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The Secrets in the Sauce
If you ever visited Italy or dined at an upscale Italian Restaurant, you know the "Secret's in the Sauce." The aroma alone makes your mouth water. You are literally drawn into a restaurant by the smells they send to the sidewalk.
As Pop says in this 1984 commercial, the ingredients of a successful Italian marriage are the "perfect combination of garlic, little bits of herbs and spices for that homemade taste." Prego bottled that homemade secret sauce and made advertising history with the slogan "it's in there." In the very same year, Clara Beller became world famous wanting to know "where's the beef!"
As a portfolio manager you want to know "where's the beef" and we are here to tell you it's in the secret sauce.
In Business, the Secret Sauce is Financial Statements and Ratios
The "beef" of any business is in their ability to produce profits year in and year out. The way they do that (or fail to do so) is hidden in their financial statements. Put another way, the beef is in the secret sauce and the secret sauce of any business is in their financial statements - understand how they make money and you will find the "beef" of any business.
Just as there are many ways to create a secret sauce, there are many ways to approach the stock market. Most “active traders” use technical analysis to forecast how a particular sock will move based on past trends. They read charts, study trends and anticipate where a stock will be in the next hour, days, or weeks. They rarely hold a stock for longer than a few months and some even trade the same stock several times in a day. This is one way to make money, but it tends to be extremely volatile and requires a trader to be "on top" of the market almost 24 x 7 in today's global trading environment.
On the contrary, "Value Investors" or “Long Term Investors” rely on fundamental analysis and invest in the business rather than in the stock. Value Investors rely on fundamental analysis to dig out important information the mysterious "beef" about a company that is often hidden in financial statements.
Experienced investors know that finance is the language of business and financial statements tell the true story of how well a business is doing, but it is difficult to get to the real meat when there is so much sauce in the way! They invest in educating themselves about a company and learn the language of business. The "beef" of every business is in their financial statements and your role as professional portfolio manager is to drill down into the financial statements until you find the beef hidden in the "Secret Sauce."
Elements of Fundamental Analysis
When conducing fundamental analysis of a business, investors want to understand, among other things:
- The Market a Business Serves and its Competition
- The History of the Company and Its Management Team
- Financial Statements
- Financial Ratios
Most beginning investors can tackle the first two elements by visiting Yahoo Finance or a similar site. By clicking on Company Profile, Key Statistics, SEC Filings, Competitors and Industry, you can assemble most of what you need to know. These links combined with visiting the target company’s website and searching for Current News tell you and every other prospective investor where the company has been, where it is now, and what the outlook is for the future.
That part of fundamental analysis is straightforward. You don’t need a degree in finance or economics to assemble this background information and compare it with the information you read about from other prospective targets.
Financial Statements and Ratios May Bore You but Understanding them Can Make You Rich
Unfortunately, most investors stop with the first two elements and fail to delve into the key statistics, financial statements, and financial ratios at the proper level. Very few investors understand what the statistics, statements, and ratios mean, let alone how to use them in deciding whether to invest or not.
Let’s start with the basics and build from there. To begin, the Securities and Exchange Commission (SEC) requires every publicly held business with more than 500 shareholders and $10 million in assets to file quarterly and annual reports, called 10 K’s and 10 Q’s. These reports are available to the public on EDGAR, the SEC’s electronic filing system. By entering the company name in the search box, an investor has access to several years’ worth of quarterly and annual reports.
The Income Statement and its Many Aliases
With a few more clicks, we have access to a “Consolidated Statement of Earnings” or the company’s “Income Statement,” one of three fundamental reports every company must provide. In its simplest form, the income statement, tells us whether our prospective business is making money or losing money.
Also known as, the “Profit and Loss Statement,” the Income Statement covers a specific period – a month, quarter, or year and tells us how much money the company made from sales and other sources, how it spent that money and how much they had left at the “end of the period.”
Investors and others use the “bottom line” of “net earnings” (loss) as one very important gauge of how well a company is performing. If the “bottom line” trend is positive, that usually means a company is doing well. A company that shows a positive trend over a long period is one of the first things a value investor wants to see.
A more experienced investor will drill down into more details and look for positive and negative trends. They want to see revenues increasing while expenses decrease. That means the percentage of profit is showing a positive trend. They want to be sure that revenues are coming from current sales and not from investments or the sale of assets.
The next report experienced investors study is the “Balance Sheet.” Just as the Income Statement tells us how a business is doing over a specified time-period, a Balance Sheet reports “how we stand” at a given point it time.
The Income Statement tells us how a company makes money and the Balance Sheet tells us how it manages its money.
Put another way, the Balance Sheet tells us “how much we have,” and the Income Statement explains, “How we got it.”
The Balance Sheet is a “snapshot of the assets, liabilities, and retained earnings at a specific time. It lists both current assets like cash, accounts receivable, and inventory and longer-term assets like property, plant, and equipment. Investors want to see how the company is using the assets and whether or not they are adding to their net asset value over time. Again, a positive trend of increasing asserts coupled with increasing revenues are a sign of a healthy company.
Cash Flow from Operations
The final statement in the primary trio of financial statements is the “Statement of Cash Flow.” The Cash Flow Statement tells us how the business uses its funds. It shows us where the money goes during a specific period like a month, quarter, or year. It shows us how money moves around the balance sheet. It shows how money moves from one balance sheet account to another over time.
Investors watch to see how a company moves money around to fund operations, manage long-term debt, and invest for the future.
After the experienced investor reviews the financial statements, they “drill down” into several key financial ratios. The most revealing ratios focus on:
- Profitability Over Time – Profitability ratios compare sales, revenue, and profits over a specific time-periods. Again, we are usually looking for positive trends in all three areas. Gross margin and net margin are often the most telling profitability ratios. Is our target company making money or losing money on a percentage basis? The ratios are a great way to compare one company to another because they show percentages and not specific dollar amounts.
- Operational Efficiency – This set of ratios tells us how well management is running the company. They compare expenses to revenue, compile the average day’s outstanding, report inventory turns, and provide insight into how well management “runs the company.”
- Liquidity – Liquidity ratios point to the overall health of the company. Can it sustain a downturn? Does it have the cash flow to support operations over an extended period? Banks and other lenders use liquidity ratios like the current ratio and the quick ratio to check the financial health of the business. How well equipped are they to meet short term and long term obligations?
- Leverage – Finally, the “leverage ratios,” tell our experienced investors how well positioned the company is for the future. Do they have an extraordinary amount of debt that puts the business at risk? Are there notes coming due at high interest rates that could cripple the company?
Where's the Beef? It's In There!
Prior to making an investment in a company, you owe it to yourself to analyze both the business itself and the financial statements that tell the full story about the business. So, where's the beef?
It's in the Sauce and Financial statements are the "Secret Sauce of Business."