Five steps for better fundamental analysis of a company

By Paul Farah

In this edition of Investing chronicles, Lockstep CEO Paul Farah outlines a five-step checklist for conducting a thorough fundamental analysis of companies before investing.

This week, I want to share my investing process and how I use a checklist to invest better. While it doesn’t guarantee success, it improves my odds.

1. Searching for new investments

The first step in investing is finding new investment ideas. This is not easy, but it can be fun, like searching for treasure. I have covered the topic in How to find your next great investment, so check it out for more details.

For simplicity, here is a summary of a few options available:

Stock screening: Rank companies based on fundamental metrics such as growth or value metrics.

Fund letters: Professional money managers often write about their best investment ideas as a form of marketing in their quarterly or annual newsletters to investors.

13F filings: Any fund investing over $100 million in US-listed companies has to report their holdings quarterly. It is a great place to see what they are buying and selling.

Investing forums: Forums are a great place to read other investors’ investment ideas and theses, but ensure you read quality research.

Insider buying: Managers and large owners of US-listed companies must disclose when they buy or sell shares via an SEC Form 4 filing. It is a great place to look for potential ideas.

2. A company’s economic history

 
So you’ve found a company that looks interesting. Now what?

It’s now time for a deeper dive, which involves understanding the business, how it makes money and its history. If you don’t know what makes a company successful, you can’t expect your investment to be a success.

Where do we find all these details? The company’s annual report or 10-K.

As it might feel like a daunting process, especially for newcomers, let me walk you through an example of one of my investments…

The Buckle (BKE) case study
I first noticed BKE in 2020 when it screened on the Magic Formula Investing website. After a few quick calculations, I found it to be a high-quality business (high ROC) and valued very attractively (high earnings yield). It was time for a deeper analysis:

i) What does the company do?
As per the 2023 annual report (page 4), BKE is a retailer of medium- to better-priced apparel, footwear, and accessories for young men and women. As of January 2023, the company operated 441 retail stores across 42 states in the US. The company primarily markets brand-name apparel, including its own in-house brand.

ii) How does it make money?
As per page 5 of the report, the company breaks down where its sales come from:

As you can see, most of the company’s sales come from denims followed by tops. This trend has been consistent for the last three years.

So, we know how the company makes money, but we need to see if it has consistently made money.

Simple enough!

iii) Historical performance
Next, we work through as many annual reports as we can get our hands on and summarise the business’s financials. While the list is not exhaustive, I am looking for the historical trends of metrics that are important to me, including:

• Revenue growth
• Operating income (EBIT) margins
• Cash flow yield
• Dividend yield
• Earnings yield
• Net debt
• Return on capital: See the article on Magic Formula Investing
• Growth in book value per share

My metrics might differ from what you’re looking for. If you want dividend-paying stock, then dividends are essential. If you want a high-growth stock, revenue growth is obviously key.

You need to decide what matters to you.

But let’s get back to BKE:

As you can see from the chart above, revenue has been growing over the years; however, there is a period from 2016 to 2022 where revenue retreated, and while margins have been healthy, they too compressed as revenue declined.

While the negative revenue growth from 2016 to 2022 is disappointing, it gives us a fantastic opportunity to learn more about the business and the risks involved. Please don’t skip digging into what went wrong because it will help you when the company faces other headwinds.

Other metrics

As with revenue growth and margins, I look at the other metrics in a similar manner, and have summarised my findings for simplicity:

Each company will have different findings from the analysis of the financial statements. In BKE’s case, what stood out was the excellent cash generation of the business, as evidenced by the high margins and cash flow yield, which the company returns to shareholders in the form of a dividend.

(FYI…negative net debt = net cash, which is excellent!)

Looking deeper, BKE has consistently paid a special dividend each year without exception for the last 20 years, resulting in a high dividend yield. The negative is the low revenue growth, meaning I can’t expect that dividend to grow over time.

However, when I analysed the company, the share price was at $19.00 per share vs. the $37.00 per share today. This meant that I could buy a much higher dividend yield at $19.00, and I was locking in the high dividend because of the sustainability of the dividend payout.

I was now very interested in BKE, providing the rest of the analysis worked out.

Summary of BKE’s historical analysis

While revenue growth was poor, the company has consistently had high operating margins, it has never made a loss going back to 1993, and it has paid a dividend with the cash it has generated since 2003. Therefore, there was a high probability that the company would continue to produce cash and return the money to shareholders.

Because of the depressed share price due to the pandemic, I could lock in a very high dividend yield by buying shares at $19.00 per share.

3. Who is the competition, and how are they doing?

Understanding who the competition is, how they perform, and how they have done over time is essential.

What if your company has the lowest growth, the worst margins, and is the most expensive in the industry? You will only know this if you analyse the company’s peers.

