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For a quick, yet very insightful view of fundamental analysis, look no further than Michael Thomsett’s book Getting Started in Fundamental Analysis.  It’s not quite the in depth (and boring if you ask me) view that Benjamen Graham presents, but it does give the beginner and intermediate trader a great snapshot on the most important principals.  The book is available in paperback, and is a quick read, but can also occupy a permanent spot on your bookshelf.

Here is one of my favorite sections of the book on Off-Balance Sheet Liabilities:

A very troubling final observation about balance sheet ratios concerns off-balance sheet liabilities.  Most of the trends you develop and track will be affected by obligations that do not show up.

Among the many tricks used by executives in those corporations caught deceiving stockholders in the past, was one in which off-balance sheet liabilities were carried, at times in the billions of dollars.  As a consequence, the value of the company and its stock could be vastly inflated….

The lack of disclosure may easily distort the true picture, just as increases in long-term debt may distort a seemingly positive trend in the current ratio.  The solution is to develop an ability to understand footnotes, and to adjust your trend analysis so that your trends and ratios are complete and realistic.

For a more detailed view of the book’s contents or to purchase the book, just click the book below.

Getting Started in Fundamental Analysis by Michael C. Thomsett

Is there anyone left that actually looks at the fundamentals?  Or has everyone become  a market historian, screaming BUY after a rally, and SELL after a selloff?  According to this Marketwatch study,  it appears that all the newsletters in the land have jumped in to declare the bottom.

To give you an idea how quickly this emerging consensus has been formed, consider the Hulbert Stock Newsletter Sentiment Index (HSNSI). This index represents the average recommended stock market exposure among a subset of short-term stock market timing newsletters tracked by the Hulbert Financial Digest.

On Nov. 20, HSNSI closed at minus 18.9%, which meant at that time that the editor of the average short-term market timing newsletter was recommending that his clients allocate 18.9% of their equity portfolios to shorting stocks. As of Tuesday night, in contrast, the HSNSI stood at 43.5%, or 62.4 percentage points higher.

But the fundamentals of almost every sector are still waning.  Perhaps it is the quantitative easing and forecasted $1 trillion 2009 deficit that everyone is so excited about?  Or maybe it was the 693,000 jobs lost in December?  Surely those unemployment checks will incite mass purchasing at local malls everywhere?!?!

As for me, I maintain my neutral stance on the markets.

• I will hedge nearly everything I buy.
• I will maintain some cash on the sidelines.
• I will take both long and short positions.
• I will remain skeptical of all these bulls who continue to ignore the fundamentals.

By nearly any measurement, 2008 was a wake up call to reckless CEO’s who took extreme risks and watched those risks backfire.  Several “invincible” firms have now completely vanished from the scene, including Countrywide Financial, Washington Mutual, Indymac, Bear Sterns and Lehman Brothers.  Yet even more are hanging on by mere threads, and are now part of the Sub Two Dollar Stock Club.

Take a look at the 5 year chart below showing a good mix of the members in the sub two dollar stock club.  To be a member of the two dollar stock club, your chosen CEO must have nearly destroyed all of the equity in your firm.  2008 was a great year for adding new members into the two dollar stock club.  The Google Finance stock screen I used had three criteria:

• Current market cap greater than $100 million
• 52 week price change between -80% and -100%
• Current stock price betwen 50 cents and $2

There were 41 companies in the latest screen.  It’s quite possible that some or even most of them could be completely wiped out in 2009. The 5 year chart (3 years visible) below shows five companies in the sub two dollar club.  Notice the end result that all of them were down very close to 100%.

Is there any rebound hope for the members in the sub two dollar club?  Anything is possible but at very long shot odds.  However, a solid recovery by members in this group could yield hefty profits to those wanting to take on the risk.  And before you go throwing your cash at these names, be aware that the risks are immense!

