Comparative Analysis: Apples to Apples

If you have been following this blog over the last couple months, first, I would like to say, Thank you! It has been a pleasure writing for you. If you haven't, you can catch up by visiting a few of my other posts. We have been discussing how to find stocks of interest in your everyday life (here), a few tips on what to look for in a stock as a beginner (here) and some free online resources to dig up additional information (here) on a publicly traded company.

Today, I am going to discuss comparative analysis. It sounds intimidating but trust me, you are already familiar with the concept. You have probably heard someone say the phrase "compare apples to apples", "that's apples and oranges" or some other similar phrase. It just means that it is far easier to compare things that are alike.

Consider the following question; Which is a better movie, Braveheart or The Notebook? I personally think they are both great movies (yes, I have been known to enjoy a chick flick on occasion). But I like them both for very different reasons. If I watched Braveheart and I wrote down what I thought made it such  great movie and then judged The Notebook by the same criteria I don't expect I would consider it great or even good. Nearly everything I enjoyed about Braveheart was absent The Notebook. I simply cannot compare the two by the same criteria and come to an honest conclusion. The same is true for Stocks.

When you are doing your stock research you will come across a lot of number and ratios that won't make sense by themselves. How much debt is too much? What is a good dividend? What is a good Price/Earnings ratio?

There is no template for what a good investment looks like. Different industries or sub-industries should be judged by different criteria. To determine what criteria a company should be judged and to get some context for all of those numbers and ratios you should look at a few different things;

Revenues ~ Looking at the reported quarterly revenues is a good place to start. Revenue is the total amount of cash coming in from sales of the product or service the company provides. This is often referred to as the "top line". For this number obviously higher is better.

Net Income ~ Net Income is the revenues minus expenses and losses. This is commonly referred to as the "bottom line". Again, the higher the number the better but you also want to be mindful of the relationship between revenue and net income. If revenue goes up drastically but net income stay the same there may be issues that need to be investigated. There are many factors that can impact that relationship, some good, some bad. Perhaps raw material costs are going up (probably bad) or maybe the company has been investing in new equipment (probably good) but whatever the case, it is important you know why.

Gross Margin ~ The gross margin can help you define the relationship between the revenue and the net income. It is generally expressed as a percentage. That percentage identifies how much revenue is turned into profit on a per unit basis. It sounds complicated but conceptually it is not. Think of it like this; If I own a sandwich shop and I sell a foot long sub for $5 and the cost of the bread, meat, cheese, vegetables, condiments, paper wrapping and labor come to $3 my Gross Margin per unit is 40%. This is an indication of how efficiently the company makes money.

Debt ~ Not all debt is bad. In many industries you will find that a certain amount of debt (it varies) is appropriate. In fact, having little or no debt might actually be harmful to a company in a competitive industry. Debt is often used to expand a company. Having no debt might mean that the company does know how or has no desire to expand which can limit earnings potential. Of course having too much debt is bad as well. Finding a range of what is the appropriate amount of debt for a company can be difficult but comparative analysis can help.

Price to Earnings Ratio (P/E) ~ As I explained in a previous article (here) the P/E is a very important number that can signify the perceived growth potential (or lack thereof) or value of a company. This number more than all the others discussed above is only valuable when compared to other P/Es.

That is a few of the numbers you should be comparing but to what do you compare them? 

• Competitors ~ Always look at the competition, preferably the company's chief rival like Coke and Pepsi. 
• Past Performance ~ To know where a company is going it helps to know where it has been. What is the company's P/E ratio now and how does that compare to its highest and lowest over the last few years? Are they accruing more debt or paying debt down? Are revenues trending up? Is net income outpacing the trend in revenue or is it lagging? Identifying trends is an important part of Stock Analysis. Often companies have a seasonal cycle, so be sure to compare the 1st quarter of one year to the 1st quarter of the next, the 2nd quarter to the 2nd quarter and so on.
• Expectations ~ Company's often make statements in earnings reports or press releases that indicate how much they expect to earn or grow in the upcoming quarters. Financial Analysts do the same. How do their expectations compare?  Do they match your expectations?

When performing comparative analysis, context is king. The more context you have the more sense you can make of that great jumble of numbers you will find in earnings reports, financial statements and Yahoo! Finance pages.

I will break down those numbers in a future blog so stay tuned and as always, if you have any questions feel free to post them in the comments section. I would love to hear them.      

