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Stock Market Success For Beginners

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Maksim Pecherskiy
Stéphan Laouadi
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Bachelor Thesis
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Spring semester 2008
Atlantis Program
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 semester 2008

Authors: Maksim Pecherskiy and Stéphan Laouadi

Tutor: Dr. Emeric Solymossy

Title Stock Market Success For Beginners

Key words Investing; Stocks; Stock Exchanges; Fundamental 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.

ii
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.

iii
Table of content

Abstract ...................................................................................................................... ii
Acknowledgements.................................................................................................... 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
a
 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

b
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.

1
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?

2
Research Methodology

Nature of the Problem

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.

3
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.

4
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
Total 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.

5
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.

6
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.

7
Why, How and Where does A Company Sell Stock?

Selling stock to raise 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.

8
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

1 Investopedia.com

9
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.

2 Investopedia.com

3 IBID

10
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.

11
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 symbol 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.

4 Investopedia.com

12
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.

13
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.

14
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

15
 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 Investment 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)

16
 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.

17
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)

18
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.

19
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.

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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)

21
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 numbers 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.

22
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

23
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)
14

A high degree of operational effectiveness

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)

24
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.

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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)

26
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.

27
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:

28
 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.

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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

30
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
31
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.

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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%.

33
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.

34
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.

35
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
36
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

37
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.

38
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 number of periods
A = Average Inventory

Where It Can Be Found: This must be calculated

39
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

40
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

41
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

42
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

43
 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.

44
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.

45
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.

46
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!

47
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

48
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.

49
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

50
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

51
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.

52
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
example a P/E of 10 means that the current price is 10 times greater than that latest EPS. It follows 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
53
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 follows
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.

54
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.

55
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

56
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

57
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

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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 day-
trading 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/stock_screener.asp

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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 double-
checked 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
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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 SeekingAlpha.com.

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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

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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

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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)

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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

30 Benjamin Graham, The Intelligent Investor, Revised Edition(527)

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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”.

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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.

32 G. Hagstrom The Essential Buffett: Timeless Principles for the New Economy(65)

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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.

33 Philip Fisher Common stocks and uncommon profits and other writings (126)
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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?

35 Philip Fisher Common stocks and uncommon profits and other writings(47)

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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.

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 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”

37 G. Hagstrom The Essential Buffett: Timeless Principles for the New Economy(81)
38 IBID (82)
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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 follow 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 writes, “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.

39 G. Hagstrom The Essential Buffett: Timeless Principles for the New Economy (85)

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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.

40 G. Hagstrom The Essential Buffett: Timeless Principles for the New Economy(95)

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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 analyzes 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.
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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 long-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

41 Robert Hagstrom, The Warren Buffet Way (122)

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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.

42 IBID(122)
43 G. Hagstrom The Essential Buffett: Timeless Principles for the New Economy(129)

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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)

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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
investor.

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.

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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 could 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)

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 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

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 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.

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 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:

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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.

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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 ⇅ Is the industry growing as fast as company or is the company pushing to the
top of the industry.
Projected Earnings Growth ⇅ 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.

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 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:

87
Company Strengths
Company
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 How
a new great patent?
Industry
Is this a fast growing industry?
Is it something that will take off
in a few years?
Company Challenges.
Industry
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?
Growth And / Or Value Why Buy?
Is this a value or growth stock?
Hopefully it’s both. 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
Price Target fundamentals are correct? Is
high do you think this stock will the ROE great?
go up before it starts going back
down.
Increase Position Target
If you are using DCA (explained
further) when you should you
increase your position? This strategy
recommends 10%.
Re-Evaluation Point Why Sell?
How much does a stock have to
decline in order for you to re- What would have to happen
evaluate your position? This strategy that would cause you to re-
recommends 10% evaluate 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?
Stop Loss Target
When should you pull out and cut
your losses? This strategy
recommends at 15%
90
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.

91
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)

92
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.

93
 Analysis Phase 1
Return
Company 52 Wk Debt / Total Industry On
Current Daily $
# Date Name & High / Market Cap Capitalizati Debt / Total Equity
Price Volume
Ticker Low on Cap – ROE
⇅
Hansen
$68.4 /
1 05/21/08 Natural $28.46 $2.7b $5.8m 0.1% ↓ 54.60% 45.2%↑
$38
HANS
2
3

Analysis Phase 1
Insider Stock
Industry 5yr Price Current Avg 5 Industry Price to
# Ownership Buyback
ROE Appreciation P/E Year P/E P/E Sales ⇅
% Plan
1 30.90% 22 Yes 5366.00% 17.9↓ 23.86 19.2 2.83 ↓
2
3

94
 Analysis Phase 2
Industry
Earnings Per Core Earnings EPS – Core Net Earnings
# Ticker Core P/E Earnings
Share ⇅ Per Share ⇅ EPS Growth ⇅
Growth
1 HANS 1.79↓ $1.51 $0.28 27.46 62.7% ↑ 11.30%
2
3

Analysis Phase 2
Projected
Current Ratio Industry Industry Dividend Yield Sales Per Share
# Earnings Quick Ratio ⇅
⇅ Quick Ratio Current Ratio ⇅ ⇅
Growth
1 20.1 2.8↑ 4↑ 0.7 1.1 n/a $9.15↑
2
3

Analysis Phase 2
Free Cash Net Cash Flow Projected Value Line Value Line S&P Stars S&P Fair
#
Flow / Share / Share High / Low Timeliness Safety Rating Value Rating
1 $1.08 $1.62 No access to value line b 5
2
3

95
 Analysis Phase 3

Expense to
Revenues to Cash Ratio Gross Growth Rate Growth Rate
# Ticker Revenue
Direct Costs ⇅ Margin ⇅ Of Expenses of Revenues
Ratio ⇅

1 HANS 2.07 0.92↑ 51.20% 15.00% 45.90% 1.34%

2
3

Analysis Phase 3

Operating Working Bad Debts to Accounts

Inventory DCF Margin Of
# Profit Capital Accounts Receivable
Turnover Valuation Safety
Growth Turnover Receivable ⇅ Turnover ⇅

1 4.33% 4.83% n/a 12.10% 5.40% $35.54 $7.08 / 27%

2
3

96
Company Strengths Growth And / Or Value Why Buy?
This is a value buy,
Company because the stock is The company has an extremely small amount
The company's products are made to currently undervalued by of debt and a huge return on equity to
differentiate. It owns major energy drink a large margin. shareholders. It is poised better than the rest
Price Target
Monster which is a large competitor to of the industry. The earnings prediction is
Long term hold
Red Bull in the US. In addition, France will 20% for the next five years, and DCF valuation
be legalizing Red Bull and other energy shows a 27% margin of safety.
drinks therefore opening a new market
for Monster.
Increase Position Target
Industry $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 $23.50 re-evaluate.
material cost, all companies will have to
do the same.

97
 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

98
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 long-
term 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.

99
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Appendix

S&P reports on Hansen Natural

Figure 10 – S&P Report for HANS

Source: Standard and Poor’s

104
105
106
107
108
109
Reuters report on Hansen Natural

Figure 11 – Reuters Report For Hansen Natural

Source - Reuters

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113
114
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