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Equity Fundamentals (Part Two)

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The second equity fundamentals contains the deeper dive into company fundamentals. In this level you review the finances of your long and short candidates. For long candidates, you’re seeking improving year over year fundamentals. For short candidates, you’re seeking deteriorating year over year situations. Look back over 3 to 4 years, since a longer term fundamental trend being driven by economic factors discussed earlier is best. There are specific aspects to review. Most of these are easily available on MorningStar.com, so you don’t have to calculate them yourself, just look them up.

What We’re Looking For

For Longs you want the following: Rising Annual Revenue or Sales (Strong majority of sales in “Cash” and not Accounts Receivable), Falling Long Term Debt, Rising Interest Coverage, Rising Gross Margin, Rising Operating Margins, Rising Asset Turnover, Rising Inventory Turnover, Rising Return on Assets, Rising Return on Total Assets, Rising and Positive Operating Cash Flow, Rising Current/Quick/Cash Ratios, and Rising Free Cash Flow.

For Shorts you want the following: Falling Annual Revenue/Sales (Strong majority of sales in Accounts Receivable over cash), Rising Long Term Debt, Falling Interest Coverage, Falling Gross Margin, Falling Operating Margins, Falling Asset Turnover, Falling Inventory Turnover, Falling Return on Assets, Falling Return on Total Assets, Falling or Negative Operating Cash Flow, Falling Current/Quick/Cash Ratios, and Falling Free Cash Flow.

IssueGenerally Positively Impacts Asset PricesGenerally Negatively Impacts Asset Prices
Trend Drivers:Net Institutional BuyingNet Institutional Selling
Share Events:Stock Splits (Lowers cost to purchase)Initial Public Offerings
Dividends:Dividend Initiations (+Demand/fundamentals)Dividend Omissions (-Demand/fundamentals)
Equity Buybacks & Sales:Repurchases & Tender OffersSeasoned Equity Offerings
Share Listings:Spinoffs/DivestituresNew NYSE/NYSE AMEX Listings or IPOs

Management should also be considered. For Long candidates, you want management that has traits that will improve the company. They should be competent, honest, aware, logical, humble, and rational. They should also be regarded as strong in terms of leadership, and take responsibility for firm performance in all scenarios. For Short candidates, you want management that has traits that will sink the company. They should be incompetent, deceitful (or seem shady/untrustworthy), oblivious, isolated from reality, arrogant, and shift blame to others.

Business Model Considerations

The company’s business model should also be considered. If the company is easily substituted with another firm in their industry, with little penalty or loss to performance, they have a fairly weak business model. This is bad for a company, thus good for short candidates. If the company is hard to replace, has a high barrier to entry, and has penalties or losses of performance for switching to competitors, they have a fairly entrenched business model. This improves a long candidate and company.

Firm Beta

You must acquire each firm’s BETA for all long or short candidates during this stage. The beta for each firm will be used in the risk and hedging process. This is listed on multiple sites, but beta should always be acquired from the same place. Beta values are the result of a regression test comparing the index’s returns against the company’s equity returns. Different websites often use different durations for the test, which results in different Betas. Make sure that all betas are acquired from the same place using the same duration. You also can use an excel regression to test to find beta over 3 years (756 Days) of data manually, if not gathering Beta from Morningstar while reviewing fundamentals. This requires downloading 756 days of the Long Candidates closing price, 756 days of the Short Candidates closing price, and the last 756 days of the index. You will need to calculate the daily change for those 756 days for the long candidate, the short candidate, and the index. For any given Day this is simply: (Day – Day Before) / Day Before = Percentage Return.

Run a regression test in excel between the Long Candidate’s returns and the Index’s returns, then the Short Candidate’s returns and the Index’s returns. The “X Variable 1” output is the Beta. The “intercept” is the Alpha. A positive alpha exceeds market performance, and is beneficial for long candidates. A negative alpha lags market performance, and is good for short candidates. You don’t need to be strict about alpha requirements, but it is a hint you’re on the right track.

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International Economic Analysis:

  • Major Currency Economic Summaries
  • Performance of Major Imports and Exports
  • Mandates of Central Banks versus Expectations
  • Performance Indexes of Major Economies
  • Economically Correlated Currency Projections
  • Large Funds Currency Sentiment Readings
  • List of Technical Indicators to Look For
  • Occasional: Foregin Exchange Technicals Markups

American Markets Analysis:

  • Summaries of American Economic Structure
  • Performance of Major
  • Imports/Exports
  • Federal Reserve Mandate versus Expectations
  • Performance Indexes of U.S Economy
  • Economically Correlated U.S Dollar Projections
  • Large Trading Fund Index Sentiment Readings
  • Market Wide Earnings Versus Valuations
  • Fundamental Ranking of U.S Business Sectors
  • Best and Worst Future Consensus Estimates
  • Occasional: Firm Fundamental Strength Report
  • List of Technicals to Look for While Trading

WealthCE FX + Equity Analysis

Major 8 Economic Summaries
Economic Performance Index
Currency Market Sentiment
Equity Index Market Sentiment
Sector Strength Tracking
Equity EPS/PEG Estimates
Fundamental Firm Analysis
Trend Following Trading Plans

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