What Fundamental Analysis can do for YOU


Welcome to the next part of your spread betting course. And today we'll look at one of the two types of analysis you can use to decide where a share or index is leading, in order to help you make a spread bet: fundamental analysis. In the next course you'll be introduced to the other form of analysis - charting.

If you are going to tackle spread bets through a fundamental analysis approach, it's critical you stay on top of what's going on in the markets. To know what is going on minute-by-minute, Bloomberg, CNBC and CNN are all you really need. Together with the top newspapers and periodicals like Investors' Chronicle and Shares magazine, you should have enough information to make sensible spread betting investment decisions. If you are using fundamental analysis to study a company's shares you would typically look at the latest set of financial results, together with news stories, director dealings and analysts forecasts. For indices and currencies the main factors to focus on would be on economic data. However, knowing what is going on and making money from this information are two totally different things.

Bursting the bubble

The problem with fundamental analysis is that it tends to reflect current analysis or opinion. Those who follow such advice may find that even in the case of the most profitable companies or situations they may be coming to the party too late to profit. In addition, fundamentals, even if they have been assessed correctly, can take a long time to come to fruition. This is generally not suited to spread betting, whose timeframe is most successfully demonstrated in days rather than months or years.

Maybe the greatest problem with discussing fundamental research is the fact that even though balance sheets and corporate statistics such as price earnings ratios, profit margins and profits can be measured in objective terms, how you interpret them is largely a subjective matter. Marconi was a solid company in 1999, but some time in the three years that followed, as the share price fell from over 1000p towards 0p, this situation changed. If you waited until the management confessed that there was a problem, you would have found the share already down to 250p. Arguably, a technical analyst would have told you there was a problem long before even most skilled accountants could have.

However, fundamental analysis remains an essential part of trading. The number of sources of information regarding companies has ballooned, thanks to the Internet and increased public interest, with many specialist sites, like t1ps.com, and the newsletters coming under the Fleet Street Publications' umbrella providing a sterling service. These include spread betting services like Spread Trader and Swing Trader - which both consider fundamental and technical analysis when recommending a trade. The best advice on fundamentals is to do what the experts do.

The experts' ways

It would not be too much of a generalisation to say that the majority of experts study companies on the stock market like hawks. Here is a distillation of some of the characteristics of the fundamental research carried out by them:

  1. They go and meet or call the companies they are thinking of recommending. There is little second-hand information.
  2. They get to know intimately the business that the company is involved in - what kind of demand there is for the product and whether this is improving.
  3. They gauge the sentiment in the sector the company is in as well as the sentiment towards the company itself. This will come from stockbrokers as well as the press.
  4. They are prepared to go out on a limb if necessary and, providing the fundamentals have not changed, will stick to their recommendation.
  5. Visibility of earnings going forward, ratings such as P/E ratios and P/E/growth ratios are very important, as is net asset value and the amount of cash in the bank. If these criteria are not met, they will back away or recommend a sell.

The fundamental ratios you need to know

In order to assess whether a company is a buy or sell you need to look at some of the key ratios related to its financial performance. Earnings per share (EPS) is the post-tax profits of a company, divided by the average number of shares in issue during the period in question.

EPS is so important because the EPS of a company represents the amount shareholders will receive either directly (via a dividend) or indirectly as 'retained earnings', which are reinvested in the company and add to its net assets.

As an investor, you will want to unearth companies that not only have a consistent record of growing their earnings historically, but also that are likely to continue to do so for the foreseeable future. But be careful.

For a start, earnings growth is not everything. Is the company generating cash? How strong is its balance sheet? And are those earnings numbers distorted either by constant changes in the tax charge or by accounting policies that strike you as odd? If the company has a low tax charge currently, how long will it stay low?

And how secure are the earnings of a company going forward? Personally, I would bet that the forward earnings of a dull metal-basher are far more secure than those of a business-to-consumer website. Finally, you must ask yourself if a company's earnings growth potential is not already discounted in the share price.

The facts about the P/E ratio

The P/E ratio is the current share price divided by the earnings per share of the company in question. When you see a P/E ratio stated in a paper, the ratio in question is almost certainly the historic (or trailing) P/E ratio - the current share price divided by last year's reported earnings per share. However, most professional investors are more concerned with the forward, or prospective, P/E ratio - the current share price divided by the current year's predicted earnings. Remember that the City always looks ahead and share prices are dictated by future, rather than past, profits.

