company is. This formula should be used in conjunction with the current ratio to judge a company's management of money. If both remain level over several reporting cycles, then the company is managing money well. However, if they fluctuate it may mean that the company is using long term debt to keep the current ratio level, which would mean a level of dishonesty to share holders and is a way of creating long term problems to avoid short term ones.

21 Michael C. Thomsett, Stock Market Investors Pocket Calculator

It's also very important to look at off-balance sheet debt, such as pension liabilities. GAAP does not require companies to report certain kinds of debt on the balance sheet, and an investor who is carefully researching the stock will most likely find them.

Where It Can Be Found: This number can also be found on a number of stock screeners and financial sites such as Yahoo! Finance and Google Finance as well as the Scottrade stock screener.

Dividend Payout ratio

A related indicator of a company's capitalization is a dividend payout ratio. This compares dividends paid to earnings per share. As earnings grow, so should dividends along with them, and therefore this ratio should remain pretty level. If it's slipping over the years, this is generally a negative sign because earnings are not doing well.

D / E = R

R = Dividend Payout Ratio

D = Annual Dividend Per Share

E = Earnings Per Share

This ratio provides a snapshot of the company's capitalization, cash flow and growth over time. If the company has rising debt levels, the dividend ratio will have to slip because the company will not be able to pay dividends. Similar scenario would occur with a declining cash flow. However, if earnings per share are increasing and the dividends are increasing in line with them, then growth prospects are good. It is also revealing to make comparisons within a market sector of this ratio.

Where It Can Be Found: This number can also be found on a number of stock screeners and financial sites such as Yahoo! Finance and Google Finance as well as the Scottrade stock screener.

Market Capitalization

This formula determines the overall value of the stock on the market.

S * P = C S = Shares issued and outstanding P = Price Per Share C = Market Capitalization

The distinctions regarding capitalization are important because they are an indicator of risk levels, price volatility and investment desirability. The largest corporations are usually capitalized at over $200 billion, large are $10 to $200 billion, medium size are $2 to $10 Billion and small cap are under $2 Billion. The larger the market capitalization the smaller the price volatility of the stock generally is.²²

Where It Can Be Found: This number can also be found on a number of stock screeners and financial sites such as Yahoo! Finance and Google Finance as well as the Scottrade stock screener.

22 Investopedia.com

Income Statement Analysis

Tracking Revenue

Just about every investor will not touch a company with a long history of declining revenues. That makes sense of course, since a company with declining revenues isn't making money, and stocks of companies that are not making money generally don't go up. However, since each sector involves several competing companies, it's not realistic for a company to have revenues go up each and every year even if it is well managed. It's also good to keep in mind that a lot of times analysts and other investors may have unrealistic expectations for revenue growth. For example if a company shows a growth of 5% one year, 10% the next year the expectations is for it to have a growth of 15% next year. However, that may often be impossible, and the company will not be able to make it causing the stock price to drop. If it's a well managed company and all the other financial fundamentals look good it can be a bargain to purchase it when the stock price drops because the company did not make growth expectations.

C- P / P = R

C = Current Year Revenue

P = Past Year Revenue

R = Rate of Growth in Revenue

This is the most popular way of tracking revenue as a change from year to year in percentage terms. If a company's annual growth remains the same or consistent, it's a very positive thing since the company is well managed is not just riding a current trend.

Where It Can Be Found: This number can also be found on a number of stock screeners and financial sites such as Yahoo! Finance and Google Finance as well as the Scottrade stock screener.

Sales per Share.

Sales are the main driver of revenue for most companies. Therefore, it is necessary to calculate sales per share for the company as well as look at the trend of this ratio. Here is how to obtain it

SPS = R / S SPS = Sales Per Share R = Past Year Revenue S = Average Shares Outstanding.

For growth companies, it is good to look for increasing sales over the past five years. ²³ On the contrary, value companies whose shares have gone down in price but are still showing a positive SPS trend are wonderful bargains.

Where It Can Be Found: This number can also be found on a number of stock screeners and financial sites such as Yahoo! Finance and Google Finance as well as the Scottrade stock screener.

23 John D., CFA Stowe, Thomas R., CFA Robinson, Jerald E., CFA Pinto, and Dennis W., CFA McLeavey, Equity Asset Valuation

Tracking Earnings

In order to fully analyze growth trends, it is necessary to look not only at revenue growth, but also at earnings growth. If the company reports increases in revenue, but is at the same year losing earnings, it's not a company an investor wants to be interested in. Traditionally, earnings growth is measured with this formula

C- P / P = E C = Current Year Net Earnings P = Past Year Net Earnings E = Rate of Growth in Net Earnings

Where It Can Be Found: This number can also be found on a number of stock screeners and financial sites such as Yahoo! Finance and Google Finance as well as the Scottrade stock screener.

However, as previously mentioned before, the net earnings from a company's income statement can be manipulated and is not always the most accurate one. To get a clearer picture, it is better to utilize core earnings found on the S&P stock report.

CC- PC / PC = E CC = Current Year Core Earnings PC = Past Year Core Earnings E = Rate of Growth in Core Earnings

It is also necessary to compare the difference between net earnings growth and core earnings growth, as previously stated in order to gauge how honest the company is and how honest the management of the company is and if there is any creative accounting going on.

Earnings per Share

Earnings per Share is considered to be a key ratio is deemed instrumental in judging the value of a stock. It is calculated by this formula traditionally

N / S = E N = Net Earnings (Year) S = Shares Outstanding E = Earnings Per Share or EPS

To further clarify this, since the shares outstanding fluctuate throughout the year, the shares outstanding number should be calculated as an average. ²⁴

Where It Can Be Found: This number can also be found on a number of stock screeners and financial sites such as Yahoo! Finance and Google Finance as well as the Scottrade stock screener. Some data sources may use the number of shares outstanding at the end of the year to simplify their calculation, so be careful to get the correct number.

24 Investopeda

However, as previously mentioned, in order to get a clear picture, in calculating earnings per share it is necessary to use core net earnings.

CN / S = E CN = Core Net Earnings (Year) S = Shares Outstanding E = Core Earnings Per Share or EPS

The EPS is a representation of a company's profit divided by a share of common stock and is often tracked by analysts as the most important indicator of the price of a share, but can be easily manipulated, so in this paper it will be considered a bit further down the line. Companies have EPS estimates that they try to reach every quarter and price may fall if they are not reached.

Comparing Revenue to Direct Cost and expenses

In order to understand why the revenue has increased or decreased as well as why the earnings have gone up or down, the investor should look at the relationship between the revenue and gross profit.

R - DC = GP

R = Revenue

DC = Direct Costs
GP = Gross Profit

Direct costs include anything that relates to the generation of revenue. They should remain constant from year to year unless a specific event such an acquisition, change in mix of business or valuation methods for inventory will change. Therefore, the trend for revenue and growth profit should correlate from year to year.

The percentage of growth profit to revenue is called growth margin. This number should stay about level from year to year unless one of the aforementioned events happens in the company.

G / R = M G = Gross Profit R = Revenue M = Gross Margin

Where It Can Be Found: This number can also be found on a number of stock screeners and financial sites such as Yahoo! Finance and Google Finance as well as the Scottrade stock screener.

Expenses to Revenue

The picture becomes even clearer when expenses are compared to revenue. Even though expenses do not directly influence revenue, because they can include factors such as interest expense, electricity bills and salaries of employees that are not directly related to generating revenue, the movement of expenses should correlate on some level with the fluctuations in revenues. The rate of growth in expenses can be calculated as

C- P / P =E C = Current Year Expenses PC = Past Year Expenses E = Rate of Growth in Expenses

Once this has been calculated, the investor can compare the ratio of expenses to revenues using this

formula

E / R = P E = Expenses R = Revenue P = Ratio (Percentage)

The consistency in this over the years can mean several different things. It means a good internal control system and efficiency, and that management is keeping expense level well and overhead costs down in order to generate revenue.

Where It Can Be Found: These numbers must be calculated

Operating Profit Analysis

The operating profit is the profit from all core activities, or continuing operations. This is the number that should be watched in order to quantify growth potential. The first formula to look at in this case is the rate of growth in operating profit. It's very similar to the rate of growth in net earnings, but it excludes all other income and expenses and focuses only earnings from operations.

C - P / P = R C = Current Year Operating Profit P = Past Year Operating Profit R = Rate Of Growth In Operating Profit

Where It Can Be Found: While most financial websites will not have it, brokerages a lot of times provide a research report for a stock compiled by Reuters which will provide this number. If not, it can be calculated.

Cash Flow Statement Analysis

Free Cash Flow

On a statement of cash flow, the investor should look for companies that produce a lot of free cash flow. This can be calculated by the following formula:

NI + (A or D) - C- E= FCF NI= Net income A= Amortization D= Depreciation C= Changes in working capital E= Capital expenditure FCF= Free Cash Flow

This is the money that allows the company to pay debt, dividends, repurchase stock and increase business growth. It is the excess cash produced by the company and can be either returned to share holders in terms of dividends or invested in new growth opportunities.

It's good if a company can pay for the investing figure out of operations cash flow without having to rely on outside financing. This signals very strong fundamentals.

Where It Can Be Found: While most financial websites will not have it, brokerages a lot of times provide a research report for a stock compiled by Reuters which will provide this number. If not, it can be calculated.

Net Cash Flow per Share

Cash flow is the stream of money through a company. It measures how the company is receiving its money and if they get paid as they sell or if they sell a lot on credit to make their revenues look bigger. This number should be looked at as a trend over five years, and the investor would want it to increase. It is calculated as follows

C / S = R C = Current Year Net Cash Flow S = Average Outstanding Number Of Shares Over The Year R = Net Cash Flow Per Share

Where It Can Be Found: Most financial websites will have it, and brokerages a lot of times provide a research report for a stock compiled by Reuters which will provide this number. If not, it can be calculated.

Estimating Intrinsic Value Using DCF

There are several ways to estimate the intrinsic value of a company, and we found the Discounted Cash Flows formula to be used by Warren Buffet. The formula is complicated, and calculating it is out of scope of the average investor's expertise, but a formula calculator can be found here. http://www.moneychimp.com/articles/valuation/dcf.htm

Figure 6 - Discounted Cash Flow Calculator Screen

Source: http://www.moneychimp.com/articles/valuation/dcf.htm

Some things here need to be explained. Earnings per share should be put in here as the core earnings found from the S&P stock report. The earnings growth projections can be found on a number of financial websites as well as the Reuters Research Report. The investor should assume that the earnings growth rate will level off to 0 after 5 years to give him or herself a «margin of safety.» In addition, on average the S&P 500 is usually growing by about 11% annually, but for additional safety the investor may want to decrease that number. Then just click calculate and the calculator will do all the complicated formula number crunching!

Technical Analysis

While fundamental analysis is focused on looking back at the financial trends, the focus of fundamental analysis is looking forward and trying to predict what will happen with the stock price. It is focused on how the day's price, volume and trading trends will affect the price in the future. It is important to remember that technical and fundamental analyses are not exclusive, but are usually used in conjunction with one another by successful traders. Neither point of view is considered «right» since any analysis is essential an estimate, but the more information the investor has, and the more data he or she can gather, the more confident he or she can be in his decisions. Just like looking at only history data and ignoring price trends is a mistake, while only looking at price without checking profitability is similarly misguided.

Furthermore, technical trends are very important for identifying risk levels. Even a company who has great management, growing revenues, and growing dividends may have high volatility levels in price. After all, the shares in the market are priced and move based on supply and demand. Oftentimes, companies with similar fundamentals may have wildly different volatility levels which define market risk and any investor would be stupid to ignore those facts.

In addition, numerous technical signals could predict changes in fundamentals. For example, a change in the volatility of the stock price can predict earnings surprises. If a share is bought and sold 50,000 times a day, the investor can use the combined knowledge of the traders by looking at the charts to predict his or her own moves.

