Tuesday, September 14, 2010

Real-World Fundamental Analysis

I was just reading the current issue of TIME and on page "Global 14" there is an article that brought up several testable points. The article discusses a new technology called "hydraulic hybrid" that is used to build fuel-efficient, "green" garbage and recycling trucks. They run about 20% higher than the typical $200,000 for these monster trucks, and they're produced by Eaton, Parker Hannifin, and Peterbilt. There are 70,000 garbage and recylcing trucks currently driving around this nation, and they'll all have to be replaced eventually. Notice how the facts so far have been about sales and the size of a potential market--that's fundamental analysis. Given this information, a great fundamental analyst like Warren Buffett could take an envelope and a pencil and answer some basic questions on each of those three firms like:
  • How many trucks will need to be replaced each year for the next 10 years?
  • How big is the company's market share projected to be?
  • What is their profit-per-unit-sold?
  • How much will profits on these vehicles impact the company's overall net income/bottom line?
  • Does the company have a competitive advantage?
  • Who are the officers and directors, and what have they done in the past?

Notice how some of these questions are answered with numbers and some are qualitative. No matter how quantitative we get, it's all based on projection and speculation. Out of 70,000 vehicles that need to be replaced, we first have to guess how many of those customers will pay the higher price for the hydraulic hybrid. We could be way off there. Then, we have to guess what % of the projected market will go to the firm we're analyzing. At this point, we could be so far off that every calculation about the revenues, costs, and profits will become exponentially inaccurate. Maybe that's why the efficient market theorists have such a following? Not only do we have to get these calculations and assumptions right, but we have to do a "discounted cash flow" model to figure the "net present value." And, we'd have to somehow marry that sort of braniac calculation with the guesswork involved with deciding if a particular senior management team is trustworthy and/or more likely to succeed in this new market space than any other. So many places it could go wrong. Not to mention that this new technology exists largely through government subsidies, and so the fundamental analyst has to try to figure out if those subsidies will keep coming and, if so, will they increase or decrease? If they dry up, which company would most likely survive without them? So, we have regulatory risk (subsidies might dry up) and risk of obsolescence (the technology) also threatening to make a mockery of our sophisticated calculations. No wonder there are technical analysts who leave all this fundamental hand-wringing to others. Just tell them the stock symbol, and they'll pull up the data on its market behavior. What's the 52-week high and low price of the stock? What's the 200-day moving average for its closing price? Where's the support and resistance? What's the volume? Technical analysts study market data, your exam might say.

Fundamental analysts, on the other hand, study companies--their operations, their projected revenues and profits. And, I'm sure some of them pretend they buy stocks based on the "discounted cash flow model" when, really, they just have a feeling about this Google, Facebook, or Groupon company everybody's talking about.

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