If you look at today's paper you will see that certain shares, such as the water companies, trade on a historic P/E ratio of less than 10. But IT services companies such as Logica used to trade on historic price earnings ratios of 50 or more. The long-run average historic P/E ratio for industrial shares is in fact a little over 12 and the FTSE 100 currently trades on a P/E of around 22. So what does that tell us, apart from the fact that however hot a company's P/E ratio is now it is likely to fall towards 10-20 in the long run?

Investors, as a herd, will pay a higher multiple of earnings - a higher price in effect - for shares that are expected to deliver superior earnings growth. Hence, utilities - which will do well to deliver any real earnings growth at all - command very low P/E ratios, while IT shares - perceived as capable of delivering premium growth - command much higher ratings. Sectors such as house building generally trade on a relatively low P/E ratio because earnings per share in that industry can easily rocket for two years and then slump for three. In other words, a lack of consistency and visibility of earnings will also damage the P/E ratio a share can achieve.

If a share trading on a P/E ratio of 10 issues a profits warning, its share may fall by 10 or 20% - on such a low rating, there was clearly some bad news 'in the price' already. But if a share on a glamour P/E ratio issues a warning, prepare to lose a lot of money. Let's look at LMN plc, which is trading at 100p. Having achieved 2p of earnings in year 1, it suddenly reveals that trading has weakened considerably and instead of earnings being set to rise by 50% a year, only 10% a year (or less) is now on the cards. Suddenly, instead of owning a share trading on a forward P/E of under 30, investors own a share on a forward P/E of 46. And what is worse, instead of being a growth share, LMN plc's prospects are now starting to look very ordinary. If it is set to deliver only market-average earnings growth why should these shares trade on a P/E ratio more than double the market average?

Of course, the next move is inevitable. Shares in LMN plc are likely to slump to around 40p, at which stage they will trade at an average sort of P/E ratio. That is the risk in buying highly rated shares - there is no room for disappointment. One slip and you will lose heavily - unless you are short via a spread bet.

How to decipher fundamental jargon

Institutional research is written for institutional clients, whose performance is judged in relative, not absolute, terms. In other words, a fund manager is a star if he outperforms the FTSE All-Share, not if he simply records gains: a 10% gain in a market up 20% is worse than a 10% loss in a market down 20%. Hence, when a broker is positive about a share, he is not saying that it will go up, merely that it will outperform its peer group index.

'Buy', 'Strong Buy', 'Recommended List', 'European Focus List', 'Weak Buy', 'Strong Hold', '1, 2, 3M', '3L', 'Outperform'... the list of possible broker recommendations is endless, but does it mean anything?

Different brokers use different scoring systems. However, broadly they can be categorised into seven distinct categories.

  1. Buy (sometimes referred to as 1 by brokers who use a numeric system): Means that on a 12-month view the broker expects the share to outperform its peer group index by 10% or more.
  2. Outperform, add, accumulate, 2, market outperformer: Means the broker expects the share to outperform, but by less than 10%.
  3. Trading buy: Something of a cop-out. Essentially, the broker is saying that this is a poor quality share, but that its shares have fallen so far the bad news is more than discounted. This is not a strategy for wealth creation that is generally advocated, nor is it one followed by great investors like Warren Buffett.
  4. Strong buy, European focus list, Recommended list, Member of 'model portfolio': A couple of years ago when brokers realised that they rated most shares as a buy, a few of them decided to introduce various categories of 'super buys' - their overall favoured shares.
  5. Hold, Neutral, 3, Market performer: Share is expected to trade broadly in line with index performance over the following 12 months.
  6. Underperform, Market underperformer, Reduce, 4: Share is expected to underperform the market by between 0 and 10% over the next 12 months.
  7. Sell, 5: Share is expected to underperform by 10% or more ov-er the following year.

Fundamental analysis versus its technical partner

Fundamental analysis is very helpful, but unfortunately not flawless. But even if fundamental analysis is not for you, don't worry. In the next course we'll be back to detail the advantages of using technical analysis, and introduce you to some basic charting patterns.

>> Next Page - How to use technical analysis to make money

Recommend this on Google

The content of this site is copyright 2016 Financial Spread Betting Ltd. Please contact us if you wish to reproduce any of it.