Introduction to Technical Analysis

Technical analysis is based on one thing: the stock price and the trends in price movement. Volume is also key to considering the movement of a stock's price. The main idea of technical analysis is to attempt estimate the next direction the stock's price will move and to invest either in a short or short term position. Technical analysis can also be used to estimate hold and sell decisions as well. To do this more successfully, techniques such as chart watching, price and volume formulas and observations of trading ranges are employed by the investor.

Technical analysis originates from the Dow Theory that stock prices tend to act in concert. Some very specific concepts determine how trend analysis takes place. The first time frame technicians look at is the tertiary movement or the daily trend of the market, not reliable for estimating long term trends. The next is the secondary movement measured on the 20-60 period and this movement reflects current sentiment. Finally, the primary movement can go on from several months to several years, which is what is used to determine if it's a bull market or a bear market.²⁵

Current Price

This is the price the stock is currently trading at.

52 Week High / Low Price

The highest and the lowest price within the last 52 weeks, or one year.

25 Jack D. Schwager, Getting Started in Technical Analysis

Daily Dollar Volume

This tells the investor how much money trades in the stock on a given day, determining how liquid the stock is, or how easily it's bought and sold. The thing to keep in mind is that most mutual funds won't touch stocks with low dollar volumes because it may be difficult for them to sell the stock in the future because they trade in very large lots. The bare minimum trading volume should be no less than $50,000 a day. Small cap investors will look for low daily volume, less than $ 3 million so that the mutual funds are not touching it. When the volume spikes, the mutual funds will go for the stock if it's a good value, and the price will increase.

Chart Patterns

The whole premise of technical analysis is the study of price and its patterns. There are several specific price patterns and concepts that form the basis of technical analysis. In addition, the purpose of computing the market mood and directions is not just to make good timing decisions, but also to judge risk and volatility. Viewing price trends demonstrates the risk / reward relationship. If the price movement is volatile, there is a greater chance of upward movement, but also a greater chance of lower movement. Conservative investors would rather accept lower volatility as a trade off for smaller returns.

Trading Range, Resistance, Support

Volatility is defined by the trading range. Usually, the prices of stocks establish a range of number of points in which they trade. If the price breaks through this range, it's a significant event forecasting a new rally or decline in the price level. Also, technicians will look at the stock's price level approaching the upper or lower limits two or more consecutive times, attempting to break through, and event called the breakout. If that happens, it's usually a signal that the price will move in the opposite direction.

Figure 7 - Trading Range, Resistance, Support

Source: Stock Market Investor's Pocket Calculator (159)

The upper trading limit is called the resistance level and is the highest price in the current trading range. The lower level is called the support level which is the lowest price of the stock. Once these have been crossed, the trading range could become more volatile, until a new range has been set. It is also necessary to point out that trading range changes may foreshadow things like earnings surprises or meeting or not meeting earnings expectations, causing the stock price to go up or down.

Head and Shoulders

A classic charting pattern is named head and shoulders, named because it involves three high prices with the middle price being higher than the first and third.

Figure 8 - Head and Shoulders Charting Pattern

Source: Stock Market Investor's Pocket Calculator (163)

It is seen as an attempt of the price to break through the resistance, and once the price retreats without breaking through, the pattern forecasts a price retreat. The inverse head and shoulders pattern indicates the opposite, and forecasts a pending price rally. ²⁶

26 Michael C. Thomsett, Stock Market Investors Pocket Calculator

Gaps

Gaps occur when the price closes at one level one business day, and opens above or below the trading range of the previous day (highest and lowest price). Gaps are important because they imply major changes in trading range and interest among buyers or loss of interest among sellers.

Figure 9 - Gaps

Source: Stock Market Investor's Pocket Calculator (165)

Four kinds of gaps exist that are worth looking at:

· Common gap is part of daily trading and implies nothing

· Breakaway gap pushes the price into a new territory and does not fill during further trading

· Runaway Gaps are several gaps over a few days moving the price in the same direction.

· Exhaustion gap is usually large signaling the end of the runaway pattern. After this gap, the price usually moves in the opposite direction. ²⁷

Other Patterns

There are many other patterns that are used by technical analysts, but these represent the major ones and are the most important for forecasting. In addition, it is out of scope of this paper to go into full detail on technical analysis. Trading the range of the stock reveals the degree of volatility and market risk. The trading range is the best value of risk.

Further Measuring Volatility through Formulas

To the technician, the price volatility is of central issue. A smaller trading range implies lower volatility. Therefore, even as price levels change, the trading range may state the same. However, if the trading range begins to widen or narrow, it is a sign of coming change. Even though it is possible to calculate the price

27 Jack D. Schwager, Getting Started in Technical Analysis

volatility by subtracting the 52 week low price from the 52 week high price and dividing it by the low price, this formula is not entirely accurate. Any investor that has looked at a stock chart measure the performance over the course of a year knows that spikes in price of a stock are imminent. Most often, these spikes do not represent the trading range well because they are abnormal, and therefore, they should be adjusted for. A spike can be defined as a price that is outside of the trading range substantially and the price trading immediately returns to normal trading levels, and the spike is not repeated. The formula proposed for calculating volatility is adjusted volatility.

(H - L) - S = V

H = 52 Week High Price

L = 52 Week Low Price

S = Price Spikes

V = Point Based Spread Volatility

Beta

Beta is a measure of systematic risk of a security, as compared to the market as a whole. A good way to understand beta is how a return of a security moves with the market. Beta is calculated using regression analysis and is often used in the Capital Asset Pricing Model, which is out of the range of this paper. However, it is useful for an investor to know the Beta of a company in order to understand how risky a security can be. A beta of 1 indicates that the price of the security moves along with the market. If the market moves up one point, the stock moves up one point. A beta that's greater than 1 is an indication that the security is more volatile than the market. For example a lot of stable companies such as utilities will have a beta of less than one, meaning that the investor can expect less volatily, but he or she gives up a higher return. However, on the other hand, technology stocks have a beta greater than one indicating that in order to get the possibility of a higher return that comes with purchasing a tech stock, the investor needs to take on additional risk.

Combined Testing

There is a large debate about whether technical analysis is more reliable or better than fundamental analysis. But the main point is, who cares? Smart investors will use both to their benefit and succeed in the market. Both offer useful information to make good decisions as an investor. In fact, each side is valuable for interpreting trends in the other side. For example, when there is a lot of difference between reported earnings and core earnings, stock volatility tends to increase, and when the investor analyzes the stock from a technical standpoint, his suspicions can be affirmed.

Furthermore, it is necessary to note that technical and fundamental analysis are compliments to each other, rather than two directly opposing theories of valuing securities. A long term investor will focus on fundamentals to make sure he or she is buying a good company. That's great because in the long run fundamentals are what really determine the market price of the stock. However, in the short term they do not work, and technical analysis must be relied on. Therefore a speculator will use those techniques to make his or her decisions.

Finally, what this section will talk about is factors that combine fundamental indicators along with technical indicators, and these are the most watched factors for any security.

P/E Ratio

The major indicator that combines fundamental and technical information is the P/E ratio. Annual P/E and Quarterly P/E

P / E = R

P = Current Stock Price

E = EPS (Annual or Quarterly)

R = P/E Ratio

Basically, the ratio determines the multiple of earnings that the current prices consist of. So for exam ple a P/E of 10 means that the current price is 10 times greater than that latest EPS. It fol lows that the P/E that is calculated and shown on most financial websites is based on unadjusted EPS. What the investor needs to do is to adjust it based on Core EPS. Therefore instead of calculating P/E as Price / Earnings per Share, calculate it as Price / Core Earnings Per Share, calculated earlier.

The importance of P/E ratio is important in determining whether the stock is currently trading at bargain levels. This is critical to the value investor. When the stock price is driven up, the P/E follows, and the investor could tell if the stock is overpriced or not. A good way to narrow down the investments is by using a stock screener and eliminating all stocks trading above a certain P/E.

Another advantage of the P/E ratio can help the investor set entry and exit points into position based on this ratio. If the P/E falls too low, the investor may want to sell, and if it goes very high, he or she may want to sell at the high point. In addition, comparing P/E to Core P/E can be a great test of volatility.

It also helps to determine the average P/E Over the past several (usually 5) years:

Average P/E over N Number Of years

(P/E¹+ P/E²+ P/Eⁿ) / N

P = Current Stock Price

E = EPS (Annual or Quarterly)

R = P/E Ratio

Comparing this with the current P/E can help to determine if the stock is overpriced or under priced more than usual.

Problems with P/E

While the P/E is widely used, it is potentially unreliable when the earnings figures used are quarterly, and that is what one would expect to find on the financial websites. For example, in the retail industry the report that comes out December 31 has the highest earnings, because of the holiday season. If the P/E calculation takes place using those numbers, it could be very unreliable. However, even when tracking annual P/E reliability problems come up because the annual P/E could easily become outdated several months after the annual report.

Overcoming P/E Problems

They key is to measure annual P/E and track its historical trend, as well as measure quarterly P/E and track its trend as well. Also, evaluate year-end P/E and price range next to current quarter data. If the investor discovers that the current P/E is out of range with the year-end historical P/E, it could be that information is

flawed and a lot has changed since the earnings that the investor is using. Also, it is necessary to confirm P/E changes by comparing other ratios such as price to revenue, book value per share, and cash. This is valuable in improving the reliability of information and determining if the current price is typical or not by looking at trends.

PEG Ratio

The PEG ratio is popularized by Peter Lynch, but is more of a rule of thumb than a mathematical ratio. According to Lynch, a P/E of a company that's fairly priced will equal its growth rate. This usually works better for growth stocks than it does for value stocks. PEG ratio is calculated as PE/Projected Earnings Growth Rate over the next 5 years.

Price to Sales or Revenue

Price to Sales is calculated as fol lows

P / S = R

P = Current Stock Price

S = Sales Per Share

R = Price To Revenue Ratio

The price to sales ratio can also get the investor more information if for some reason he or she is unable to determine core earnings of the company. Because this compares sales, which usually tend to be the core sources of revenue for the company, they may provide a clearer picture. It is also useful to compare it in situations where earnings are flat as a percentage of revenue, but grow each year. In this case the P/E may not be very revealing, but the Price to Sales ratio may provide a better view.

Finding Information

One of the most important things any investor needs to do when he or she wants to invest in the stock market is to be able to have access to information. There is many ways to access information and that's a really good thing because after having any information, investors need to check its credibility. Checking all information is the first step to limit mistakes. In the following section, we will discuss about where an investor can find information. While some sources are free, and others require a subscription, each source is unique in its own way, and all of them have a reputation for reliability. Some of the subscription sources are accessible in library or in investment group. Beginning investors should go to their public library and ask for any information concerning finance and stock market. Following is a list of ways, techniques and medias where business and financial information is available. All that sources are reliable but all investors have to double-check any information before investing in stock market.

Companies Themselves

One of the most easiest and classic ways to have information about a company is to ask directly for it to be sent to you from the company itself. All companies have an investor's packet that they will send to you with pleasure. When an investor is asking for such packet it's important that this one contain at minimum an annual report, and last 10-Q and 10-K. Sometimes, for big companies, investors can find it on the company website. Otherwise, they can call the investor relations department of the company directly.

The annual report

The annual report is a document that public companies must provide to all its shareholders in order to inform them about their operation and financial conditions. Generally, an annual report will contain at least these elements:

- Financial Highlights

- Letter to the Shareholders

- Management's Discussion and Analysis

- Financial Statements and their notes

- Auditor's Report

- Summary Financial Data

- Corporate Information

The 10-Q

This document which is published quarterly and submitted to the Securities and Exchange Commission, report the company's performance for the last 4 months. There is no 10-Q for the last 4 months because at the end of the year, it's replaced by the 10-K

The 10-K

As for the 10-Q, this document has to be submitted to the Securities and Exchange Commission. It reports also the company's performance, but it contains more detailed information than the 10-Q or the annual report. Most important information is for example the company history, organizational structure, the holdings or the subsidiaries. Generally the 10-K must be filled 2 months after the end of the fiscal year.

