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Fundamental Equity Analysis

Chris Argyrople, CFA

Concentric Investment Management LLC

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Humor & Caution: DLJ’s Springsteen Theory of the Dow

• DLJ noted in their April 17, 2000 research report that:• The Dow outperformed the NASDAQ after leg 2 of

the Springsteen Tour• Conclusion:

– 1) The Boss Rules– 2) Humor is Acceptable – 3) SOMETIMES IT IS MUCH TOUGHER

TO DISCERN WALL STREET’s BS THAN IN THE SPRINGSTEEN EXAMPLE

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Why Take this Class?

• Develop Rigorous Analytical Approach Towards Evaluating an Equity

• Integrate Concepts from: Corporate Finance, Accounting, and Strategy

• Profit

• Improve Thinking Skills

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Where is the Market Going??

• I have no idea where the Dow or S&P will trade in the next year

• Long Term: earnings will drive stock prices and earnings have risen about 9% per year over time

• This Class = Forecast Results for Individual companies, not the market

• IT IS A STOCKPICKER’S MARKET GOING FORWARD, SO YOU ARE IN THE RIGHT CLASS

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Allocate $1,000 between these 3

• Company A: P/E ratio 15, consensus growth estimate 17%, analyst dispersion around consensus of 12%, payout ratio 0%.

• Company B: P/E ratio 2, consensus growth estimate 0%, (20 analysts all in agreement), payout ratio 100%.

• Company C: P/E ratio 10, consensus growth estimate 30% (20 analysts all in agreement), payout ratio 0%.

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Course Goals

• Be able to thoroughly analyze a company

• Learn how to Integrate all knowledge into a portable “toolkit” for analysis

• Help Train the Next Peter Lynch :-)

• NOTE: The great student will take the science to a higher level than the teacher

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How/What Will You Learn?

• Learn from Yourself, about Yourself• Learn from Classmates (don’t minimize)• Learn from Professor • TURN MISTAKES INTO LEARNING

My Goal / Deliverable:Students can prepare a professional securities

analysis by end of sessionDestination is > Interim Progress

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My Finance Philosophy

• Models are Important

• Analysis augments Thought

• Accounting is Important

• Details are Key, but stop when you reach diminishing returns.

• Logic and Thoughtfulness are more important than modeling

• I would rather be Warren Buffet than Fisher Black

• Strategy is Equally important as Finance

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Two Approaches to Research

Traditional MBA

Do some ratios

Quick Answers

EASY WAYThis Class

Sleuthing

Thought & Logic

Analytical Models

CORRECT WAY

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What to Expect

• Hard Work

• Boring Data Gathering and Data Entry.

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

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What I Expect

• Lots of Hard Work

• Plenty of Participation

• Debate and Differing Viewpoints

• More Hard Work

• I Expect you to be Good at Both the Modeling and the Thinking. These are 2 different things. Example: How do you Calculate this E(r)?

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About The Markets

• Market Timing is nearly impossible

• The Last 15 Years have been Incredibly easy to make money

• The Next 15 Years will be Stockpickers Markets

• Thus, Fundamental Analysis

• Quant models face a difficult future because, by definition, quant models eliminate efficiencies they exploit

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Characteristics of Good Analysts

• Intelligence– Can’t be Taught, BUT it can be offset by other factors– Buffet is rumored to be a genius– Geniuses can see what others don’t

• Work Habits: Work Smart & Hard, Focus• Independent Thinking / Guts to Act• Experience & Training

– Learn from Mistakes, Be Open Minded

• Passion For the Work

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MODEL BUILDING

• EDGAR (Elec. Data Gather. & Retrieval)

• Data Entry -- actuals from 10Ks & 10Qs

• Try to Pick Companies / Industries that have lots of data -- Data drives good fundamental models. Don’t want to multiply last years revenue by 6%.

iQuantity)* (PriceSales

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Pick A Company / Industry

• Pick Industries where Data is Available– Maybe you work in that industry

– Want to Drive Revenue with Fundamental Data

• Pick Something you Like

• At my Firm, we like High Fixed Costs, Operating Leverage, Data Availability

• DON’T WASTE TOO MUCH TIME CHOOSING A COMPANY; WILL LEARN FROM : Your Firm, Classmates, & Prof.

