Fundamentals & Technicals

When I wrote the last Letter my plan was to write two issues in December. But, when I sat down to begin writing this issue I couldn't stop. So I talked myself into writing one Expanded Edition letter for the month of December and reward myself with a break for Christmas. Because it's rather lengthy, I've added the printable version to The Archives already. Hopefully you'll have the opportunity to read the Christmas message at the end of page 2. Let's get started...

The Fundamentals - Part II

Well, here we are in the thick of the holiday season and the markets appear to be downright euphoric. As for me? Well, before I allow the euphoria (and the bubbly) to overcome me, I'll finish presenting the tools I use most frequently in making investing decisions. Ultimately, the goal is for you to learn how to use this information to make your own decisions.

In addition to the P/E ratio, I also look at the Price-to-Sales (P/S) and Price-to-Book (P/B) ratios. While the P/E ratio reflects the price you pay for a company's earnings, the P/S ratio indicates the price that you are paying for a company's sales.Ideally, we like to invest in funds with a P/S of less then one. In fact Dr. Steve Sjuggerud, author of "The True Wealth" investment letter, indicates that stocks with a P/S of 0.9 or less will increase 81% in price over five years!The P/S ratio is calculated as follows:

Total Market Cap (total shares x price per share)/Total Sales = P/S Ratio

While sales and earnings ratios may be common to you, book value might not be. Yet, book value (also called owner equity or net worth) is just what's left over after you take a company's assets and subtract its debts. The ratio is calculated thus:

Total Market Cap (total shares x price per share)/Total Equity = P/B ratio

The P/B ratio indicates the premium that you're paying over free and clear assets. But guidelines for its use are not quite as straightforward as they are for the P/E and P/S ratios.The P/B ratio indicates the premium that you're paying for free and clear assets. But guidelines for its use are not quite as straightforward as they are for the P/E and P/S ratios.The P/B ratio can be skewed by...

• How assets are being reflected on the Balance Sheet. For instance, a company will reflect raw land at the purchase price rather then market value thereby understating current value.
  


• The type of business. A service intensive business may have fewer assets which would understate book value while, by every other measure, be a solid, viable enterprise.
  


• Business climate. In an "up" market you can expect to pay a higher premium for a company's assets simply because it's generating higher sales and earnings. There will be times when the economy and business in general is booming. At those times, it won't be uncommon to find that the P/B ratio is higher then 2. Generally speaking, P/B ratios of 2 or lower are most desirable.

So, let's summarize what we have thus far:

The P/E ratio reflects the price you pay for a company's earnings. Typically, you will make more money when investing in companies (stock mutual funds, ETFs, stock index funds) with a lower P/E. Historically, P/E's have a high in the mid-20s. If you reverse the P/E, you obtain the earnings yield. The yield allows you to compare stock earnings to earnings from CDs, savings accounts, bonds, etc. The higher the P/E, the lower the yield. I automatically discount any stock with a P/E below 5. (Parenthetically, over the past century every major bull market has started from a low P/E - that is, below the historical average.)

The P/S ratio is second in importance to me. It is an indicator of the price you're paying for sales. Funds with ratios of 0.9 tend to rise 81% in price over five years.

The P/B ratio measures the price paid for the equity of a company or stock fund. Generally speaking, I seek a P/B of 2 or less however, factors such as bull markets will result in higher P/B ratios.

You can find these numbers represented as "trailing twelve months" (ttm) or "estimated" for twelve months into the future. My tendency is to rely on the ttm figure because analyst estimates are subjective. But, if both are available, I tend to take an average of the two.

Here you see I've used the term stock interchangeably with stock fund, stock index fund, stock mutual fund and stock exchange traded funds (ETFs). Since these fund types are comprised of individual stocks, the value of these ratios is the same.

For busy investors, stock funds have several advantages over investing in individual stocks. To begin with, the fund manager and his team have discounted any suspect stocks. They've also selected stocks that fall within the established criteria - i.e. value stocks are contained within value funds, growth stocks in growth funds, etc. Our job then is to use the ratios to evaluate our fund choices, help us select funds that meet our investment goals and appear well suited to the current state of the business cycle.

Skillful investing is as much an art as a science. As we progress through upcoming issues I'll demonstrate how these fundamentals will help you to effectively allocate your investment dollars.

At this point you've become familiar with some of the fundamentals that are used to select stocks and funds. Some folks opt to make their investment decisions based solely on the fundamentals. To me, fundamentals are the first piece of the puzzle.

Others use price charts to make their investment decisions. These investors are called technicians; they base their investment decisions solely on technical indicators and patterns. I prefer to use them to determine trigger points to enter or exit an investment.

The Technicals

Initially I thought it would be informative to provide you with examples of various chart types. Halfway through the draft, I scrapped the idea. It became very involved and I realized that I'd be wasting your time. Instead, I've focused on the charts I use most frequently - the weekly charts. When I use other charts, I'll explain them at that time.