Financial Publications

There are hundreds of financial publications, most of them are reliable, and the important thing with financial publication is to find one that you like to use. Beginning investors will not use the same publication as someone who has been investing for 15 years, or as professional stock market investors. Investors have to feel confident with the publication, it's always better to understand well an easy-reading publication than to not understand at all a really difficult one.

Magazines

The magazines selected here give a good view of the general economic and financial condition of the world. The two first specialized in finance offer to their readers an easy-reading approach of the main news, and opportunities of the market. The last one, more general is a good way to stay informed of all international information that can influence the market. Because this paper's strategy is based on real world and not stock fluctuation, it's primordial to stay aware of how the economic world is doing in order to anticipate opportunities and so make higher profits.

Smart Money

Smart Money is the magazine edited by the Wall street Journal. Published monthly, SmartMoney's objective is to provide to professional and managerial people, information about personal finance. It covers articles about saving, investing, and spending and does a really good job with mutual fund and stocks. The magazine also has articles on technology, automotive, and lifestyle subjects.

An annual subscription cost $12 for 12 issues.

Contact information: 800 444-4204. www.smartmoney.com

Kiplinger's Personal Finance

Kiplinger's Personal Finance is a magazine published every month since 1947. It's the oldest personal finance magazine in the US. Articles talk about personal finance and stocks, but also about other financial topics such as credit cards, college tuition, buying homes, cars and other major purchases.

An annual subscription cost $12 for 12 issues.

Contact information: 800-544-0155. www.kiplinger.com

The Week

The Week is a news magazine published as its named say, every week. It defers from other magazine by publishing a digest of best articles of the week published in other domestic and international Medias. It's a good way to stay informed of the most important «classic information» with only one publication.

An annual subscription cost $50 for 50 issues

Contact information: 877-245-8151. www.theweekdaily.com

Newspapers

Those 3 newspapers are specialized in finance, 90% of all information published is directly or indirectly related to the market. The Wall Street Journal and the Financial Times can be considered as the «Holly Bible» of investors. All important information concerning the market is published by those newspapers and the reader can be sure that the relevance of the information is guaranteed. The last newspaper this paper advice to read is the Investor's Business Daily, less conservative than the 2 others, it give also relevant information and investors will love its stock table measurement which are not available in other publications.

Wall Street Journal

Created by the Dow Jones Company, the WSJ sells 2.6 million copies annually. Its articles treat about financial and economical subjects in USA and international world. One of the most important sections of the wall Street Journal is called «Money and Investing», which tracks among other things, the performances of indexes, the interest rate, the currencies and commodities prices. This newspaper is one of the most important financial newspapers in the world along with the Financial Times.

An annual subscription cost $99 for print and online access.

Contact information: 800-369-2834. http://online.wsj.com

Financial Times

The Financial Times is a Britannic newspaper famous for its salmon pink pages. The newspaper is divides in 2 main sections, the first one treat about national and international news, whereas the second one is focus on the markets and company news. Printed in 24 sites as London, New-York, Los-Angeles, and Tokyo, the Financial Times is the main rival of the Wall Street Journal.

An annual subscription cost $298

Contact information: 800 628 8088. www.ft.com

Investor's Business Daily

The Investor's Business Daily was founded by William O'Neil because he was frustrated because he couldn't find all information he needs on the Wall Street Journal. Treated about economical and financial subject as the markets growth, indexes, stocks, the Investor's Business Daily is characterized by its stocks table that contain 6 selected measurements that no one else published in its clear way.

An annual subscription cost$295 for print and online access.

Contact information: 800-831-2525. www.investors.com

Newsletters

The interest of newsletters is to have a different point of view of the market condition. The 3 newsletters selected here are of course reliable in term of information and commentaries. The two first are published by main investment companies, Morningstar and S&P, they provides good information concerning the general tendencies of the stock market, explain easily what are the opportunities and gives advices that can be interesting to research. The third one, Outstanding Investor Digest, is more a way to be in contact with the high level world of finance. It gives summary of researches, international conference and so one. It's the best way to know what the last ideas of professional investors are.

Morningstar FundInvestor

Morningstar is a big investment research company. Its newsletter, FundInvestor is focused on strategies which have proved their success and tries to explain them in practical terms. FundInvestor gives advices and analyses for creating and managing an aggressive or conservative portfolio.

An annual subscription cost $105

Contact information: 800-735-0700. www.morningstar.com

The Outlook online

Published by Standard & Poor's, the Outlook is a reliable newsletter wrote by S&P analysts. It provides easy-understandable market commentary, stock analysis and advice for investing. Published on paper and online, most of professional use its online version easiest to use.

An annual subscription cost $200.

Contact information: 800-852-1641. www.spoutlookonline.com

Outstanding Investor Digest

This newsletter is, as indicated by its name, a digest of the market resentment. It publishes interviews, conference call transcripts, letters to shareholders and so on. This newsletter is a good way to be «inside» the financial world and to stay in contact with new ideas.

An annual subscription cost $295

Contact information: 212-925-3885. www.oid.com

Internet

With the huge development of Internet, financial information is every day easier to access. The problem of Internet concerning that information is that there are so many sources that it becomes difficult to distinguish those which are good and those which have been written by a teenager of 14 years old.

Stocks screeners

A stock screener is a financial tool which gives the possibility to investors to filter trough certain criteria of their choice stock existing in the market in order to easily select companies that seem to be interesting. In the large range of criteria available in a stock screener some include the share price, the dividend yield or the price/earnings ratio. Using the progress of informatics, stock screener has reduced at few minutes, a task that was needed sometimes several days of work. The 3 stocks screener selected here are very good. The main difference between them is there approach for the investor. It's really important to feel good with a stock screener because a beginning investor will pass lots of time to set criteria that correspond to his or her research. Some of them are easier than other and some of them give more information than other too. The best way to select a stock screener is for sure to try different one and to stay with the one investor will prefer.

Yahoo! Finance stock screener

As all stock screeners, Yahoo! Finance is an efficient and rapid way to find stocks which respond to basic criteria determined by the type of strategy an investor want to use. In its paying version Yahoo! Finance stocks screener, offer the possibility to have access to real time data, which is not really useful, unless in a daytrading strategy. Nevertheless, in the free version, you can determine criteria divided in 6 categories, and then have access to charts; reports and others research with a stock that you pick.

Contact information: http://screener.finance.yahoo.com/stocks.html

Morningstar stock screener

Created by Morningstar Inc, this stock screener uses partly the Morningstar system of grade (from A to E). Therefore, you will be more used to it by also reading the Morningstar publication. One of the main advantages of this stock screener is the possibility to select the type of stock as a criterion, like aggressive growth, hard assets, high yield or speculative growth. Beginning investor could feel more confident with such criteria.

Contact information: http://screen.morningstar.com/StockSelector.html

Scottrade stock screener

Scottrade is a broker which provides for free a stock screener, nevertheless, for investors who trade with this broker it provides really good services where criteria can be added or rejected. One of its main difference with other brokers is that investor can play with criteria like ROE, PEG or select the capitalization from micro to mega-cap. It's a good stock screener for investor who wants to select companies' through a large number of criteria.

Contact information: http://research.scottrade.com/public/stocks/screener/stockscreener.asp

Stock exchanges Websites

A good way to have access to reliable information is to go directly at the source, the stock exchange itself. It can be the New-York Stock exchange (NYSE), the National Association of Securities Dealers Automated Quotation System (NASDAQ) or the American Stock exchange (AMEX). All have a really good website, with live updates where an investor can find lots of good information. Free information on each company is available, like its profile, some data regularly updated, news or analysis. These websites will provide some basic information about a stock.

Contact information: http://www.nyse.com

http://www.nasdaq.com

http://www.amex.com

Other websites

It exist maybe hundreds website about finance, stocks, markets, exchanges and so on. When an investor has to choose which websites he or she will use, 2 main criteria are important. The first one is the reliability and the credibility of the site. Even if you double-check any information, using a website which is not totally reliable is a waste of time, and in finance maybe more than anywhere else, «Time is money». The second criteria which is important is the feeling you have with the website, the easy-use way a site is built can make a great difference to the accessibility of the information. A good advice is to not stay in a website where you feel lost. Here are some investments websites on which investors can trust the information, and always doublechecked it with another sources.

Barron's online

Directed by the Wall Street Journal, the Barron's online website give accesses to lots of data, commentary and interview of experts. There are also lots of general articles about technology, different industry sectors, and new challenges. Barron's online is a good way to access to of information easily.

Contact information: http://online.barrons.com

Bigcharts

Also directed by the Wall Street Journal, Bigcharts provides, as indicate by its name, many charts which are customizable, by time, or for comparison. It's a useful site for technical analysis.

Contact information: http://bigcharts.marketwatch.com

Business week

Partner of standard & Poor's, Business week offer reliable data through charts and articles on many different business subject. It provides also a summary of the S&P newsletter, The Outlook.

Contact information: www.businessweek.com

Clearstation

Subsidiary of E*Trade, Clearstation allow you after a free registration to have access to some analysis doing by non-professional investors and to track their performance. It's a good way to have access to other ideas but any investors who will use Clearstation need to be very precise with checking information.

Contact information: http://clearstation.etrade.com

Morningstar

The website of this investment research company provides a lot of tools that can be more or less useful for investors. More than the articles about the market and business life in general, Morningstar has got a really good discussion forum where investors would find interesting responses to their questions.

Contact information: www.morningstar.com

Mootley fool

The most interesting thing in Mootley fool is its discussion forum which will provide investors with a really good analysis about the general market condition as specific investment topics. Most of the participants of the discussion board are non-professional investors, so an automatic checking about the information is strongly recommended.

Contact information: www.fool.com

SmartMoney

The SmartMoney website is done by the same journalist that working in the SmartMoney magazine (which is edited by the Wall Street Journal), that's why this website is really reliable. Investors will find articles regularly updated and its breaking news section on the top of the home page which is interesting is really tracking the market.

Contact information: www.smartmoney.com

TheStreet

TheStreet is maybe the website with the more articles of this entire list, there is articles from a technologic side to a health care point of view. Everybody will find something interesting to read. Although most of the articles need a subscription fee, there is an free trial access for a month where investors will have time to try this website.

Contact information: www.thestreet.com

Other websites are also interesting to have a look on them; it's possible to name StocksCharts.com, Marketwatch.com, Yahoo! Finance.com, Google finance.com, Briefing.com, or SeekingAl pha.com.

Other Medias

Information are available everywhere, it will be stupid to limit research just at one or two magazines, newspapers or websites. Here are some others sources which can be really useful for investors who want to have a perfect access to all the information.

Value Line Investment Survey

The Value Line Investment Survey gives report and commentary for more than 1,700 companies in the US. On the 2 pages devote to each company, investors will find elements like a ranking, a price projections and insiders decisions, a price history chart or even a quarterly financial statement. Regardless to the price of the subscription, Value Line advices to consult a tax advisor because the subscription may be tax deductible.

An annual subscription cost $538 for online access.

Contact information: http://www.valueline.com

Standard & Poor's stock reports

More detailed than Value Line, the Standard & Poor's stock reports, provides information on more than 5000 companies. Each reports contains reliable data and objective analysis, it's a good resource to identify investment opportunities, evaluate the performance of a portfolio and to build strategies.

Subscription cost of $35 for each company (possibility to buy for the whole industry)

Contact information: www.standardandpoors.com

Reuters

Reuters is provider of information, divided in business & finance news and general one, investors can have access to it via its Website. The Headquarter is based in London but the information is really international. It's an efficient way to have access to financial and general news in the same time.

