Delusions Dying, Investors Return to the Fundamentals

Give the Nasdaq Stock Market at least this much: Its sense of irony is acute.

A year ago Friday the Nasdaq composite index closed at its all-time high of 5,048.62. To mark the anniversary the index plummeted 115.95 points Friday, or 5.4%, to end at 2,052.78--a new 27-month low and just 33 points above the level that would mark a record 60% loss from the peak.

By now, many investors who have continued to hold on to collapsed technology stocks must simply be numb. That’s also a big part of the problem: This sell-off has gone on for a year because the level of disbelief over the stocks’ losses has remained high. But with each new low, more investors who said they’d never sell at these prices do just that. Each new low also pushes another group of holders closer to the edge and ready to jump.

The greatest source of anxiety for most tech stock owners is, of course, the money they’ve lost on paper or for real. But what’s also deeply troubling for many investors is the jarring realization that they can’t intelligently evaluate the companies they own.

If your only investment “strategy” in recent years was to buy a stock because it was going up, you probably put little or no effort into studying the actual business, the company’s financial health or its true long-term potential for success.

As tech stocks soared, simply playing the momentum price game was a great money-maker and a virtual no-brainer. Now, as the stocks plunge to multi-year lows, investors who still own the shares--or who are tempted to buy at these levels--find themselves turning to a discipline that was ignored or even mocked a year ago: fundamental analysis.

For those who’ve forgotten or have never been initiated, the Barron’s Dictionary of Finance and Investment Terms defines fundamental analysis like so: “The analysis of the balance sheet and income statements of companies in order to forecast their future stock price movements.”

If it sounds like work, it is. But then, successful investing in the years ahead is likely to involve some effort--which would just be a return to the norm. The old line “If it was easy, anyone could do it” should apply to investing if it applies to anything.

Many investors’ only attempt at fundamental analysis is to look at a stock’s price-to-earnings ratio based on the last year’s earnings per share and hope that it will instantly reveal whether the share price is cheap, fair or overvalued.

Though the P/E is an important element of fundamental analysis--and outrageous P/Es on tech shares a year ago were the most visible signs that the stocks’ risk levels were off the charts--no single statistic can tell you everything you need to know about a stock or a company.

A first step in evaluating any company is to ask two basic questions:

* Where does the money come from to make the business grow?

* How does the company use the money it takes in?

Required reading material, if you’re addressing these questions, is the company’s latest annual report and its most recent quarterly report.

The first question will lead you to an analysis of the company’s sales growth--how much it’s selling in goods or services each quarter or year and the percentage increase or decrease in the dollars generated by sales.

*

The first question also forces you to consider the company’s debt situation and other capital-raising issues: Has it borrowed, and does it continue to borrow, as part of its growth program? Is the debt manageable--or is the interest-expense item on the company’s income statement rising far faster than sales or earnings?

With younger companies, debt may not be an issue. But if the company’s growth is largely financed by the sale of additional shares to the public, that presents a different potential challenge.

If investors in many now-failed dot-com companies had merely focused more closely a year ago on the question of where the money came from, they might have understood that much of what the companies promised was totally dependent on their access to capital markets. In other words, with relatively little in the way of sales, the only way these businesses could sustain themselves was to devour capital from investors.

But the door to capital markets isn’t permanently propped open. It closes from time to time, as investors’ willingness to take on risk ebbs and flows. When it closed on the dot-coms, they were doomed.

The second question--how a company uses the money it takes in--gets to the heart of what most investors ultimately find interesting about fundamental analysis.

People get excited about a business because of the products or services it offers and the potential for those products or services to find a wide audience. If that happens, shareholders figure, they will reap the winnings.

But managing growth is a major challenge for any company. The right decisions have to be made about how to invest in the business--that is, which product lines to pursue, how to price those products, where to sell them, how much to pay employees so the firm retains the best work force it can, how much capital to retain as a hedge for bad times, etc.

What you’re betting on, as a shareholder, is that the company is going to manage itself well enough to produce strong and consistent earnings growth for years to come.

But that is no easy feat--as my colleague James Flanigan details in his column today on Coca-Cola, a company that for years produced stellar growth but now is struggling to get back on track.

A cornerstone of fundamental stock analysis is determining what kind of growth one can expect from a business and then placing a fair price on the stock today based on that projected growth.

The assumption is that future earnings belong to the shareholders. You have to make that assumption even if management is entrusted to use those dollars wisely, and even though, unlike for much of the last century, many companies no longer return much of their profit directly to shareholders via cash dividends.

To put it another way: You’re trying to determine the “present value” of the future dollars the company hopes to generate.

It sounds more complicated than it is. In any case, the goal of fundamental analysis isn’t to merely find the cheapest stocks, as measured by low stock P/E ratios or other value gauges.

A stock can appear cheap compared with near-term earnings for good reason: The business may be in its twilight. Unless you’re buying stocks based solely on their liquidation value, you probably won’t be attracted to companies that aren’t growing.

*

Ralph Wanger, veteran money manager at Liberty Wanger Asset Management in Chicago, says one of his fundamental-analysis tests for a stock is the “quit test.” That is, he says, “If I could quit my current job to go run that business, and own it all, would I do it?” The key here is not just running the business, but paying the current market price for it, Wanger notes.

There will always be businesses that are so exciting investors will pay a premium to get a piece of them. That’s why “high” P/Es aren’t necessarily a bad thing. If you expect a company to grow at a very fast pace, generating high returns on the money you’ve invested, then it follows that the stock should sell for an above-average P/E. This gets back to the idea of putting a fair value on future earnings. You would expect to pay more today for an investment that is going to grow faster than alternative investments over time.

Therefore, if you believe a particular tech company may struggle through the next year, but longer term still has stellar growth prospects, the lower its stock goes in the current market malaise the greater the opportunity to buy it at a more reasonable--even cheap--level relative to future earnings.

The great mistake a year ago was that investors were paying high prices for tech stocks not just relative to estimated 2001 or 2002 earnings, but relative to estimated 2005 or 2006 earnings. Some of those investors argued that they were, indeed, doing fundamental analysis, and were highly confident about those 2005 results.

But true fundamental analysis also demands a certain realism on the part of investors. Robert Rodriguez, a veteran investor who manages the FPA Capital Fund in Los Angeles, says investors who deluded themselves into paying record prices for tech shares failed to understand that “the further you look out [in estimating earnings growth], the more suspicious you have to be” that the numbers won’t pan out as expected.

*

High stock P/Es, Rodriguez notes, may not be problematic in and of themselves. But what investors must accept is that “the higher the P/E goes, you’re taking on greater risk. All you have to do is tweak your growth expectations a small amount, and you’ll have a problem.”

Rodriguez also notes that fundamental analysis--paying attention to a company’s debt load, for example, and to the amount of free cash the firm generates each year after paying its bills--is no guarantee of investment success. Even Warren Buffett, the master of fundamental analysis, has picked stocks that have bombed.

While paying attention to the fundamentals, Rodriguez says, you’re still going to be making projections and trying to guess the future--always a risky endeavor.

But you may at least be lowering your risk of making a huge mistake with a stock, while “trying to increase the probability that you’re going to be successful,” he says.

*

Tom Petruno can be reached at tom.petruno@latimes.com.