Plus, the more you learn about the competition, the more you learn about the industry, increasing your certainty, remembering…

Lower uncertainty = Lower risk

How to analyse peers

Just like you’ve done with the company’s financials you’re analysing, you want to examine the competition and see how they have performed over time.

In The Buckle’s case, the peers were other apparel companies, especially those specialising in denim, given how BKE made most of its revenue.

I therefore analysed companies such as Levi Strauss (LEVI), Express (EXPR), Abercrombie & Fitch (ANF), and several others. What stood out was that BKE had far superior margins to the competition yet had a much higher earnings yield. This is unusual, so I needed to find out why.

A deeper dive – including talking with the management of BKE – revealed that BKE had strategically chosen slower growth, as evidenced by the low revenue growth, for better cost control, evident from the higher margins.

BKE therefore stood out among its peers as it operated more efficiently, while slow revenue growth explained why it was the cheapest apparel business at the time. The high dividend made up for this however, especially at the depressed price of $19.00 per share.

4. Who owns and manages the company

The next step in the analysis process is understanding who owns and operates the business.

Again, most of the information can be found in the 10-K and the company’s annual shareholder meeting filing, known as the proxy statement. Here, you can see who the principal shareholders are, who runs the company and, most importantly, how management is rewarded or incentivised.

“I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it.”
Charlie Munger

According to Munger, incentivisation is everything, and it’s our duty as investors to know the motivation of management. If a manager is paid a fat salary regardless of the job he has done, then there is little to motivate him other than making sure he keeps his job.

But suppose a manager’s base salary is low and her bonus is linked to the company’s long-term performance. In that case, she is motivated to act in the company’s long-term interest and, therefore, our interest as shareholders.

In The Buckle’s case, the company’s largest shareholder is the founder of the business, while the CEO has been with the business since 1973 and owns a significant portion of shares.

This ownership structure is excellent news for shareholders because it’s doubtful that the chairman will do anything to compromise shareholder value, as it will impact him more than anyone. The chairman also receives no compensation for heading up the company’s board of directors. It is, therefore, unlikely the dividend policy will change soon.

5. To invest or not

After all your hard work, it’s time to decide: Is this a business you want to own for the long term or not?

The time it takes from the start of the process varies depending on the company and the situation’s complexity. In BKE’s case, it was reasonably easy to decide after I saw the dividend yield and how sustainable it was, especially after I realised the chairman was incentivised to keep paying this high dividend for as long as possible.

Remember to be honest during this final step!

Just because you have invested 50+ hours in analysing a business doesn’t mean you need to invest.

Whether or not you invest, remember that you have gained much more than monetary returns. During the process, you would have learned so much about the company and the industry, and that knowledge compounds and transfers to when you analyse your next apparel business.

Checklist for fundamental analysis of stocks

1. Search for new investments

• Utilise stock screening to rank companies based on fundamental metrics.
• Review fund letters from professional money managers for investment ideas.
• Analyse 13F filings to observe the buying and selling activities of institutional investors.
• Participate in investing forums to gather insights from other investors.
• Monitor insider buying activities disclosed through SEC Form 4 filings.

2. A company’s economic history

• Obtain the company’s annual report or 10-K to understand its business model and history.
• Analyse revenue sources and major product lines to comprehend how the company generates income.
• Examine historical financial performance, including revenue growth, operating margins, cash flow yield, dividend yield, and return on capital.
• Look for years of strong and weak performance to learn more about potential risks.

3. Competitive analysis

• Identify key competitors in the industry and assess their financial performance and market positioning.
• Analyse industry dynamics to understand the overall market environment and potential challenges or opportunities.
• Compare your company’s performance with its peers to gauge its competitive advantages and weaknesses.

4. Ownership and management

• Review the company’s major shareholders and their level of ownership and influence.
• Examine the background and tenure of key executives, including the CEO and chairman.
• Evaluate management incentives and compensation structures to assess alignment with shareholder interests.
• Consider the impact of management decisions on long-term shareholder value and corporate governance practices.

5. Investment decision

• Synthesise all gathered information to make an informed investment decision.

There’s plenty more to discover with Lockstep.

Head over to Lockstep to subscribe to Paul Farah’s weekly investing newsletter. It’s never been easier to gain valuable insights that you can apply to your investment journey and take your money game global.

* Paul Farah has worked in financial markets since 2006, holding positions at prestigious firms from New York to South Africa. Now, he manages his own money and provides access to his entire portfolio through his company Lockstep Investing. The views and opinions shared are his own and are for informational purposes only, it is not intended to serve as investment advice and it does not represent the view or opinion of Standard Bank. This information should be used as a starting point for generating investment ideas,and should not be relied upon as the sole basis for making investment decisions. Lockstep Investing (PTY) LTD and the Standard Bank of South Africa Limited will not be responsible for the results of any investment decisions made based on the views provided.