Contact information: www.reuters.com

Bloomberg

Bloomberg is provider of information, mostly financial. Most non professional investors can have access to Bloomberg services trough Internet or their TV channel, nevertheless it exist a computer platform system used by professional which is updated in real time and give the last information about the market. Thanks to its professional analytic tools, Bloomberg is a good way to access information or to check information already known.

Contact information: www.bloomberg.com

CNBC

The "Consumer News and Business Channel» (CNBC), is an American TV channel which provide business information and cover the financial markets. Although different from Bloomberg, CNBC is a also a good way to stay informed of major Business and financial news.

Contact information: www.cnbc.com

Personal experience

A good way to start finding companies that can be interesting to invest in, is to follow your money. Few investors are thinking like that, but you are probably buying the same things as millions of people. Try to know why you are buying this product rather than its competitors. Peter Lynch who had managed Fidelity Magellan Fund during 13 years has built his fortune partly like that. He has invested in Taco Bell because he had liked it when he tried one in California; he has invested in Apple Computer because his children and the system manager of his firm were wanted those computers.²⁸ The fact is not to invest in the entire product an investor is consuming, but more to be aware of what product worth to be examined to maybe become a future investment.

As we have seen, finding the right information is important to make good investment, checking the information is also something necessary to limit mistakes. There is a lot of information available everywhere, now it times to understand the information. A good advice that investors should keep in mind is go step by step, time and experience will give them the knowledge to find the best information they need and to understand it perfectly.

28 G. Hagstrom The Essential Buffett: Timeless Principles for the New Economy

Successful strategies

Benjamin Graham

Who is Benjamin Graham and why he is important

Born in London in May 1894, Benjamin Graham (born Grossbaum), moved to New-York when he was a child. His family was rich until the death of his father in 1903, and the bankrupt of the boarding house of his mother. After his Bachelor of Science from Columbia University, Benjamin Graham started to work in Wall Street at 20 years old. First as messenger in a brokerage firm, he quickly became a partner. At 25 years old, his salary was $600,000 a year.

In 1926, he created an investment partnership. At the same time Graham was managing his own company, he took courses of finance at Columbia University. With the help of David Dodd, professor at the university, Benjamin Graham wrote what will become a classic of the investment world, «Security Analysis», published in 1934. The second book of Benjamin Graham published in 1949 «The intelligent investor» is still a classic of investment strategy. Buffett says that is «the best book on investing ever written».

Because Benjamin Graham is still considered the father of value investing and because his theory and strategies are still applicable nowadays, we consider it's important to refer to him in order to give to the reader a good approach of the market. It's also a good way to understand the philosophy from which the strategy of this thesis is found.

Main ideas from «security analysis» and «The intelligent investors» for selecting stocks

In order to understand perfectly how Benjamin Graham was looking at the market, investors have to know that for Graham, the market is non rational, and that non-rationality comes from being human. For Graham, fear and greed are the factors that make stocks fluctuate. When investors are greedy, it will drive the market to overprice stocks, and the opposite effect can be expected when they are afraid. Benjamin Graham considers that stock prices are not representative of the value of a company because the market is driven by human emotion. In order to help the investor not to «listen» to his emotion (which has no use in stock markets), Graham gives us a way for selecting stocks.

Investment Vs Speculation

First of all, Benjamin Graham clears up a difference between investment and speculation. He was not considering speculation as an investment strategy, for him it was more relative to gambling than to investment. Graham's idea is not always easy to understand because for him, there is no perfect criteria to determine the difference between investment and speculation. Here is a definition of investment given by Graham: «An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.²⁹» For him, a bond with a low return can be associated as a speculation even if it's a bond, as well as, a stock which is priced under the value of the company, is not speculative just because it's a stock. Graham considers that it's more why you are investing than in what you are investing that defines if it's an investment or a speculation. He believes that there are 3

29 Benjamin Graham, Security Analysis(18)

criteria that define investing. First the investor should analyze the company, second the investor has to protect him or herself against big losses and third, investors should expect adequate returns and not get rich quick schemes.

Satisfactory return and a limited risk

Graham was considering that the return of a stock is made both by the income it generates and by the appreciation of the stock itself. He advises investors to not take into account the day to day fluctuation of a stock because great returns need time. Any investment should be done for a long period, which means several years. Because for him, an investment is a mix between satisfactory return and a certain amount of risk, Graham also believes that in order to reduce the risk, they should diversify their portfolio. It's important to understand that for Graham, risk is inherent to investment, and a limited risk exists when the potential of losses is restricted.

Because he wrote «The Intelligent Investor» for the common investor who is not a professional, Graham is really prudent about the amount an investor should put in the stock market. He explains that, any investors should at minimum have 25% of their investment in bonds. He also asks the question of the risk to put all the rest in stocks. At this time, the general thinking was that the amount of money you put in stock is a function of your age. (100 - your age = % of your investment in stocks). Graham refutes this idea, explaining that a couple which are retired with a good pension, don't have the same relation to the risk, that a young couple that want to invest to buy a house, pay the school of kids, the medical care, and so on.

Margin of safety

The main notion that Graham gives to the investment world was what he called «the margin of safety». The basic concept take for sure that is impossible for any investors to always be right in their valuation, the margin of safety is a way to limit the risk of loss. Defined quickly, the concept is «By refusing to pay too much for an investment, you minimize the chances that your wealth will ever disappear or suddenly be destroyed.³⁰»

Graham develops the idea of margin of safety this way. If an investor has found a company which seems to have an expected growth, he or she has to buy stocks of it. Investors have 2 ways to buy those stocks, in the first case, the market is in a bear condition, and it undervalued most of the stocks. In the second case, the market just undervalued the price of this stock compare to the value that you asses to the company. In both case, because the price of the stock is under the intrinsic value of the company, there is a margin of safety which will limit the risk of loss. For Graham, the best way to limit the risk is to buy companies which are undervalued by the market. The bigger the difference between the price of the stock and the intrinsic value of the company, the bigger the margin of safety and the smaller the risk of loss.

In order to evaluate the value of the company, Graham suggests using the «future earnings power» of the firm. Nowadays, investors which are following the main idea of Graham are not using this «future earning power» to determine the value but the future cash flow discounted to today's value.

«There are two rules of investing,» said Graham. «The first rule is: Don't lose money. The second rule is: Don't forget rule number one. ³¹» This «don't-lose?» philosophy steered Graham toward two approaches to selecting common stocks that, when applied, adhered to the margin of safety: (1) buy a company for less than two-thirds

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of its net asset value, and (2) focus on stocks with low price-to-earnings ratios. As we have seen, Benjamin Graham which is considered as the father of the «value investment» has developed a concept which is always used now. Some investors like Warren Buffett are still using Graham's principle in all their trading operations. If Graham is seen as the father of value investment, let's have a look, on Philip Fisher, the father of «growth investment».

Philip Fisher

Who is Philip Fisher and why he his important

Born in September 1907, Philip Arthur Fisher is considered as the father of Growth investment. Graduate from Stanford University in Business Administration, he began his carrier as an analyst, in a firm of San-Francisco, 2 years later; he was the manager of the bank statistical department. He opened his own investment company in 1931, two years after the crash of 1929. He had said that it was the best moment to open his business because investors who still have little money are probably not satisfied of their old broker. His most famous book, «Common Stocks and uncommon profits» is still today a reference for many growth investors. One of the most profitable investment he ever made was to purchase stock of Motorola in 1955, he hold them until his death in 2004.

As well as Graham for value investing, Philip fisher is considering as the father of growth investing. His theory and strategy are still used by many investors in the world. It's important that the reader understand the basis of Fisher's contribution to the investment world because the strategy develop later in this paper is for a part based on Fisher's view of the market.

Main contribution of Fisher to the investment world

When Philip Fisher was a student at Stanford University, one of his professors required him to come in order to visit companies together. Each week, Fisher and his professor were going to visit a different company, see how it works, and they have a discussion with the managers. After each visit, during the way back, Fisher and his professor were talking about this company, how they perceived it, its strength and weaknesses. Fisher will say later about this discussion during the way back that «was the most useful training I ever received³².» From these useful experiences Fisher will develop the idea that companies with a higher return than the average have 2 common points. The first one is that they have a potential of growth higher than the average of their industry, the second one (probably link to first one), is that they have a great management. Fisher will develop criteria in order to select those companies which are able to generate higher profit for investors.

Selection of good companies

Increasing of sales and profit during several years

For Philip Fisher the only way for a company to increase sales and profits during several years is to have a product or service which has a market potential growth. Fisher was looking for company with a future growth higher than the average. He was also aware that an investor can judge a company only through several years because a year of result is not representative of the company potential.

Research and Development

One particular aspect which determines the potential of a company for Fisher is its ability in research & development. Because he was looking for a company with a future high potential, and because for him sales a related to the product of the company, he knew that a company with a good research and development department will generate future sales from their new product. Fisher proposes that even companies which are not in a technical industry have to possess a good R&D to implement new services, new process and be more efficient.

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Sales organization

Although a Company can have an efficient Research and Development department, it's not enough in Fisher's point of view. The R&D create new product or services but they will be sold by the sales department, if they are not, all the effort is useless. Fisher also believed that the company has to generate profit from the sales in order to make new investments and generate return for shareholders. Fisher wrote in Common stocks and uncommon profits that «All the sales growth in the world won't produce the right type of investment vehicle if, over the years, profits do not grow correspondingly.³³» He tries to explain to investors that R&D generate good product that can be sold in the market. Those sales have to produce a profit that can be reinvested in order to increase future sales and future profit. He also says that a marginal company in a marginal industry can generate profit but it will not be recurrent over the years. Fisher has just created the growth strategy

.

No or few debt

For Fisher, all those condition are still not enough to invest in a company. If a company wants to deserve his interest, it needs to fulfill all those criteria, but without accumulating debt. Because companies with debt are more fragile during period of bad economic conditions, Fisher was interested only by company able to generate enough profit internally to be self-financing.

Management honesty

The last advice that Fisher gives in order to select good companies is in regard to the management. During the numerous company visits he made with his professor, Fisher found that many managers are not honest with shareholders. In his writing, Philip Fisher advices investors about the absolute requirement of integrity and honesty of managers. Too many managers are putting their own interest before the interest of shareholders. A good way to determine a well-done management style for Fisher is the ability of a manager to speak about bad news. All companies encounter problems, the honest managers will not try to hide those, and will communicate to shareholders all information concerning the situation. That's for Fisher the best way to see if management is working in the best interest of the shareholders.

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Investment in good companies

Focus portfolio in a circle of competence

Because the selection process of Philip Fisher is long and time consuming, he was aware about that, he simply tells investors to limit the number of companies in which they will they invest. In Fisher's point of view, having a diversified portfolio will just diminish the return and increase the risk, because selecting a few good companies with high return is more profitable and less risky, Fisher's advice to have a focused portfolio.

The last advice Fisher gave to investors, is what he called «the circle of competence». Investor shouldn't invest in industry that they didn't know. He explained concerning a mistake he made «to project my skill beyond the limits of experience. I began investing outside the industries which I believed I thoroughly understood, in completely different spheres of activity; situations where I did not have comparable background knowledge.³⁴»

In order to have an overall look on Fisher way of thinking there is the fifteen point he advices any investors to look before investing a company

.

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The fifteen points to look for in a common stock³⁵

- Does the company have products or services with sufficient market potential to make possible a sizable

increase in sales for at least several years?

- Does the management have a determination to continue to develop products or processes that will still

further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?

- How effective are the company's research and development efforts in relation to its size?

- Does the company have an above-average sales organization?

- Does the company have a worthwhile profit margin?

- What is the company doing to maintain or improve profit margins?

- Does the company have outstanding labor and personnel relations?