• AIG - Years ago I remember the Motley Fool guys touting this stock as one to own for life.  But those fools apparently had no idea that AIG was writing trillions of dollars in mortgage insurance contracts it had no ability to pay.  AIG is still alive today because of the $85 billion emergency taxpayer funded loan, but it still carries severe risk of collapse.  The financials on AIG are to complex to understand completely, but Standard and Poor’s recently rated it a HOLD, with a 12 month price target of $3.  They also are forecasting a return to profitability in 2009, with full year EPS of $.40.  Keep in mind, however, that Standard and Poor’s and Moody’s were asleep at the wheel and furiously giving AAA rubber stamp ratings to nearly everything that crossed their desks.  AIG closed today’s session at $1.69.
• ETFC – The online discount broker has over 4.8 million accounts in more than 40 countries, according to their website.  At some point, their CEO and board decided to branch away from their CORE and invest gamble on sub prime mortgages.  That gamble nearly wiped out the company and they are still struggling to recover.  But Etrade still has a lot going for it in its large and growing account base.  According to Standard & Poor’s, the Q3 2008 financial results showed a 4% increase in customers and a 6.6% increase in daily average trade revenue.  But S&P still forecasts a loss in 2009 equal to $.16 per share (down from an estimated $1.31 loss per share in 2008).  ETrade closed today’s session at 1.31.  It’s current S&P rating is HOLD, with a 12 month price target of $2.50.
• GGP – General Growth Properties is one of the largest shopping mall owners and operators in America.  But it is struggling with an enormous debt load that may crush the company out of existence.  It’s shares last traded at $1.42, giving it a market cap of $381 million, but with a last reported total debt load (from 9-30-08) of nearly $25 billion! The latest Standard & Poor’s report is apparently to embarassed to refer to 2009 “earnings”.  Instead, they describe 2009 projections in terms of “funds from operations”.   Commercial property is under enormous pressure from declining rents, vacancies, and insolvent tenants.  But if you believe there is a sliver of hope for an drastic economic recovery, then it may be possible for GGP to hit their 12 month S&P price target of $2.00 per share.  They closed today’s session at $1.42.

Check out your own Google Finance screen for more members of the sub two dollar stock club.

Disclosure: Currently long AIG, but may or may not invest or trade in other mentioned names in the future.

Disclaimer: Invest and/or trade at your own risk!  This post is NOT advice!

To use the Phil Town method for calculating the fair value for a stock, you need four numbers:

1. Current earnings per share (EPS)
2. Estimated (future) EPS growth rate
3. Estimated future price/earnings ratio (PE)
4. Minimum acceptable rate of return

Keep in mind that calculating fair value works best for companies that fairly and honestly report their earnings in an easy to understand way.  That little caveat excludes all financial companies.  It is also best to calculate fair value on companies that have real and actual earnings.  That requirement eliminates American automakers and homebuilders, and other bailout beggars! And fair value is also easier to calculate using companies with sustainable and consistent earnings, not erratic earnings such as with mining and defense companies.  Let’s take McDonald’s as an example of a company with real earnings to calculate fair value.

Excluding dividends, McDonald’s trailing twelve month earnings per share were $3.96, according to the MSN Money summary.  Next comes an estimate for future EPS growth rate.  MSN Money averages out analyst estimates of future earnings estimates on their website, and McDonald’s is currently listed with a 12% future growth rate over the next 5 years.  But Phil also recommends looking at past growth rates.  According to Google Finance, (more annual data history than MSN Money) the last 4 years of earnings per share data for McDonald’s were $2.06, $2.09, $2.44 and $2.88.  Those annual earnings per share results correspond to growth rates of 1.4%, 16.7%, 18%.  Therefore, a 12% analyst estimate of future earnings growth seems reasonable.

To get an estimated future P/E, Phil recommends taking the lower of either the historical P/E or twice the expected growth rate.  The analyst expected growth rate is 12%, which corresponds to a future P/E ratio of 24.  But McDonald’s is only currently trading with a P/E ratio of 15, so it is the better estimate to use for future P/E ratios.  In fact, conservative investors may want to go even lower than 15 in today’s secular bear market, and collapsing P/E ratios.

The final piece of information for determining fair value is the minimum acceptable rate of return for this investment.  Phil Town recommends a default rate of 15% as the minimum return.  So the four numbers that we will use to determine fair value of McDonald’s are:

• current earnings per share – $3.96
• estimated future EPS growth rate – 12%
• estimated future P/E ratio – 15 (perhaps less due to secular bear market collapsing P/E effect)
• minimum rate of return – 15%

The next step is to determine what the earnings per share will be in 10 years, based on the 12% growth rate in earnings, and starting with a base of $3.96 per share of earnings.  Using either a calculator, or Excel, the earnings per share of McDonald’s in 10 years based on a 12% EPS growth rate are $12.29 per share.  Assuming a future P/E of 15, McDonald’s could theoretically trade for $184.35 per share by achieving the assumed 12% growth rate over the next 10 years.  Finally, to get the sticker price of McDonald’s, we know that our minimum 15% rate of return requires an approximate quadrupling of the stock price over 10 years.  (Use calculator or excel to verify yourself) So all we have to do is divide the future expected stock price of $184.35 by 4 to come up with today’s theoretical sticker price of McDonald’s shares.  Based on all of the above assumptions and calculations, the sticker price of McDonald’s shares today is only about $46 per share, and it is currently trading at $61.29.  In fact, Phil Town also recommends a steep 50% margin of safety for new investments.  In following Phil’s approach, we would not want to pay more than $23 per share for McDonald’s today, and therefore would want to look elsewhere for rule #1 stocks.

