How ‘Common Sense’ Fundamental Analysis Can Make You a Better Investor

Here at TradeSmith, we think about the markets differently from most investors.

As I explained in a Money Talks series back in February (here and here), we’re big fans of a “factor-based” approach to investing.

If you’re not familiar, factors are simply the various characteristics of an investment responsible for its potential risk and reward. You can think of them as the reasons why a particular investment does or doesn’t perform well.

Just about any characteristic can be a factor. But they generally fall into one of two broad categories: technical factors and fundamental factors. Now, in investing, the word “technical” is typically associated with drawing lines on price charts. And in practice, technical analysis can often appear to be as much art as science.

But technical factors can include just about anything related to the price or price action of an investment. This includes more objective, quantitative characteristics like momentum and volatility.

Fundamental factors, on the other hand, are generally related to the quality of the investment itself. In the case of stocks, this typically includes characteristics like valuation, growth rate, and dividend yield.

As regular readers know, our research has shown that technical factors — and momentum in particular — have historically been the most reliable predictors of future performance.

That’s why we made these factors the foundation for all our proprietary software, from our super-affordable TradeStops tools all the way up to our most sophisticated products.

However, that doesn’t mean fundamental factors aren’t useful too.

In fact, we’ve found our technical tools can work even better when we also take fundamental factors into consideration.

That’s exactly why we created our powerful Ideas by TradeSmith tools. With Ideas by TradeSmith you can easily combine some of the most powerful fundamental factors with our proven technical approach.

Of course, I understand that, unlike TradeStops, a subscription to Ideas by TradeSmith may not be feasible for every investor.

So today, I’d like to share an easy way you can add fundamental factors to your investing.

It’s a simple checklist that can help you decide if any stock is worthy of an investment.

All you really need to use it is an internet connection, a search engine, and a free financial database like Yahoo Finance or Google Finance. No complicated math or finance degree required.

Now, before I share it, let me be clear…

This list is not meant to be exhaustive or foolproof.

A company could meet all these criteria and still not be a great investment. Likewise, just because a company doesn’t meet all these criteria doesn’t necessarily mean it’s a bad investment.

These are simply traits that great companies with strong fundamentals tend to share.

So you should not use this list as the sole reason to buy or sell a stock. Rather, it is best used in addition to your existing investment strategy.

At TradeSmith, that means we would consider buying a stock only if it was also in a healthy state and showing positive upward momentum (i.e., trading in the Health Indicator Green Zone).

Sound good?

OK, here’s the list. I’ve added commentary below each question for clarification.

1. Does the company have a strong, recognizable brand?

   This one is fairly obvious: Great companies tend to have strong brands.

   2. Does the company generally receive great feedback from its customers?

   Happy customers tend to be repeat customers. They also bring in new customers through word-of-mouth advertising.

   There’s no better source for this kind of data than our friends over at LikeFolio. But you can also get a sense of consumer happiness through online reviews and message boards.

   3. Does the company have a clear competitive advantage, or “moat,” that is likely to protect it from potential competitors?

   The world’s best businesses have a “moat” — something that sets them apart and is hard for competitors to replicate or disrupt.

   4. Does the company currently have any direct competitors, both established companies and potentially disruptive start-ups?

   Significant competition can be a serious red flag, even if the company is currently doing very well.

   5. Do company executives and directors own a significant percentage of outstanding shares?

   Not every great company has significant insider ownership. But executives with substantial skin in the game tend to be more responsible managers.

   6. Was the company profitable over the past 12 months?

   While there are exceptions — such as early-stage, fast-growing companies — great businesses tend to be profitable.

   7. Did the company have positive free cash flow (FCF) at least two of the past three years?

   Companies can sometimes use accounting tricks to inflate reported earnings. FCF — the amount of cash a business generates each year that is free and clear of all obligations — is difficult to manipulate and can be a more reliable measure of a company’s quality.

   8. Has the company increased its sales by at least 10% per year over the past three years?

   Consistent sales growth is a hallmark of a quality business. And like FCF, sales growth is a more reliable indicator than earnings growth.

   9. Did the company earn a return on equity (ROE) of 15% or more over the last five years?

   ROE is how much money a company can earn on its net assets, or equity. This is simply the value of all the assets it owns minus any debt and other liabilities. Great companies tend to produce a high ROE.

   10. Is the company’s debt-to-equity ratio less than 50%?

   This is a measure of how much debt a company carries relative to its net assets. A ratio of less than 50% means the company has more than $2 in net assets for every $1 of debt.

   While there are exceptions, generally the higher the ratio, the more risk a company is taking.

I hope this list is useful. As always, I’d love to hear what you think at [email protected].