- Does the company have outstanding executive relations?

- Does the company have depth to its management?

- How good are the company's cost analysis and accounting controls?

- Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the

investor important clues as to how outstanding the company may be in relation to its competition?

- Does the company have a short-range or long-range outlook in regard to profits?

- In the foreseeable future will the growth of the company require sufficient equity financing so that the

larger number of shares then outstanding will largely cancel the existing stockholder's benefit from this anticipated growth?

- Does the management talk freely to investors about its affairs when things are going well but "clam up"

when troubles and disappointments occur?

- Does the company have a management of unquestionable integrity?

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Warren Buffett

Who is Warren Buffet and why his is important

Warren Buffet is well known by all investors around the world for several reasons, one of them, which make him someone unusual is that he is the richest person in the world. In its annual ranking, the magazines Forbes of February 2008 had ranked Warren Buffet number 1, with a personal fortune estimated at $62 billion.

Born in Omaha, Nebraska in August 30, 1930, Warren Edward Buffett was pre-determined to work in the Stock exchange; his father was a local stockbroker. As a young boy, Warren Buffett was fascinated by numbers and mathematics. At only 8 years old; he was reading his father's books on the stock market. At the time he was in the University of Nebraska studying business, he read «The Intelligent Investor» by Benjamin Graham, professor at the Columbia University. So interested by the ideas of Graham, Buffet applied to Columbia University in order to study directly from Graham, who became Warren Buffett's mentor.

Only just graduated with a master in economics, Warren Buffett was going to work in Graham's company. During the Two years he worked in the Graham-Newman Corporation Buffett was immersed in Graham investment approach of the market. In 1956, Graham went to retire and Buffett went back to Omaha, where at only 26 years old he founded an investment partnership with seven partners and $100,000. For the 13 years he was CEO of this investment partnership, he has got an average annual rate of return of 29.5% a year. One of the most famous investments Buffet made at this time was with American Express which as victim of a scandal saw its shares drop from $65 to $35. Remembering a lesson of his mentor; that when stocks of successful company are trading under their value, investors have to act intelligently, Buffett bought $13 million of American Express shares (40 percent of the partnership's total assets). Two years later, and after a tripling of the prices of the shares, partners received a profit around $20 million. In 1969, because he was thinking the market was too speculative, Buffett closed the investment partnership. Buffet's shares of the investment partnership had grown to $25million, which was enough to take the control of Berkshire Hathaway.

At the beginning, Berkshire Hathaway was a textile company which quickly became the holding of Buffett to invest in other companies. At first, Warren Buffet through his holding purchased insurance companies. He had interest in insurance companies mainly for one reason: Insurance provide a constant stream of cash flow via the premium paid by policyholders. Following the advice of Graham, Warren Buffet was persuaded that there is an opportunity when a structural good company is under-evaluated by the market. That was the case with The Government Employees Insurance Company usually called GEICO. In 1976, GEICO' stock price dropped from $61 to $2, in five years, Buffet has invested about $45.7 million in this company, persuaded it was a good investment due to the competitive advantage of GEICO. Few years after, the company made impressive performance and Buffett continue to invest on it. In 1994, Berkshire Hathaway purchased all the company which is still making really good profits.

Berkshire Hathaway still exists today and it's still directed by Warren Buffett. He had closed the books of the Textile Company in 1985. Berkshire Hathaway now owns companies in many other sectors than insurance, like in the food industry, clothing, media or luxury industry. Warren Buffet took the control of Berkshire Hathaway, a company with a net worth of $22million, nowadays, the same company, 35 years in the hand of this man, has a net worth of $69 billion. If investors are interested investing in this company, they just have to know that the share is trading around $134,000. That makes it the most expensive share in the stock market.

With this kind of resume of Warren Buffet it's easy to understand why this paper wants to develop his strategy. Based on Graham's and Fisher's view of the market, Buffett's strategy is more contemporary, it's easier for the reader to understand what are the criteria that makes Buffett invest in a company. As well as Graham and Fisher, the strategy and the approach of Buffett is important for the strategy developed later, it gives a background in order to understand the context and the factors that are important for investing in good companies and make profit in the stock market.

Strategy: Buying good company at a bargain price

The beginning of the strategy of Warren Buffett is made by some tenets that characterize his way to select a company in which he will invest. Following are the most important tenets that Buffet is using, there a combination of his personal experience, his mentor principle and Philip Fisher theory.

Tenets of the Warren Buffett Way³⁶

Business Tenets

- Is the business simple and understandable?

- Does the business have a consistent operating history?

- Does the business have favorable long-term prospects? Management Tenets

- Is management rational?

- Is management candid with its shareholders?

- Does management resist the institutional imperative?

Financial Tenets

- Focus on return on equity, not earnings per share.

- Calculate «owner earnings.»

- Look for companies with high profit margins.

- For every dollar retained, make sure the company has created at least one dollar of market value.

Market Tenets

- What is the value of the business?

- Can the business be purchased at a significant discount to its value?

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Business Tenets

It's important to understand that for Warren Buffett, stocks are not the most important factor when he is doing an investment. Warren Buffett considers that investors have to use the same scrutiny in buying stock as they will do when they buy the whole company. He based his decision on how the business is done by the company and not on how the market perceived the business. Here are some fundamental principles Buffett is attentive of when he starts looking at a company.

Is the business simple and understandable?

The first tenet of Buffett is to understand very well the business in which the investor want to invest. It's important to know almost everything about the industry, the sector and the company. In doing so, any new information will be understood as a new factor that influences the portfolio of the investor. Although Buffett was a «disciple» of Graham, he took one of the main ideas of Philip Fisher when he is talking about investing within your «circle of competence». The purpose is not how big the circle of competence of the investor is, but how well he or she can understand all the parameters inside it.

Does the business have a consistent operating history?

In the Buffet's view of investing; investors have to avoid all companies that are changing radically their position in the business because the previous one is not efficient now. He also advocates to never buy stocks of a company which is actually solving difficult problems. Buffett emphasis the fact that he avoid Radical change and Difficult problem, in the sense that all companies are constantly modifying their positions in the market by launching new products and solving «day to day» problems. Buffett observes that «Severe change and exceptional returns usually don't mix.³⁷» For him, best returns are achieved by companies which are consistent on their product line in the long term.

Does the business have favorable long-term prospects?

In order to understand perfectly the long term view of Warren Buffet, it's important to distinguish the difference he made between what he called a «Franchise business» and a «Commodity business». A franchise business is characterized by the fact that they don't have a close substitute and they operate in a market which is not regulated. At the opposite; a commodity business' product is not distinguishable from competitor, like oil, gas or chemical product. According to Buffett, commodity businesses have a low rate of return and are more exposed to profit' problems whereas, franchise businesses he said, «Can tolerate mismanagement. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage.³⁸»

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Management Tenets

After having watched with scrutiny the business, Buffett tells investors to have a look at the management style of the company. He thinks that managers who are acting like the owner of the company are more able to see the long term objectives and so they will act with more rationality.

Is management rational?

For Warren Buffett, the rationality of a management is seeing with the allocation of capital. For him, the allocation of capital is essential because that's what will create the future value for shareholders. The allocation of capital has to be in accordance with the position of the company on its life cycle (development, growth, maturity or decline). In Buffett's mind, all cash that invested internally will produce a rate of return on equity higher than the cost of capital has to be invested in the company. There is no logical reason to not reinvest those earnings. The only reason, for him to not reinvest this cash is that it will not produce a return higher that the cost of capital. In such situation, the company has to give this cash to shareholders trough dividend or share buy-backs that will increase the value of each share in circulation in the market. For Buffett, the way the cash is allocated between the company and the shareholders is the proof of the rationality of the management. Berkshire Hathaway, has almost never distributed dividends to shareholders.

Is management candid with its shareholders?

Because management is human, Buffett insists on the fact that managers have to be respectful and honest with shareholders and always act on their best interest. He likes when annual reports contain explanations of what is right in the company, but he prefers to know what is wrong, and why. For him, managers who have the courage to discuss publicly the problems of the company are able to resolve those problems. It's normal that a company encounters problems, it's business, the most important is to not hide them. As all managers, Buffet is using the Generally Accepted Accounting Principles (GAAP), but he also refers to data that are not required by the GAAP.

Does management resist the institutional imperative?

Another point that distinguishes exceptional manager from others is their ability to resist what Buffett calls, the «institutional imperative». For him, the majority of managers are not independent in their way of thinking; they imitate other managers which also imitate them. Buffett saw «free-managers» as the top of the basket, they are making their decisions based on their own knowledge and understanding of a situation and will not fol low the group blindness.

Of course it's difficult to measure the quality of a manager; there is no quantitative data that can be used to identify strength and weaknesses of managers, all is about qualitative perception of a Human that by definition can make errors. «When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics,» Buffet w rites, «it is the reputation of the business that stays intact.³⁹»

Financial Tenets

When Buffett has selected companies which are running the firsts tenets, he analyzes how the company is doing financially. Mostly, he looks at 3 criteria that are non-negotiable, the return on equity, the high profit margin and the creation of market value, here are those criteria.

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Focus on return on equity, not earnings per share.

After having looked at the business and the managerial skill of a company, Warren Buffett analyzes the financial situation of companies he is interested in. When most investors analyze the earning per share, one of the main criteria for Warren Buffet is looking the return on equity. For him the return on equity gives a better understanding of the financial health of a company than the earning per share. He explained that companies can accumulate previous earnings and use it to increase the actual earnings per share, so this time horizon problem can sidestep the analysis of the health of a company. In order to perfectly use the return on equity ratio that is more accurate of the company' used of shareholders equity, Warren Buffet told investors to make some adjustments. Investors should exclude of their calculation all the gains or losses due to capital operation as well as all extraordinary gains or losses that influence the earnings. Return on equity should reflect the normal activities of a company; it should show how the management is able to generate return with the capital employed. Always concerning the return on equity, Buffett point of view, is that a company should generate profits without or with few debts. There are 2 reasons to this «debt allergy». The first one is because with debt, a company can increase their return on equity through the leverage effect of the debt-equity ratio. The second reason is that company with no or few debts are more able to resist to bad economic conditions.

Look for companies with high profit margins.

For Warren Buffett, investors should focus their attention to companies with high profit margin. He distinguishes 2 types of managers regarding the profit margin: those running a high-cost operation, and those who are running a low-cost operation. For him, high-cost operation managers always added overhead expenses and are fighting against cost only when it significantly reduces the profit. On the other hand, low-cost managers are always trying to find ways to reduce expenses.

Buffett reckons that when a company managed in a high-cost way tries to cut-off expenses through a «cost-killer program», it will affect the return of the company. He explains that «The really good manager does not wake up in the morning and say, this is the day I'm going to cut costs.⁴⁰» Buffett emphasizes the fact that the overhead expenses of his company, represent less than 1% of the operating earnings, when similar companies have something around 10% of overhead expenses; in doing so, shareholders are losing 9% of the operating earnings.

For every dollar retained, make sure the company has created at least one dollar of market value.

Another financial tenet Buffett considers is that for each dollar invested by shareholders, the company should generate at least one dollar of market value. Less than one-for-one is a loss for shareholders. Nobody wants to invest $1 and be the owner of 50cents a few years later. Good companies should increase their value in the market by more than the value of earnings they retained.

Market Tenets

After having analyzed previous criteria, Warren Buffett is able to know if the company is a good one or not. If it's a good one, he will analyze how the market perceived this company. When most investors are looking at the market first, Buffet is looking at it at the end of his selection process. By analyzing the market he will try to know if it's time to invest on the company to take advantage of a bargain price.

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What is the value of the business?