Rule #1 investing is an aggressive method for buying stocks at a steep discount.  But finding those stocks is often very difficult to do.  But when you do find them, it is very unlikely that you will see events such as the 2008 financial crisis and stock market decline affect your portfolio of rule #1 investments.  Phil’s book is definitely worth buying!

Rule #1: The Simple Strategy for Successful Investing in Only 15 Minutes a Week! by Phil Town

Related Articles:

• Stock Fair Value and Rule Number One – Sticker Price
• The Basics Of Buy Low, Sell High And Channeling

Phil Town’s Rule Number 1 investment book is yet another classic that deserves a spot on every investor’s bookshelf.  Rule #1 of investing, if you are not aware is “Don’t lose money”.  Rule #2 of investing is also “Don’t lose money”, and Rule #3 is “Re-read the first two rules”!

Phil Town is a classic value investor, and his book is filled with insight into what how to pick solid stocks to invest in, and then how to interpret the financial numbers to determine when to pull the trigger.  He talks in detail about return on investment capital (ROIC), sales statistics, earnings per share (EPS), stockholders equity, and cash balance.

Rule #1 also talks about the intangibles, such as betting on the jockey (strong company leadership), looking for companies with a moat (barriers to entry for competitors), and demanding a margin of safety.  And he goes into great detail on how to calculate the sticker price (intrinsic value or fair value) of a stock, or a reasonable value for the shares based on all the existing financial numbers, future forecasts and intangibles.  But requiring a margin of safety is critical and a margin of safety is achieved by never paying sticker price for a stock.

Rule #1: The Simple Strategy for Successful Investing in Only 15 Minutes a Week! by Phil Town

Also see:

• Calculating Fair Value For a Stock – Rule Number One

Active Value Investing, by Vitaliy Katsenelson, is another one of those “must own” investment books to buy and keep.  Read it and tab out the important pages that you may want to refer back to, and keep it on your bookshelf forever.  Similar to John Mauldin’s Bull’s Eye Investing, Katsenselson also talks about collapsing p/e ratios during secular bear markets, a simple concept that far to many people neglect and get burned on.  But Katsenelson goes a step further to break down more precisely the mechanics for determining fair value.  Forget about those lunatics on television telling you XYZ stock is cheap because of it’s low p/e ratio compared to peers.  Instead, use the absolute p/e model discussed in detail in the book and determine what the fair p/e ratio is based on the expected EPS growth rate.  The base and fair p/e ratio for any stock growing earnings at 5% per year is only 11.25, according to Katsenelson.  From that number you add in expected dividend payments and subtract out the risk factors (business, financial, and visibility) to determine the absolute p/e ratio in the current environment.

You really need to buy this book!

Active Value Investing: Making Money in Range-Bound Markets (Wiley Finance) by Vitaliy N. Katsenelson

It’s just to much fun to pick on Jim Cramer these days. When will people realize that he is just an entertainer, and knows nothing about the fundamentals of this economy?!?! Here is him over one year ago raving on Mastercard (MA). He tells the same “no credit risk” story as the other lunatics on CNBC. But one year later, it seems even Mastercard is not immune to credit risk, and their shares have weakened drastically as a result.

Related article:

• CNBC fails attempt to prolong Visa and Mastercard bubble

Warren Buffet is a brilliant investor, but it does not mean I would blindly follow his investments.  I am a Berkshire Hathaway (manged by Warren) shareholder, so in a sense, I am blindly following him.  But I don’t pay to much attention to the Berkshire stock holdings report, and when do I learn of new Berkshire holdings, I’m certainly not eager to purchase them in my own account.