Despite all the fear, Economy on the mend

If you have been paying attention to the Stock Market over the last few weeks you are probably confused, perhaps frustrated and maybe even feeling a bit nauseated. Since last Thursday the DOW has been like the ocean roiled by a great storm, swinging over 400 points alternating from positive to negative, 4 times (see the chart below) over the last week. Overall the DOW is down over 1,500 points since mid-July. If your new to the Stock Market or have purchased any stock in the last few months chances are you are in the red. This is a scary time but there is a valuable lesson here. Much like the ocean, one must respect the power of the Stock Market. It can bring you a great bounty or ruin if you do not take proper precautions but you can stay afloat.



DOW 5-day chart: Dangerous Waters



Don't Panic!!! 

The first step to surviving in these dangerous waters is to keep your wits about you. This is not the time to bail out of your holdings. Remember, you haven't lost a penny until you sell your stock for less than you bought in. It may make your stomach turn to look at your unrealized gains/losses but I highly recommend you hold on and let this storm pass. The Stock Market has weathered many storms over the last century and I don't expect that this one will be different.

If checking on your portfolio is giving you heart burn I recommend tuning it out for a little while. Take into account your time horizon (when you plan on accessing the funds in your account). If it is an IRA and you have 25 years until retirement age, you don't have to watch your portfolio every day, week or even every month. You should be investing with a very long term view and your holdings should not require a lot of maintenance (check out this article for more details).  

This isn't 2008 

A lot of media folks are trying to draw comparisons to the market in 2008. Don't buy it. While economic conditions seem worse now than they did then, the truth is, underneath it all companies are far healthier. They have less debt, more cash and are more efficient than they were in 2008. While our Government may be worse off, American companies are stronger than they have been in years. Its going to be American companies that drag us out of the recession, not the US Government.

Unfortunately, the health of American companies has not translated to a much needed increase in hiring. Unemployment is the greatest risk to the economy. While the health of the US Government is a concern, it is a symptom not the cause of our economic troubles. Companies are not hiring because up until now they have been able to squeeze greater productivity out of fewer employees but that only last so long. Eventually, efficiency is maximized and to increase capacity a company has to hire. I believe after 2 years of layoffs and process improvements American companies have reached that point. Hiring will soon follow. It may be in fits and starts but I think we could see hiring turn around as early as this fall.

What is happening?

A few things are causing this crazy volatility in the Stock Market but it all really boils down to fear and uncertainty. There are a lot of people that are genuinely frightened by the European debt crisis. There are some fairly large economies in Europe that are in trouble. While the Global economy seems to be in recovery the worry is that the instability that these countries may cause by going bankrupt would push us back into recession. People are also concerned that America may be on a similar path to bankruptcy and the political strife in Washington, DC isn't building confidence. The recovery is not happening fast enough for many analysts and that is prompting a lot of media reports that foster more fear and uncertainty.

A slow recovery is .....good?

Yes, the pace of the recovery is slow but I view that as a good sign. Sound crazy? If you think so, believe me, you are not alone. I know lot of people are still unemployed and people are losing their homes to foreclosure. That is terrible but give me a chance to explain.

Think of the Global Economic Crisis of 2008 like a broken bone. When you break your arm you go to the hospital and have it set and placed in a caste so that you will not damage it further and to give it a chance to heal, right? We did that by bailing out some banks and automakers, injecting cash into the economy with government bond buying programs (Quantitative Easing and QE2) and lowering the cost of borrowing by keeping interest rates low.   

Eventually, you have to take the caste off but the limb has atrophied. It is weaker and you use it reluctantly afraid it may snap.You use it tentatively and rehab it, slowly building the muscles back to their previous strength. Similarly, households, companies and even countries are rehabilitating their economies. Everyone is altering their sending habits whether they be cutting coupons, laying off workers or establishing austerity measures. Everyone is reestablishing fiscal responsibility by saving more and spending less. We are all strengthening our balance sheets and trying to improve our credit. It is a slow but rewarding process of which there are no real effective shortcuts.

One might suggest a shot of steroids to help with muscle growth but if the muscle recovery outpaces the bone hardening that may cause the bone to snap all over again. Even if the bone doesn't snap, the muscles may become dependent on the artificial enhancer or grow a tolerance requiring more and more of the supplement. No supplement is completely devoid of side effects and as the dosage rises so does the potential for those unintended side effects.

The very same can be expected if the US or any government attempts to meddle with the progress of this recovery. Like most things worth achieving in this world, a recovery of this sort will be long and not without suffering and there is no shortcut to success. Anyone promising the contrary (*cough, Washington) is selling something and I am not buying.  

Speaking of buying

The silver lining to this troublesome tale is that the recent downturn in the Stock Market has improved the value of quite a bit of companies like Ford, Southwest Airlines, General Electric, Caterpillar and Imax (All of which I own). It is a stock pickers market and if you do your research you are likely to find some great deals.