Buffett considers that the value of a company is the total amount of the net cash flows expected in the future discounted to an appropriate rate. In doing so, he explains any company, never mind the industry, will be judged equally in an economic point of view. Buffet also explains that if an investor can't estimate with precision the future cash flow of a company, he or she should not invest on it. That's why, Buffett don't invest in new-technology company because he can't estimate the future cash flow and he explains that those companies are out of his circle of competence. Once an investor has made a good estimation of the company, he or she has to discount this value to today; the investor will use a discount rate. Buffett considered that this rate should be a risk-free rate, that's why he advices to use the long term US government bond. (Those bonds are virtually risk-free, because the government will always pay its debts). Lots of investors will add a premium to this risk free rate considering the fact that the company's future is uncertain (in comparison to the certainty of the US government bond). Buffet doesn't add any premium; he prefers to adjust the discount rate. If the discount rate is too low, let's say 7% Buffett will correct it to 10%. In doing so, he increase the «margin of safety». If he is right he just used the good discount rate, if his wrong, he just increased his margin of safety of 3%.

Can the business be purchased at a significant discount to its value?

In order to buy companies for less that their value, Buffett is using the margin of safety. This notion developed by Buffett's mentor, the professor Benjamin Graham, is the difference between the stock price of a company and its intrinsic value. If a company is a little bit undervalued by the market, there is a small margin of safety, if the value stock of the company is really undervalued there is a big margin of safety. This margin of safety is a tool to helps investors of 2 different ways. First of all, if the investor has made a bad evaluation of the company, the margin of safety will reduce the risk of looses. If an investor evaluate a company at $100 per share and the market undervalue it at $85, the investor has a margin of safety of $15. If the value of the company drops to $90, the investor has still $5 of gain. The second help, which is more or less the opposite of the first one, is the possibility to earn extra-returns.

Summary

All the strategy of Warren Buffett is a process which starts from the examination of the business in order to understand perfectly all factors that influence it. Then he looks if the top management of the company is good and rational. When Buffet has found a company with those criteria, he ana lyzes the financial health of the company in order to estimate its value. At the end of this process, he analyzes the market to see if the stock price of the company is under-valuated. Buffett likes to say that he is 85% Graham and 15% Fisher. His strategy for picking stocks is inspired by those two men. Buffett always buys quality companies at a bargain prices. A last remark is important to be made, Warren Buffett has more than 50 years of experience now, and he is lucky to have amazing business and financial skills. Most of beginning investors will not at the first time be able to analyze the market or companies like Warren Buffett. Investors can know perfectly each tenets or advice of Warren Buffett, but in order to invest like him, investors will need time to create their own experience and most of them will unfortunately never reach the success of Buffett.

Focus investment

Now that investors know about the way Warren Buffett selects the companies in which he will invest, it's interesting to have a look on what Warren Buffett says about portfolios. As well as selecting companies, Buffett is not acting like most of the investors.

The Status-quo of Active portfolio Vs index investing

The general idea about investment in the stock market is that there are mainly 2 strategies, the active portfolio investment and the index investment. Investors who trust in the active portfolio style are always trading lots of stocks in order to outperform the market. They don't select stock trough criteria based on the company but more on how they perceived the stock will fluctuate in the short term. For example intraday trading is an active portfolio style of investment. Investors are buying and selling the same stock during the day and hope they will outperform the market thanks to their superior market perception skills.

Investors who trust in the index investment are less presumptuous; their point of view is to stick the market. Because the market is composed of thousands of stocks, those investors are creating diversified portfolios which are similar to indexes like the S&P500, the Dow Jones or the Nasdaq100. Nevertheless, by acting like that, investors can't outperform the market because they are following it, so in the best chance they will have the same return of it but never more. Because of the different way of managing their investment active portfolio investors and indexes investors are constantly trying to proof that their way of investing is better than the other one. Now, it's commonly accepted that index investments have a higher return than the active portfolio. Nevertheless, those ways of investing have a common denominator; both are investing with a diversified portfolio. Many books will claim that diversification reduce risk and maximize profit. Thousands of business school' students have heard that diversification is the best, if not the only way to be successful in the market. Let's see what Warren Buffett proposes.

A third choice

Because Warren Buffett is not satisfied of the result of the previous strategies, he advises investors to invest in a focused portfolio. The main aspect of this strategy is to select few stocks of good companies, to invest more money on high return' stocks and wait without worrying about market fluctuations.

Find good companies through Buffett's tenets

As it's developed in the previous sections; Warren Buffett selects good companies through a process of 12 tenets. By doing the same investors should isolate some companies that are able to give high returns.

Having all his eggs in the same basket is an easier way to look at them

The main principle of focusing investment is to be able to invest in few companies with the highest chance of performance. Buffett explains: « If you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important lon g-term competitive advantages, conventional diversification [broadly based active portfolios] makes no sense for you.⁴¹» As he explains, the «know-something» investor, who is not a professional but someone interested in stocks with a basic knowledge, should invest money between 5 or 10 companies he or she knows very well, rather than investing in 50 companies that he or she doesn't know anything.

10 stocks at 10%?

As Buffett says, he is 15% Fisher, one of the ideas of Fisher was to invest more in stocks that have a stronger opportunity, that mean, a higher return. Following this idea, Buffett says «With each investment you make, you should have the courage and the conviction to place at least ten percent of your net worth in that

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stock.⁴²» That's why previously he advises to have at maximum 10 stocks. Nevertheless, some investments will have a higher return than others; investors should allocate more resources to those in order to have an overall higher return.

Time horizon

Focus investment is also different from diversified investment trough its relation to time. When diversified investment has a short term vision, Focus investment has a long term vision. One of the reasons to invest in the long term is to limit the risk. In short term, stock price will fluctuate due to several factors like a change in the interest rate, a new report concerning inflation, a natural disaster and so on; but in the long term share prices will more often increase. Buffett suggests having a relative turnover of the stocks contained between 10% and 20%, so the time horizon of an investor should be between 10 and 5 years.

Don't look at price fluctuation

Because prices fluctuate, and the value of stocks can drop investors are subject to panic. But because focus investors are running the long term, and because in the long term stocks are rising, there is no reason to be afraid of short term fluctuation. The reader will not be surprised to know that Warren Buffett never looks at short term fluctuation of his stocks.

THE FOCUS INVESTOR'S GOLDEN RULES⁴³

1. Concentrate your investments in outstanding companies run by strong management.

2. Limit yourself to the number of companies you can truly understand. Ten is a good number; more than 20 is asking for trouble.

3. Pick the very best of your good companies, and put the bulk of your investment there.

4. Think long term 5 to 10 years, minimum.

5. Volatility happens. Carry on.

When investors have to sell their stocks

It can appear strange, selling stock is really easy. Investors will sell their stocks due to 3 factors. The first one is because something was wrong in the equation; stocks return is not as high as expected. The second reason a change in the equation; what was right yesterday may not be right tomorrow. The third reason is life cycle, your stocks as still a high return but new one have a higher return.

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Something wrong in the equation

Error is human; sometimes investors will make a mistake when they estimate the value of a company, it will appear interesting to invest and few times later investors will realize that it was not. In such occasion, the best thing to do is to analyze the actual situation with calm, try to see how bad the situation is. Maybe it will be necessary to sell the stocks and lose money. It's business, it happens. Beginning investors are the most exposed to make errors at the beginning, that's why experience is useful in investment.

Something changed in the equation

Because focus investment is running in the long term, parameters can change. A really good company can become not so attractive a few years after. Top management can change, financial situation can become more risky, and there are several reasons this can affect a company. Even though good companies generally stay good companies in the long term, exceptions exist. In order to act and not to be subject of those changes, always staying informed of the business, the company, the sector is a way to anticipate them. If an investor sees that the company in which he or she has invested 5 years ago is not fulfilling the criteria that it should, he or she will have to sell and take his profit before the market understands the change and the stocks drop.

Life cycle

The main reason that makes investors sell stocks is that a better opportunity is coming. Investors can have a portfolio of really good stock, but sometimes, a new stock give higher expected return. The new stock will so take the place of an old stock in the portfolio. Generally, it will take the place of the stock with the lower return. Remember what Warren Buffet says about the turnover of a portfolio, it has to be between 10% and 20%, which mean a time horizon of 5 to 10 years. Investor will keep a stock during one or two years and others during 10 or more if the stock is always a top performer.

All the strategy of Warren Buffett can be summarized in one sentence. Buying quality companies at bargain prices. Warren Buffet told us to understand the market, the business, the company before investing on it; investors will have a better understanding of companies inside their circle of competence. He teaches us to buy stocks when the market underestimates the value of the company and so to take advantage of the margin of safety. Finally Buffet told us to have a focus portfolio and to run it in the long term.

«I'm the luckiest guy in the world in terms of what I do for a living. No one can tell me to do things I don't believe in or things I think are stupid.⁴⁴»

44 Quotable Executive (118)

Proposed strategy

Introduction

This section will outline the strategy that this paper will propose for investing. At first, it will outline the market philosophy that the authors of this paper will rely upon in order to develop the strategy. Afterwards, it will discuss the different kinds of risk that can exist for an investor and how an investor should know him or herself and his or her financial position in order to responsibly adjust his or her portfolio for the amount of risk that he or she can take. Furthermore, it will discuss how an investor can overcome the hype caused by financial porn⁴⁵ and so-called market gurus and control for his emotions when he or she is investing in the market. Following this, it will provide information on finding companies and evaluating them, as well as how to organize the information, and to create an investment thesis. It will finish by discussing buying and selling strategies.

Strategic Philosophy

This paper makes the assumption that markets are inefficient. It rejects the Efficient Market Hypothesis by asserting that it is possible to beat the market by picking undervalued stocks and selling them at higher prices. The main premise of this strategy will be to combine growth and value investing in such a way that the investor will be looking for strong growth companies at value prices, therefore getting into growth companies when they are undervalued and selling them when the market recognizes their potential and performance. The strategy will also attempt to control for the investor's natural ability to «be human» therefore being prone to error and emotion. In addition, it will try to time the market on a certain level by using technical charts at their most basic level only as value indicators, but not placing too much emphasis on them. In addition, the strategy will be designed to help the investor organize the numerous amounts of information he or she will collect about each company in a manner that would help make the overall analysis and the creation of an investing thesis and strategy easier. Furthermore, it will help the investor increase his or her performance by evaluating it and as such learning his flaws and trying to account for them.

Know Yourself.

Before investing, it is necessary for the investor to understand him or herself and his or her financial position in realistic terms. This section will outline different factors that will influence the strategy of each i nvestor.

Risk

Investing in the market does not come without risks, and it is a necessity to understand that. It is virtually impossible to eliminate risk for any investor in the stock market no matter how skillful. However, it is possible to control the level of risk that is undertaken on any investment. In order to understand how much risk an investor is willing to undertake, there are certain criteria that he or she needs to evaluate about his personal financial position.

The first thing that an investor needs to evaluate is how much money can be invested in the stock market. Managing of personal finances is out of the scope of this strategy, but it is necessary to mention that

45 The overwhelming amount of financial information on television and the news, much of which is useless and promises to make a lot of money in a very little time.

the investor must not be tied to any high interest debt such as credit cards while investing in the stock market. The returns gained in the market will rarely outweigh the interest compounding as an obligation to credit card debt, therefore before investing it is necessary to be free of such debts. Furthermore, it is necessary for the investor to understand that money he or she is investing in the stock market should be highly illiquid assets. This strategy will recommend long term investment and due to market volatility, the longer term, and the better. Remember Warren Buffett's quote, «In the short term the market is a popularity contest, but in the long term it is a weighing machine.»⁴⁶ It is necessary to understand that any investments undertaken need to be taken for the long term. Therefore, for example if the investor has a house purchase planned in the near future, it is wrong for him or her to put the money in the market because in cou ld devalue by the time he or she has to pull it out.

