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The Finance Professor: Fundamental Stock Trading

Scott Rothbort

I categorize investing/trading styles into four different categories:

1. Fundamental : Decision making based on quantitative analysis of the company's financial information and qualitative analysis of its business, competition and economic environment.

2. Technical : Using stock charts and chart patterns to discern trading decisions ("Chart of the Day").

3. Statistical: Developing trading models derived from a database of multiple variables.

4. Arbitrage: The simultaneous purchase and sale of a security, securities or derivatives in order to extract a low-risk profit.

My personal style is to primarily utilize a fundamental approach to investing. In addition, I have developed a series of statistical index trading models, which I also trade on, but this accounts for only a fraction of the assets I manage. From time to time, I will also employ arbitrage techniques as well as incorporate technical analysis when making a trading decision or risk-managing a position. For this installment of the Finance Professor, I will focus on the fundamental approach to investing.

Are You Interested in Growth or Value?

There are two primary schools of thought to fundamental investing: growth and value.

Fundamental Investing: Growth. If you consider yourself a "growth investor," then you are concerned with the rate at which a company will increase its earnings stream over a period of time. Growth investors seek out companies with accelerating or high levels of sustained growth, while companies with declining growth rates will be avoided. As an example, Apple (AAPL Quote - Cramer on AAPL - Stock Picks) is regarded as one of the best growth stocks in the market today. TheStreet.com Ratings reports that Apple has grown earnings per share (EPS ) at a rate of 62% in the last 12 months. Currently, estimates indicate that Apple will grow EPS at a rate of 56% in the fiscal year 2007.

However, stocks can hit the virtual brick wall of growth and exhibit growth deceleration. Starbucks (SBUX Quote - Cramer on SBUX - Stock Picks) is a prime example of such a stock. Starbucks investors were accustomed to mid- to high-20s growth rates and now the company is maturing to an expected growth rate of roughly 20% to 21% in the next two years. As a result, growth is a two-sided equation where the seductive aspects are balanced by its risks.

Fundamental Investing: Value. Value oriented investors can trace their origins back to Benjamin Graham and David Dodd who in 1934 published the ground-breaking textbook titled Security Analysis. Value investors seek to purchase companies that are selling (trading) at less than their intrinsic value. This intrinsic value can be calculated by analyzing the discounted cash flows of future earnings , valuation of assets less liabilities, or via certain ratios such as the price-to-earnings ratio (P/E or multiple ) and the price-to-book ratio (stock price divided by book value per share). The most famous value investor of all-time is Warren Buffett (Stockpickr: Warren Buffet's Portfolio).

Some value "purists" do not place any value on growth. Others value investors, such as Warren Buffett, believe that value and growth are inextricably linked. I follow the theory of "growth at a reasonable price" (or GARP), which was pioneered by another famous investor, Peter Lynch. GARP combines elements of both value and growth investing.

How Fundamental Traders Analyze Stocks

Fundamental stock analysis begins with assembling the necessary information that will provide the basis for your complete understanding of a company that you're interested in. If you're serious about fundamental analysis, here is a list of the information you'll need to gather in order to get started:

• Financial Statements: In a previous installment, I covered where to find financial statements and what to look for in them. At a minimum, make sure you read the most recent annual report and the two most recent quarterly reports.
• Conference Calls: I also covered how to approach listening to a company's quarterly conference calls (or earnings calls). Many companies have archives of these calls online. Listen to the two most recent earnings calls. Otherwise, there are some services from which you can purchase conference call transcripts. (You can supplement this with expert analysis of the calls on TheStreet.com or RealMoney Silver.)
• Press Releases and News: Do a search on TheStreet.com or other financial news Web sites and read all the press releases, news items and commentary for the company that have been published since the last earnings report.
• Analysts Reports: Review as many analysts reports as you can. However, here are two important caveats: Make sure the report is recent and stick to analysts with a solid reputation for coverage of that company or industry. Look for the "axe" in the name. The axe is the go-to analyst with the best historical call on that stock.
• Historical Data: The Street.com Ratings provides some excellent historical metrics for individual stocks. That site goes one step further and provides a letter rating based on its own proprietary modeling system. For example, click here to see the rating for McDonald's (MCD Quote - Cramer on MCD - Stock Picks).
• Analysts Estimates: Wall Street analysts provide clientele with their estimates for EPS and revenues . This data is then accumulated by information providers and an average (or consensus) estimate is then calculated. This consensus then becomes the basis for the "earnings expectation," which is often talked about on TheStreet.com and in the financial media.

With all of the above data, you can start to determine if a company's stock is a fundamental buy, hold or sale (or perhaps even a short-sale). But before you can do that, you need to first get comfortable with all these different sources of information. So, here is some homework that will help you learn the ways of the fundamental investor and analyst:

• For your favorite public company, obtain all of the data I listed above and carefully read (or listen) through it all.
• Investigate what the TheStreet.com and TheStreet.com Ratings have to say to about the company.
• Check out a copy of Graham and Dodd's Security Analysis at your local library or obtain a copy online. (When studying toward my MBA at New York University, I used the Cottle, Murray, Block edition.)