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The Class Will Cover

1) Cash Flow Methodology & Valuation

2) EVA TM, Economic Value Added Model

c Stern, Stewart & Co.

3) Strategic Management & Valuation

4) Industry Analysis

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What Moves Stock Prices?

Rank These Items:

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

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Pattern Recognition is Key in Stockpicking

• Pay attention to patterns in the markets• Always think: WHAT MOVES STOCKS?

• What happens to Financials, Homebuilders, Retailers when interest rates rise?

• Why are falling same store sales GREAT for retail stocks?

• Need Many Mental Models: “To a Man with a Hammer, Every Problem Looks Like a Nail”, Charlie Munger -- You need to draw on many experiences for successful investing

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Introduction to Valuation

• THE VALUE OF ANY INVESTMENT EQUALS THE PRESENT VALUE OF THE FUTURE CASH FLOWS TO THE BUYER

• This holds for all Investments : Stocks, Bonds, Real Estate, Beanie Babies etc.

• i = correct discount rate that reflects the risk of the cash flows

n

n

nn

i

CashFlowValue TerminalAny )

)1(( Value

1

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DCF Valuation

• Discounting future cash flows to a present value is called DCF Valuation

• DCF Valuation is ALWAYS CORRECT given the following assumptions:

1. You can correctly forecast the Future (even many years out)

2. You use the correct discount rate

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Problem with DCF Valuation

In 1977, I was in 8th Grade

Experts told us:

1. The Russians will take over America

2. Oil was going to $100 a barrel

3. Computers will take jobs away from humans

4. By 1990: the 4 Day Workweek !

If you can Predict the Future, then use DCF and Drop this Course

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Reasons for Fundamental Research in an Efficient Market

1. KEEP YOUR JOB (#1 Reason)

2. Develop E( r ) Forecasts

3. FIND OCCASIONAL INEFFICIENCIES & ATTRACTIVE SITUATIONS (this is the real #1 Reason)

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My Recommendation

• Do Lots of Fundamental Research• When you have no alpha, diversify and keep

costs low (index)• When you have alpha, throttle it. Remember,

you are in school so you can get a high paying job. If you are worth the pay, you will reap the excess returns from your best ideas. Implement your best ideas in a big way. Are your Ideas Worth the Paycheck?

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The Buffett Method

• Put all your eggs in one basket, and watch that basket very closely.

• Concentrated Positions (never less than 9 stocks)

• Intense Research, Lots of Knowledge

• Note: A good Portfolio will be:1) Industry Diversified

2) Maybe have 30 stocks

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Homework Due

• Pick a company -- Domestic USA only

• Build an equity model

• At least 2 full years of historical data ( 8 quarters: Income & Cash Flow Statem)

• Full Year Forecast for Current Year (quarterly)

• Short writeup and investment thesis & recommendation (Buy or Sell)

• Hand in on-time: Hardcopy PLUS Optional email of model

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Homework (continued)

• Use trailing and forward ratios to formulate your investment thesis & recommendation

• Only most recent quarterly Balance Sheet (for now)

• Don’t worry: you’ll get plenty of practice !

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Textbook is Optional

• The textbook is Optional but recommended

• Distributed in class

• Price $65 cash / check / your good word

• Must order text via email

• Length continually varies, but approximately 280 pages

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

• Analysis of this Career:……………………….

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Instructor (continued)

• Internships: Travelers (foreign equity quant); Colonial (bond trader)

• Willing to stay late after class to answer questions

• Have difficulty finding people jobs, but you can always ask (my contact list is finite, but the students regenerate yearly)