A full discussion of personal investment risk is outside the scope of this paper as it is up to the individual investor to decide how much risk he or she can take based on numerous different factors. Another aspect of investing that must be understood is how much time the investor has to perform research on each stock. He or she must make a decision about whether to be an active investor or a passive investor. An active investment strategy will require more research, while a passive investment strategy may just invest in an index, compromising a lower rate of return for lower volatility and less research.

A certain part of the investment portfolio should be kept in low risk assets such as bonds. The size of that part must be determined by the investor him or herself after carefully assessing his financial situation and future prospects. The part of the portfolio that can be used for investing in the stock market can also be adjusted for risk by certain factors. Several indicators such as market capitalization can be used to determine the general risk level of a given company's stock. For example, small cap companies offer a a greater chance of return for a higher amount of risk, while mega cap stocks such as the ones in the DOW offer lower amounts of risk for lower returns. It is necessary for the investor to adjust his portfolio according to the amount of risk he or she is willing to take.

Ignoring Financial Porn and Controlling Emotions

The media, internet and magazines are full of advertisements for the next big thing, and the «10 Best Stocks.» In addition, friends and coworkers are always excited about the next Furby doll or another next big thing. As an investor, it's hard not to listen to the bombardment of information that is thrown around. However, it is possible to use that information advantageously in a responsible way. Before hitting that «buy» button, the investor needs to have a well defined entry and exit strategy as well as reasons for doing so. This strategy will outline how to evaluate stocks and companies behind them while trying to control for the investor's human emotions and flaws.

46 Robert Hagstrom, The Warren Buffet Way( 103)

Finding Stocks

Circle of Competence

Even though Warren Buffett respects Bill Gates highly as a manager and entrepreneur, he never had a position in Microsoft stock. The reason for that is because technology companies are outside of Buffett's «circle of competence.» This concept is best described as the area of business you already know. For example, Tony would know the IT industry best, while Buffett would concentrate on the insurance industry. Within that circle of competence, the investor should perform thorough research to understand what the next trends are and what companies are positioned for success.

Personal Experience

As described above, investors are bombarded with «hot» stock tips, ideas from coworkers, and other sources. In addition, it's always easy to see the next biggest trends as long as the investor keeps his eyes open. For example, anyone who noticed the Abercrombie and Fitch trend when it first started would have made a very good amount of money by investing in the company. Seeing what people are buying, which industry gets interest and other such factors could point you to successful companies. However, as previously pointed out before, no investments should be made without due research into the company's fundamentals.

Stock Screener.

After thinking about personal experience, and thinking about the hot stock tips the investor has received from his friends and coworkers, if the investor can't really find any good stocks, many websites provide a very useful tool called a stock screener. With this tool, it is possible to set several criteria and then obtain a result that shows several stocks that fit these criteria. Our advice to set some non-negotiable criteria that the investor will not compromise on. A suggestion would be to specify these factors:

Market Capitalization:

The higher the cap, the lower the risk, in most cases. The definitions of market capitalizations as assumed by this strategy are as follows.

Table 2 - Market Capitalizations

Market Capitalizations
Mega Cap	More Than $200 Billion
Large Cap	$10 - $200 Billion
Mid-Cap	$2 - $10 Billion
Small Cap	$300 Million - $2 Billion
Micro Cap	Lower Than $300 Million

Created with Information from Investopedia.com

It is important to note that these definitions are not set in stone, and change from time period to time period for many reasons. In order to give a feel for returns of these companies, we have provided a table of their returns:

Table 3 - Returns By Capitalization

Returns by Capitalization
Capitalization	Index	1-Year	3-Year	5-Year
Large	MLCP	-4.27%	8.34%	10.43%
Mid	MMCP	-6.7%	10.83%	15.56%
Small	MSCP	-11.39%	8.22%	14.11%

Created Using Data From MorningStar on May 9, 2008

It's obvious to see that mid-caps provide more volatility than large-caps, less volatility than small caps, and seem to provide the best return out of all three over a long time period. But as can be seen from the one year data, the market did not do so well over the past year, and the returns here are negative. This is important to understand and goes back to the previous discussion of risk. This strategy will propose to pick mostly mid-cap stocks because of their increased return and medium level volatility. In addition, it will strongly suggest against companies capitalized at less than $350 million dollars at all, even if looking for high volatility, because it seems that these companies have a much higher chance of failure.

Daily Dollar Volume:

Low dollar volume on a stock suggests that institutional investors have not noticed the stock yet and will not touch it because since they are trading a large number of shares per trade they need high volume in order to move their stock. The investor can use this to his or her advantage because if a small cap stock has not been noticed by institutions yet and it is a fundamentally strong company, it will eventually and when it does, the stock price will increase. The other thing to keep in mind is that if the volume is too low, that means the volatility is extremely high, and there is a chance of inability to sell the shares. Therefore, this strategy will suggest a minimum daily dollar volume of $50,000 per day, and no lower than that under any circumstances.

PEG

PEG is the ratio of P/E divided by Earnings Growth Rate. In the previous discussion about earnings and creative accounting, this paper has mentioned that it is possible to manipulate earnings. Therefore, it would also be possible to manipulate P/E. However, if the P/E is used in conjunction with growth rate, the ratio itself cannot be manipulated. Following is a table of PEG Ratio of companies in 2003. The returns were calculated as of April 2006.

Table 4 - PEG Ratio Correlation to Return

PEG Ratio	Number of Companies (1,316 total*)	Median Return	Average Return
Below 0.00	213	43.9%	69.4%
0.00 - 0.99	583	154.1%	225.2%
1.00 -1.50	193	78.4%	92.6%
1.51 - 2.00	102	60.5%	79.0%
More Than 2.00	225	44.4%	69.4%

*Includes U.S. companies trading on major exchanges with market caps greater than $500 million for which data was available.

Source: Fool.com

Stocks with a PEG ratio between 0 and 1 have provided the highest average and median returns. It is necessary to note that this study is not statistically correct because there is no such thing as negative PEG unless earnings growth rate is negative, which is why the companies with PEG less than 0 provided lower returns. In addition, this usually works better for value stocks rather than growth stocks. Therefore, this will help us find value stocks, and we will use other factors to narrow them down to ones that are growth.

ROE:

Buffet looks for return of equity of at least 20%. Our ideal measure for this value would be above 25%, but if the company seems to have other good fundamentals, and debt is extremely low, then 20% is acceptable.

Debt to Total Capitalization Ratio:

We are looking for companies whose management can keep them out of debt. Therefore, we are looking for this number to be as small as possible. We will not accept stocks with more than 10% debt to total capitalization, and we will look for ideally for less than 5%.

Evaluating companies behind stocks

To be able to successfully invest, it is necessary not only to find information and understand it, but it is also important to present a clear picture of the company. This strategy would like to propose a system for doing so. The system would consist of several spreadsheets to help the investor analyze and narrow down companies that he or she is interested in. There are several phases:

Quantitative factors

Phase 1

Once the criteria has been run the first stock screener, the companies that are left after elimination will enter Analysis Phase 1 where they would enter the first spreadsheet. Here the spreadsheet will contain quantitative factors that are the most important and the investor must look at

	Analysis Phase 1
Criteria	Significance
Date	When data was collected
Company Name & Ticker	To know what company this is
Current Price	Current price of stock
52 Wk High / Low	Used to judge point based volatility and trading range
Market Capitalization	Company size
Daily $ Volume	Liquidity and volatility
Debt / Total Capitalization	How much capitalization of the company consists of debt.
Industry Debt / Total Capitalization	In order to compare the company to industry levels
Return On Equity - ROE ?	How well the company put capital to work in order to make money for investors. Bigger Is Better and should be increasing over past 5 years.
Industry ROE ?	Compare to industry.
Insider Ownership %	How much of the company is owned by insiders. Bigger Is Better
Stock Buyback Plan	If there is a stock buyback plan that is significant. Yes is better.
5yr Price Appreciation	How much the price changed over the past 5 years.
Current P/E	How high is the price of the company to current earnings. Lower is better.
Avg 5 Year P/E	In order to compare current p/e and see if it's overpriced. Current P/E should be lower
Industry P/E	Average industry P/E. Current P/E should be lower
Price to Sales ?	How is the company priced according to estimated core earnings. Should be lower, and increasing over past 5 years

It is necessary to be aware of recent stock splits as those could influence price appreciation, P/E, and other ratios. Here the investor would look at the companies and make a decision about which to keep and which he or she would not move on to the next level of analysis. Since further analysis takes time, it is necessary to narrow down companies that are not good investments as early as possible before moving on to Analysis Phase 2.

Phase 2

Here the investor will perform more detailed analysis on a smaller list of companies that the first list should have filtered out. He or she will look at:

	Analysis Phase 2
Criteria	Significance
Earnings Per Share ?	Earnings should be increasing.
Core Earnings Per Share ?	EPS adjusted for non-recurring revenues. Should be increasing.
EPS - Core EPS	Difference between EPS and core EPS. Reflects on the honesty of accounting and predicts volatility.
Core P/E	P/E based on core earnings
Net Earnings Growth ?	Growth of core earnings should be increasing
Industry Earnings Growth ? Projected Earnings Growth ?	Is the industry growing as fast as company or is the company pushing to the top of the industry. What are the projected earnings for the company.
Quick Ratio ?	How much more cash does the company have than debt due in the next 12 months, excluding inventories. Should be 1 and hopefully going up.
Current Ratio ?	How much more cash does the company have than debt due in the next 12 months, excluding inventories. Should be 2 and hopefully going up.
Industry Quick Ratio ?	How does the company compare to industry
Industry Current Ratio ?	How does the company compare to industry
Dividend Yield ?	A company with a good dividend yield could be a good investment, but we are not looking for dividends since we are looking for growth.
Sales Per Share ?	How well is capital being put to use.
Free Cash Flow ?	How much free money does the money have available to expand?
Net Cash Flow ?	How much money actually moves through the company that's cash.
Projected High / Low	What are the projections for the high and low prices. Lowest projection should be higher than current price.
Value Line Timeliness	Should be 1 or 2. How well the stock should perform relative to all other stocks in the next 12 months.
Value Line Safety	Should be 1 or 2. How safe is the stock compared to all other stocks in the next 12 months.
S&P Stars Rating	Should be 4 or 5. This is a measure that S&P uses to select for their platinum portfolio.
S&P Fair Value Rating	Should be 4 or 5. The lower the number, the more overvalued the stock is.

The stocks that pass through the analysis of this spreadsheet will move to Analysis Phase 3. This phase looks at specific fundamentals as compared to industry and is an optional analysis:

Phase 3

	Analysis Phase 3
Criteria	Significance
Revenues to Direct Costs ?	How much direct cost does it take to generate revenues.
Cash Ratio ?	How much highly liquid assets does a company have
Gross Profit ?	Should stay constant. How much revenue is left after direct costs are spent.
Gross Margin ?	Ratio of gross profit to revenue. Should stay level
Growth Rate Of Expenses	How much expense does it take to generate revenue.
Growth Rate of Revenues	How fast are revenues growing?
Expense to Revenue Ratio ?	Compare to gross margin to see if overhead is growing
Operating Profit Growth	Core income growth. Use if core earnings are not available.
Working Capital Turnover	How many times the working capital generated its value In revenues.
Bad Debts to Accounts Receivable ?	How much money is lost that is not collected by the company because of defaults by the people that owe the company? Is it increasing?
Accounts Receivable Turnover ?	Should stay level as receivables grow, otherwise the accounting is not very honest.
Average Inventory ?	How much inventory is kept on average.
Inventory Turnover	How often is the entire inventory sold and replaced.
DCF Valuation	Results from running the DCF formula.
Margin Of Safety	How much of a margin of safety the investor feels is needed.

These three spreadsheets should provide a complete evaluation of fundamental analysis of the quantitative factors of the company. Inferences made from this should be put onto the investment thesis, the creation of which will be discussed further. Companies that pass the previous three spreadsheets should be further researched by the investor, but this time in terms of qualitative fundamental factors.