Most of the charts I use are provided courtesy of BarChart.com and almost all my entry and exit decisions are based on weekly charts. Occasionally, when I'm curious about the short term trend, I'll check daily charts. Conversely, when I need a longer, more historic reference, I'll use monthly charts.

Weekly charts allow me to catch the greatest part of an uptrend while keeping downside risk to a minimum. My next consideration is price representation. Typically, I use high/low/close barcharts. If I have no other choice, I'll use a line chart.So, let's get into these charts a bit. What are those bars all about?

Each bar tells you the highest, lowest and last (or closing) prices paid for a given time period; in this case, a week. I prefer these charts because they provide the final price and the breath (range) of price action for the week.

Sometimes however, the only chart I can get is a line chart...

Line charts only reveal the closing price each week. Since I don't have the advantage of knowing the range of pricing, I tend to be more conservative when making entry and exit decisions.

The last element of importance on these charts is the moving average (MA) line. Let me take a few minutes here to give you the skinny on moving averages.

Moving averages come in many different flavors and configurations; I use the Simple MA. Simply speaking, the chart shows the average of the closing price for x number of periods. The number of periods is a matter of choice. For instance, an MA of 45 would indicate 45 days on a daily chart or 45 weeks on a weekly chart. I always use the 45 week MA.

Why 45 weeks? Well, the industry (and by extension, the media) most often refer to the 50 day and 200 day MAs corresponding to short term and longer term trends. 200 trading days coincides with 40 weeks. But remember, we don't have enough money to set the trend. Our only opportunity is to follow the trend and exploit it to our advantage so we allow a bit more time before we enter or exit a position just to confirm that the trend or, change in trend, is underway.
From time to time I do look at patterns within the charts and I'll point them out when they seem relevant.

Whew! I've covered a lot of ground and I think this is a good place to stop. In January I'll add a page that will summarize these tools and their uses. In the meantime, if you have questions, click here to submit them.

And finally...

Merry Christmas!

An Occasional Essay by Bill Mazzacca

"Merry Christmas! It's O.K. to say it."

That was the sign on the announcement board of the Christian Academy near my home. Wow! My thoughts drifted back to a different time - my childhood in New York. Christmas was a time when everyone was a little nicer, a little more helpful. And I mean everyone. From neighbors, to shopkeepers, to salespeople at Alexander's, to total strangers! As a child it was like giving a gift to say "Merry Christmas" to everyone I met and I was just as excited to hear the sentiment returned. For me, it was all part of Christmas, part of the buildup to the big event. It was exciting to walk down Fordham Road or the Grand Concourse, Poe or Devoe Park -- seeing everyone was an opportunity to exchange that gift.

Now older and living in semi-rural New York, I don't have the opportunity to meet and great as often but I still offer that gift to everyone I meet. I notice now that people are more surprised to hear it. Almost startled, they smile and say, "Oh, thank you...you too." I am, at once, amused and disappointed.

Amused because now my gift is more of a surprise then it use to be. Disappointed because it appears that we've become so busy preparing for the day that we've forgotten all about the path we take to get there. Perhaps worse, it appears that for some, expressing the wishes of a Merry Christmas is at least as uncomfortable as smoking in a public place.

But what are we talking about here? A celebration of the birth of Jesus Christ. A man that, during his lifetime, spoke of love, peace, tolerance and kinship. A man that, according to all we know, practiced the art of "turn the other cheek"; who "practiced what he preached", walked the walk so to speak.

We run like crazy all year saving for vacations in havens of peace. We save for college, infirmary and old age so that we can have safety and bring love and good fortune to those dear to us. We give to charities to demonstrate our compassion for all type of social ailment and our kinship with each other. We participate in every type of debate and pass all manner of legislation to insure that we are tolerant of others that may be unique or different from the "norm".

Yet, in spite of all of this, we seem to be missing some - seemingly glaring - points. First among them is that we are all unique. That is, in fact, what makes each of us so special. That uniqueness allows us to come together to build great things.

So, if per chance we meet and I wish you a "Merry Christmas", I hope you'll understand that I'm not concerned with your religion, politics or anything else. I just want to extend to you a small token of Peace, Love, Joy and Kinship as taught to me from the time I was a young child. And, for those of you that I may not see, let me take this opportunity to extend the gift of a Very Merry Christmas and all it has to offer.

While I'm at it, my wish for you is that the year ahead is everything that you want it to be...that every wish is fulfilled and that every challenge provides you with an opportunity for growth.

For when we're alone, not concerned with stereotypes, associations or possessions, are these not the hopes and wishes that all of us share?

Coming Up In The Fund Informer...

A New Year and a great time to review goals and sketch out a plan to get there.For January, I'll outline what I think is in store for the year ahead, on what I base those beliefs and what my plan is. As mentioned above, I'll also be adding a page that summarizes the tools I use and how I use them.

Also in 1Q07 expect to see a section on bond funds; how to evaluate and invest in them. I'll explore various investing styles and explain how to use the Morningstar.com website to track fund fundamentals.