Combining Fundamental Analysis With Seasonality Analysis

The following report summarizes:

• Why fundamental analysis of equity investments is useful when making investment decisions related to seasonality
• How to use fundamental analysis
• When to use fundamental analysis

Fundamental analysis reports are an important tool when determining the feasibility of a seasonal trade. Most fundamental analyst reports include “nuggets” of information that are useful for timely investing. The job of the seasonality analyst is to identify the “nuggets”. Unfortunately, finding “nuggets” in most research reports is like finding a “needle in the hay stack”. The investor must read through a lot of “chaff” before the truly valuable information is found.

Useful information from fundamental analyst research reports is obtained by examining comments about future events. Equities and Exchange Traded Funds respond to anticipation of a series of future news events including launch of new products and services, exploration and development activity, earnings momentum, revenue momentum and potential dividend increases. The seasonality analyst particularly focuses on future events mentioned by fundamental analysts that are known to recur on an annual basis.

Information from fundamental research reports about earnings leverage is very useful. Analysts frequently estimate the impact on earnings and cash flow triggered by a change in the price of a product or service. Also, they frequently estimate the impact on earnings of new products and services that are about to come on stream.

Information from fundamental research reports based on past data is useless and should be disregarded. Valuing companies based on historic earnings growth, historic revenue growth, book value, historic dividend yield and historic dividend payout ratios is useless. Unfortunately, fundamental research reports frequently are “loaded” with useless historic information.

Tech Talk does not like using “absolutes” such as NEVER and ALWAYS when making statements about investment strategy. The exceptions are as follows:

• NEVER buy an equity security only because it is undervalued based on fundamentals analysis. Undervalued securities can remain undervalued for extensive periods of time. Even Warren Buffet, the most famous value investor in the world considered factors other than valuation when making an investment decision including quality of management and earnings growth potential. One of Canada’s better known and successful value analysts, Larry Sarbit uses a similar approach.

• NEVER sell an equity security only because it is overvalued based on fundamental analysis. Less experienced fundamental analysts lacking market “savvy” are notorious for downgrading an equity based on an historic parameter such as price-to-book value ratio, price-to-earnings ratio or price-to-cash flow ratio. All too often, the downgrade occurs just after the equity has resumed an upward trend. All too often, the fundamental reason for the new upside move is revealed shortly after the fundamental analyst has downgraded the stock.

Comments from fundamental research reports about the future also have their limitations. Fundamental analysts frequently are required by institutional investors to provide corporate models projecting results for the next three to five years. However, the market rarely gives significant value to an equity investment based on prospects beyond the next six quarters. Fundamental analysts have enough difficulty determining earnings and revenues for the next quarter let alone the next three to five years. Most projections beyond the next six quarters assume continuation of current market conditions. Market events, that could cause a significant divergence in projections, frequently are not included in their models.

Fundamental analysts generally are bright people who go through an extensive (and sometimes onerous) process to become an analyst. One of the virtual requirements to become a fundamental analyst is to earn a Chartered Financial Analyst (CFA) designation. The designation is earned by completing three “grueling” exams usually over a three to five year period. Studies for the CFA designation focus on value analysis and portfolio management. Technical analysis is mentioned briefly. Seasonality analysis is rarely mentioned.

Some fundamental analysts are better than others. Top fundamental analysts are “worth their weight in gold” and receive the appropriate yearend bonus. Top analysts frequently are people who have at least ten years of experience in the investment industry. They have built a reputation for knowing their companies and, most important, knowing how share prices in their sectors respond. Most fundamental analysts know their companies very well. Fewer have a reputation for knowing how share prices in their sectors respond relative to overall equity market conditions.

Comments by “ranked” analyst usually are valuable. Most analysts are ranked by outside “independent” surveys. Most investment firms pay special bonuses to fundamental analysts who make the “ranked” list in surveys. The top two ranked analysts in a sector are the most valued. Their opinions are sought the most by institutional investors before making investment decisions. Several analyst ranking surveys are conducted in the U.S.. The most respected is the Institutional Investors analyst survey released each October. Comparable surveys are conducted in Canada. Results of surveys frequently are published in business newspapers including the Wall Street Journal in the U.S. and the Globe & Mail and National Post in Canada.

A few fundamental analysts (frequently with a high rank in their sector) are students of seasonality analysis and use seasonality as one of the factors that influence their recommendations. The classic example is a ranked analyst in the U.S. who followed the fertilizer sector in the 1990s. He learned from experience that recommending purchase of fertilizer stocks near the end of June and recommending profit taking near year end was a wise strategy in most years. Seasonality was mentioned in his report only as a passing comment (Seasonality analysis back then was considered equivalent to astrology: not a serious form of analysis). Over the years, he became known as “Mr. Fertilizer”. Not the most flattering name, but at least the moniker showed that investors respected his calls! Unfortunately, contact with this analyst has been lost. Fortunately, many investors have continued to follow his strategy during the past few years and have realized significant profits.

Several “seasoned” fundamental analysts on Bay Street and Wall Street, who follow the forest product and base metal sectors, have correctly called seasonal trends in their sectors in recent years. Their comments on seasonality are infrequent, but usually are valid. Their comments are highly valued by Tech Talk.

Consensus earnings estimates offered by fundamental analysts are useful. Free consensus earnings estimates for individual companies are available from several reliable sources. www.globeinvestor.com provides U.S. and Canadian corporate estimates. www.zacks.com provides U.S. corporate estimates and estimates for Canadian corporations listed on U.S. equity markets. Other consensus estimate services are available for a fee. Estimates offered by the www.globeinvestor.com site essentially are estimates offered by First Call. First Call also provides additional consensus data for a fee including revenue estimates. Examining consensus estimate data is useful when comparing data over time. Are earnings estimates rising or falling? Seasonal trades are more likely to be profitable during a time when analysts are raising estimates.

Tech Talk normally published consensus estimate data for the TSX 60 companies and the Dow Jones Industrial Average 30 companies on two occasions per quarter: Approximately six weeks after the end of a quarter when most quarterly results have been released and two weeks before the end of the quarter when most corporations enter into a “quiet” period. During the quiet period just prior to release of quarterly earnings, corporations rarely issue statement that will impact earnings projections unless an earnings warning is involved. Accordingly, consensus estimates remain relatively stable from two weeks before the end of the quarter to release of quarterly results.

The best sources for information on future events are free and come from readily available sources: corporate conference calls following release of quarterly reports, quarterly reports, annual reports, SEC reports and statements at annual meetings. Most corporate statements are readily available either from the company, corporate web sites or publicly available websites (e.g. EDGAR in the U.S., SEDAR in Canada, GlobeInvestor in Canada).

Unfortunately the effectiveness of fundamental analysis has diminished in recent years. In Tech Talk’s opinion, laws have changed inrecent years to the detriment of investors. Prior to Full Disclosure (Regulation FD) legislation in the U.S., a fundamental analyst could call a corporate executive randomly for an update during the quarter. If by chance, the corporate executive had just received fresh new useful information in the “non-material event” category, information was forwarded. The market was informed bit by bit over time and stock prices responded bit by bit accordingly. Following Regulation FD, corporate officers were prohibited from forwarding information on a bit by bit basis between quarters. Net result: fundamental analyst estimates have become less accurate and earnings surprises on the upside or on the downside have become more frequent. Risks associated with surprising earnings reports have increased significantly.

To be fair, some fundamental analysts do go the extra mile. They check supply channels and question competitors to confirm validity of their estimates. However, this type of analysis requires a substantial amount of “leg work” and time. Many fundamental analysts do not have the time or resources to do “extra curricular” analysis on a consistent basis.