Looking at Qualitative Factors

The nature of qualitative factors about a company does not permit them to be organized in a numerical fashion, such a spreadsheet. Therefore, this strategy will propose the creating of an investment thesis, containing such factors about the company. It will permit the investor to keep a clear record of why he or she is invested in the company. It will be look similar to this:

Company Strengths Company	Growth And / Or Value Is this a value or growth stock? Hopefully it's both.	Why Buy? Why invest in this company? Does it have a positive earnings outlook? Is it poised to succeed in this industry? Is the PEG extremely low and all the fundamentals are correct? Is the ROE great?
What are the strengths of this company? Is it poised for growth, does it have competitive advantages? Does it have good management? Is it an industry leader? Does it own a new great patent? I ndustry
	Price Target How high do you think this stock will go up before it starts going back down.
Is this a fast growing industry? Is it something that will take off in a few years?
	Increase Position Target If you are using DCA (explained further) when you should you increase your position? This strategy recommends 10%.
Company Challenges. Industry	Re-Evaluation Point How much does a stock have to decline in order for you to re- evaluate your position? This strategy recommends 10%	Why Sell? What would have to happen that would cause you to reevaluate your position or sell? Would the earnings drop significantly? Would ROE have to reach a certain point? Would oil have to reach a price point where you know the industry will react negatively?
There should be no significant internal weaknesses within the company. Does the company face fierce competition? Does the rising price of oil affect its growth outlook?
	Stop Loss Target When should you pull out and cut your losses? This strategy recommends at 15%

Other advices

Picking a Broker.

This strategy will recommend going with a discount broker such as Scottrade or Ameritrade, but there are many others. They have several pricing plans as well, and in order to make an intelligent choice, the investor needs to assess how he or she will invest. If he or she plans to increase his positions several times a month, some brokerages have per-month pricing plans, while other may charge $7 or $8 per trade.

Buying and Selling Strategies.

Gradually Building A Portfolio.

It's necessary to understand that not all the money you have should be dumped into investments on the first day. The reason is that at first any investor will make mistakes, and losses are sometimes inevitable. Invest in a stock or two gradually, and keep some money in your brokerage account to put into others. Besides, if you have all your money tied up in positions, then you can't buy exciting value stocks that you have recently found. It's good to keep in mind that if you miss one great opportunity, there are so many stocks that there are many other great opportunities.

Dollar Cost Averaging

In addition, you will be unable to do dollar cost averaging when you keep all your money in positions. Dollar cost averaging refers to increasing your positions in your investments that have gone down in price. In order to be able to perform this type of investing it is necessary to be absolutely sure in your companies because this involves putting more money in when the stock price goes down. This way you are able to increase your returns by averaging down the entry price of the overall position. However, this cannot work if the investor is unsure of his investments because this can lead to increasing losses.

Set Specific Targets

This strategy will assert that an investor should estimate how much he or she would like to pay for a stock, the set a limit order for that amount so that when that price hits, the broker will automatically buy the necessary shares. Therefore the investor does not have to sit in front of the computer day in and day out tracking the stock. Let your broker do all the work.

It is also necessary to set an exit strategy. This strategy proposes setting a re-evaluation point and an exit point before even investing in the stock. This means both directions. Know how low the stock will have to go for you to re-evaluate, as well as how high. For price increases, set an evaluation and target price for the stock. Estimate what price the stock has to be when you think it should be re-evaluated. If you think it's a great company, keep it and it will keep going up. But if you think it's time to sell, do it gradually. Sell only a part of your shares rather than all of them. The idea is the same as Dollar Cost Averaging, but works backwards. By making gradual sells, the investor can still get a piece of further price increases when the price reaches his target point. The same goes for price drops. Know at what price you should re-evaluate your investment and consider cutting your losses, and a price point at which you should sell to stop your losses. Sometimes it's hard to admit a mistake, but doing so can save you from losing a lot more.

Emotion and Fluctuation In The Market.

It's necessary to understand that the market will not stop fluctuating when you have money in it. In fact, it will probably seem to fluctuate more when you have money in it. It's necessary to keep a cool head and remember the reasons that you own the company and the reasons that would cause you to sell. If none of those reasons have been reached, leave it alone. The market will fluctuate, but it's important to remember that «Time helps great companies and destroys mediocre ones.»⁴⁷

Tracking Performance

To track performance, several things need to be kept in mind. If your portfolio returns 4% annually, then what's the point when you can get the same rate in a bond? The return of your portfolio needs to justify the risk that you undertake. Furthermore, you must account for the capital gains taxes on the returns that you get. A discussion on taxes is well out of the scope of this paper, but it is a consideration to be made when tracking your portfolio's performance. In addition inflation is another thing to consider. How much money are you making after factoring out those factors? In addition, another factor that must be considered in gauging your performance is the fees that you pay your brokerage. If you pay $8 per trade, then it takes you $16 to enter and exit a position. These calculations need to be taken into effect when calculating portfolio return.

To track your performance with the individual stocks themselves, you can track four factors: - Stock Price 3 months Before Purchase

- Buy Price

- Sell Price

- Stock Price 3 months After Sell.

Based on these factors you can determine whether you bought too high, sold too low, and how well the Dollar Cost Averaging strategies helped you out.

⁴⁷ Robert Hagstrom, The Warren Buffet Way(147)

Example

Explanation: Following is an explanation of the theory we have proposed, because we believe that seeing it in action will provide a clearer example for a beginning investor.

Stock Screener Criteria Used the 05/21/08:

ROE: 25% or more, and above industry average

PEG: Less than 1

Debt to Total Cap: 0 - 5% and below the industry average Capitalization: Mid cap, $2-10billion

Returned 4 companies, and we picked HANS because of the stability of industry, and because it's in our circle of competence.

Analysis Phase 1

#

Date

Company Name & Ticker

Current Price

52 Wk High / Low

Market Cap

Daily $ Volume

Debt / Total Capitalizati on

Industry Debt / Total Cap

Return On Equity - ROE ?

1

05/21/08

Hansen Natural HANS

$28.46

$68.4 / $38

$2.7b

$5.8m

0.1% ?

54.60%

45.2%?

2

3

Analysis Phase 1

#

Industry ROE

Insider Ownership %

Stock Buyback Plan

5yr Price Appreciation

Current P/E

Avg 5 Year P/E

Industry P/E

Price to Sales ?

1

30.90%

22

Yes

5366.00%

17.9?

23.86

19.2

2.83 ?

2

3

Analysis Phase 2

#

Ticker

Earnings Per Share ?

Core Earnings Per Share ?

EPS - Core EPS

Core P/E

Net Earnings Growth ?

Industry Earnings Growth

1

HANS

1.79?

$1.51

$0.28

27.46

62.7% ?

11.30%

2

3

Analysis Phase 2

#

Projected Earnings Growth

Quick Ratio ?

Current Ratio ?

Industry Quick Ratio

Industry Current Ratio

Dividend Yield ?

Sales Per Share ?

1

20.1

2.8?

4?

0.7

1.1

n/a

$9.15?

2

3

Analysis Phase 2

#

Free Cash Flow / Share

Net Cash Flow / Share

Projected High / Low

Value Line Timeliness

Value Line Safety

S&P Stars Rating

S&P Fair Value Rating

1

$1.08

$1.62

No access to value line

b

5

2

3

Analysis Phase 3

#

Ticker

Revenues to Direct Costs

Cash Ratio ?

Gross Margin ?

Growth Rate Of Expenses

Growth Rate of Revenues

Expense to Revenue Ratio ?

1

HANS

2.07

0.92?

51.20%

15.00%

45.90%

1.34%

2

3

Analysis Phase 3

#

Operating Profit Growth

Working Capital Turnover

Bad Debts to Accounts Receivable ?

Accounts Receivable Turnover ?

Inventory Turnover

DCF Valuation

Margin Of Safety

1

4.33%

4.83%

n/a

12.10%

5.40%

$35.54

$7.08 / 27%

2

3

Company Strengths Company

Growth And / Or Value This is a value buy, because the stock is currently undervalued by

Why Buy? The company has an extremely small amount of debt and a huge return on equity to shareholders. It is poised better than the rest of the industry. The earnings prediction is 20% for the next five years, and DCF valuation shows a 27% margin of safety.

The company's products are made to differentiate. It owns major energy drink Monster which is a large competitor to Red Bull in the US. In addition, France will be legalizing Red Bull and other energy drinks therefore opening a new market for Monster. Industry

a age g Price Target Long term hold

Increase Position Target $30

The industry outlook for this industry is neutral, projecting steady growth in companies' earnings and cash flows.

Company Challenges.

Re-Evaluation Point

Why Sell?

$25

Industry

If the company begins to accumulate debt, or

The industry is threatened by the higher

if the ROE falls below 20% we will evaluate

costs of corn, and therefore HFCS, but

position. Also, we will watch the prices of

because it's so competitive, companies

HFCS and aluminum and predictions for

price increases will be passed to

those. In addition, if the legal arena for

consumer because if one company has to

Stop Loss Target

energy drinks changes, this may cause us to

increase prices because of increase in raw material cost, all companies will have to do the sa me.

$23.50

re-evaluate.

In order to help a beginning investor understand our strategy, we decided to put it into action on May 21, 2008. After running the stock screener, we have picked one company which we have believed to be in our circle of competence. Hansen Natural, which produces various non-alcoholic beverages such as energy drinks and juice has a ticker of HANS. We have decided to analyze this company as an example.

In order to find our data, we have relied on the information provided by Scottrade in terms of financial statements. We have also used the Reuters Research Report and the S&P stock report made available to us by Scottrade. In addition, to gather our qualitative data, we have visited the website of Hansen Natural and looked over the most recent 10q and 10k. The purpose of this example is to show our strategy to the beginning investor and giving an example of a great company.

In the case of Hansen Natural, after we have completed the three phases of qualitative evaluation, we have been able to see several things that made it a good investment. First of all, the debt to capitalization ratio was extremely low (0.1%) and decreasing over the years, showing that the company has been decreasing its debt and using mostly equity to produce returns. In addition, the return on equity was 45.2% and higher than the average of the industry showing us that the company is squeezing every last dollar to make returns on investor capital. In addition, the company has grown over 5000% in the past 5 years. The managers and employees are confident in the future of the company even after the recent price drops because of the high percentage of insider ownership. In addition, there is a $200m buyback plan that was announced in April which means that the company plans to buy back shares which will eventually increase the price. In addition, we believe the industry outlook to be positive because of the high popularity of energy drinks in the US. We have also calculated a value per share using DCF and have came up with $35.54 and we feel comfortable with a 27% margin of safety provided to us at the current price. Of course, these are not the only factors and investor should look at, but weigh the importance of the ones we have provided him

Conclusion:

From all of our research, and our newfound familiarity with the topic, we conclude that investing can be a great thing, but not performed correctly it can lead to great losses. There's something in the market for everyone, from the safety concerned investor to the strong stomached. One does not have to take great risk to realize great gains, but to perform research and to maintain a long-term outlook are the two most important tenets.

The strategy we have outlined does not show anything new, but advocates diligent research and longterm investing. It combines the best aspects of the strategies that have been proven to work to try to create an idealistic hybrid. Of course, in order to have any academic significance it still needs to be proven and doing so could involve a lot of work and data collection. However, from our analysis of different sources, we believe that the strategy we have synthesized will work by helping the investor pick companies with strong assets that will perform well in the long run in a bear or a bull market.

Bibliography

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Appendix

S&P reports on Hansen Natural

Figure 10 - S&P Report for HANS
Source: Standard and Poor's

107

Reuters report on Hansen Natural

110

Figure 11 - Reuters Report For Hansen Natural
Source - Reuters

111

113

115

117