As of June 30, 2008, Berkshire Hathaway reportedly owned 48 million shares of Moody’s Corporation.  According to the Yahoo Finance profile for Moody’s:

Moody’s Corporation, through its subsidiaries, provides credit ratings and related research, data, and analytical tools; quantitative credit risk measures, risk scoring software, and credit portfolio management solutions; and fixed income pricing data and valuation models principally in the United States and Europe

Today, Moody’s reportedly (and finally!) cut its credit ratings on Fannie Mae and Freddie Mac to just above junk status.  I’m not interested in investing in Moody’s, whose business model is based on providing accurate and timely credit ratings, but who does not cut ratings until after the damage is done.  Moody’s ratings to me are no better then the predictions of the average Wall Street analyst – calling a sell AFTER a huge sell-off and calling a buy AFTER something is overbought.

I’m happy to own Berkshire Hathaway stock, but I’ll stay away from Moody’s!

Does everyone at CNBC own shares of Visa and Mastercard? You would certainly think so the way they parade those two stocks on multiple shows virtually everyday. Manipulation anyone? You’ve heard the nonsense from Cramer on Mad Money, the Fast Money morons, and a multitude of others. Everyone is terrified of holding financial companies so CNBC continually advertises that Visa and Mastercard have no credit risk. They say that they are just a payment transaction company and the credit risks fall to other banks. Well it may be true that Visa and Mastercard do not carry direct credit risk, but to say there is no risk is foolish. As the card issuers that utilize Visa and Mastercard increasingly cut off their client’s credit, Visa and Mastercard will suffer accordingly. And with such lofty valuations in both companies stocks, any slight disappointment is bound to result in a bloodbath in the shares.

Just last night Cramer was spouting his mouth off with yet another bottom call, and made specific mention to Mastercard prior to their earnings release this morning.

“I am indeed sticking my neck out right here, right now,” Cramer continued, “declaring emphatically that I believe the market will not revisit the panicked lows it hit on July 15. and I think anyone out there who’s waiting for that low to be breached is in for a big disappointment and [they’re] missing a great deal of upside.” …Cramer’s predicting the rally continues Thursday thanks to great after-the-bell earnings from The Walt Disney Co. and First Solar. And who knows what could happen after Mastercard reports in the morning.

Guess what Cramer. It’s now morning, and we see that Mastercard reported a second quarter LOSS of $747 million dollars, or $5.74 per share. Mastercard shares were off nearly 11 percent (so far) as of 9:51am est, just 21 minutes into the trading day. So much for that “NO CREDIT RISK” thesis that CNBC shoves down your face. CNBC has failed its attempt to prolong the Visa and Mastercard bubble. Thanks for the advice Jim, but I’d rather stick to the much more accurate Big Mac for my trading advice.

The Starbucks stock price topped out near $40 per share twice in 2006, but has been steadily falling since that double top formation, and now sits at around $14.40 per share. By many accounts 2006 was also the peak of the housing bubble, and leaky home values have issued a strong blow to consumer spending since that time. Two of the hardest hit states in terms of housing are also two states that make up nearly 30 percent of the Starbucks stores in the United States. A $5 latte may not have been a stretch two years ago, but in the midst of this deflating economy and credit crisis consumers are definitely cutting back.

But consumer spending is not the only thing ailing Starbucks. They are also struggling with higher acquisition costs of their two staple ingredients – coffee and milk. In fact, over the past two years, the Deutsche Bank commodity index (DBC) and Starbucks (SBUX) appear to be an exact mirror image of each other:

McDonalds is another company affected by higher commodity input costs, but that fact is certainly not reflected in their share price which has hit several 52 week highs already this year. McDonalds healthy operating model allowed them to pay off $1 billion in long term debt in 2007. Yet Starbucks, who operated most of its life with insignificant near zero long term debt, suddenly racked up $550 million in long term debt during 2007.


McDonalds is also pursuing the high end coffee market through their aggressive expansion of stores offering the McLatte. And they are doing this at the same time that Starbucks is reversing their expansion into McDonalds traditional breakfast sandwich turf. It seems that every area where Starbucks is struggling and failing, McDonalds is thriving and conquering. But the struggle of Starbucks will not last forever. Howard Schultz is taking significant steps to reverse the downtrend – revising the menu, closing poor performing stores, and even offering a new customer loyalty program. Global commodity prices have also shown signs of leakiness, and any continued price relief on the milk and coffee front could be a potential windfall for Starbucks. If McDonalds is serious about their coffee expansion plans, then they need to take action now. The opportunity to acquire the biggest name in coffee during their weakest days won’t last forever. McDonalds needs to buy Starbucks now.

Disclosure: The author of the above article holds a long position in Starbucks stock.