Years of stock market study and active participation have taught me many truths about the financial markets. One of the most important things that I have learned is that things are not always as they seem in the market. Realizing this is what enabled me to take my investing ability to the next level.
The fact of things not always being what they seem is very true in both technical and fundamental analysis.
This article will expose a crucial way that investors are often fooled into making the wrong decision by company fundamentals.
It will provide the basics of fundamental analysis, one major way investors can be fooled, and three favorite stocks are exhibiting these characteristics that you need to know.
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First, a basic primer on fundamental analysis
Many modern-day investors and traders are strictly technical analysis based. This means that they only use price charts and price movement to make decisions. While technical analysis is a critical part of the stock market analysis, it needs to be matched with fundamental analysis to be effective. Searching for prices moves via technical analysis screening then drilling down via fundamentals is how real market professionals make decisions in the stock market.
The primary things to looks for when conducting fundamental analysis are revenue, net income, diluted earnings per share and earnings before interest and taxes (EBIT).
These items are then compared with the previous quarter and year over year to determine fundamental trends. Is the company developing based on growing numbers? Are the numbers quiet or decreasing over time? These questions can provide a framework to ascertain the business’s fundamental strengths and weaknesses.
Cash flow is a critical key metric. Ask yourself where the money is coming from. Is it coming from sales? Has it been increasing or decreasing over time? How does the cash flow compare to the company’s peers in the same industry? How about the market as a whole? Answering these fundamental and simple questions can help clarify the expected direction of the company into the future.
Just because everything looks good in the fundamental factors does not mean that all is well with the enterprise. Investors need to consider the risk factors. Fortunately, the SEC makes sure that public firms list their risk factors so that investors can properly assess the investment opportunity. The SEC demands that companies reveal all known risk factors under Item 1A in the Other Information section of the earnings report. Make sure there is nothing fishy here or downright frightening to the future of the company.
Be sure to keep an eye on legal proceedings in the risk factor section. Bear in mind that many businesses have multiple small damage suits that are inconsequential to the company’s success. However, there is one type of lawsuit that can be potentially crippling to public enterprises. It is the class action suit that can cause far-reaching damages. Class action suits can do tremendous harm to a corporation, win or lose, due to the high costs of defense.
Many times very negative factors are presented in expertly chosen words designed to lessen the impact of the situation. This means that a careful reading is critical for a complete understanding of the company’s situation.
One Way Investors Are Fooled By The Fundamentals
You locate a stock whose price is just taking off on the upside. Shares keep on breaking through technical resistance levels so you decide to dig a little deeper into the fundamentals to determine if this stock would make a sound investment. Everything looks great! There are no significant risk factors, the cash flow is coming from sources that should last well into the future, and the profit margins are consistently expanding.
However, simultaneously, you notice that revenue is in a downward trend. How can this be? How can profit margins be increasing but revenue in decline?
The reason for this phenomenon is that company’s often “juice” their profits by factors other than income. The primary way this is done is by cost cutting. Cost cutting ramps up profits by lowering costs. While this is a positive thing, it can paint a deceptive picture of the actual health of the company. Companies can only “juice” their profits in this manner for so long. Soon there is nothing left to cut, and the true profits are revealed.
It is critical to avoid companies with rising profits but dropping revenue. Many investors are caught in this trap in their zeal to find hot investments. Don’t be one of them!!
Here Are 3 Stocks With Improving Profits But Falling Revenue
1. Archer Daniel Midland (NYSE:ADM)
This giant agricultural processing company is a recent example of rising profits and but falling revenue. The $29.8 billion market cap firm describes itself as being engaged in the handling of oilseeds, corn, wheat, cocoa, and other agricultural commodities.
ADM’s operations are classified into three business segments: Oilseeds Processing, which includes activities related to the origination, merchandising, crushing, and further processing of oilseeds, such as soybeans and soft seeds (cottonseed, sunflower seed, canola, rapeseed, and flaxseed) into vegetable oils and protein meals; Corn Processing, which is engaged in corn wet milling and dry milling activities, primarily located in the United States.
Gross profit margins have ramped up 9.7% year over year and operating margins have increased by 7.8% over the same time frame.
Technically, shares are trading below both the 50 and 200 day simple moving averages.
Long term investors should avoid this stock or look to close their positions should they already have it in their portfolios.
- Valero Energy (NYSE:VLO)
A $33.7 billion marketer and manufacturer of transportation fuels. Consumers are familiar with the company via its 7400 outlets. It operates through two segments.
The refining segment includes refining operations, wholesale marketing, product supply and distribution, and transportation operations in the United States, Canada, the United Kingdom, Aruba, and Ireland.
Its ethanol segment primarily includes the sale of internally produced ethanol and distillers grains.
The gross margins are smoking with a net increase of 16.7%, and operating margins have followed with 8.1% growth. These factors are very attractive to investors. Add in the fact that shares are trading above the 50 and 200-day simple moving averages and it paints a stable picture on the surface.
However, revenue has declined over 14% over the last year spoiling the bullish long-term picture.
3. Dow Chemical (NYSE:DOW)
While not as dramatic as the first two names, Dow Chemical is exhibiting the same malady of improving profits yet declining revenue.
This behemoth of a company is an integrated technology, and chemical concern operates in five segments, Agricultural Sciences, Consumer Solutions, Infrastructure Solutions, Performance Materials & Chemicals and Performance Plastics.
It boasts a market cap of over $61 billion, annual gross profit growth of over 11% and operating profit expansion of just less than 11% over the same time frame. However, as alluded to, revenue has slipped close to 2% annually.
Drilling into the chart, the price has moved below the 50-day simple moving average after building a double top formation in the $53.00 per share zone.
Both fundamental and technical analysis are needed to make smart investing decisions. It is critical to be aware of how the market fools investors both fundamentally and technically. One of the main ways investors are fooled mostly is by companies inflating their profit growth while actual revenue is slipping lower. This is usually accomplished by cost cutting and can hide a business falling from its peak from investors who do not consider what is occurring. While there are many others, the three stocks listed above are held in a vast number of investor’s portfolios and should be reevaluated by the portfolio holder.