Are financial statements a good indication of corporate health? Do financial statements provide insight into a company’s risk and value? Do you think it is important to analyze a company’s financial statements before purchasing or selling a stock?
If you answered yes, then fundamental analysis is important in your investment process. So do you know which aspects of these financial statements are the most correlated to future stock returns?
Investment anomalies based on fundamental analysis are the class of anomalies that looks at which pieces of the financial statements are indicators of future stock performance. Since there’s lots of information contained in the income statement, balance sheet and statement of cash flows, you need to know what’s important and what’s not. That’s where anomalies come in.
Let’s look at some examples. Debt-to-Equity and Pretax Margin are two of the great investment anomalies based on company fundamentals. Although both are commonly used for stock selection (both Warren Buffett & Peter Lynch prefer companies with low debt and strong profit margins), they are still effective in choosing stocks that can outperform the market. It is important to look at both because they use figures from different financial statements. Debt/Equity uses items from the balance sheet and Pretax Margin uses income statement items. Using a combination of data from the income statement and balance sheet results in a great example of a fundamental anomaly.
Debt/Equity, which is defined as total long term debt divided by total common equity, simply measures the proportion of shareholders’ equity and debt that’s used to finance a company’s assets. It provides a good indication of the amount of leverage a firm is using. The same is true with companies as is with individuals: too much debt is problematic. Therefore, companies with little or no debt as a proportion of equity perform best.
Good investment approaches often draw on information from different financial statements and it’s especially important to tie the balance sheet and income statement together. That’s why we will also take a look at Pretax Margin.
Pretax Margin, which is the ratio of pretax income to sales, provides a gauge to a company’s profitability and operating efficiency. If the margin is high, the company is very effective at turning sales into income. However, if the Pretax Margin is low, then expenses are high relative to sales which results in lower income.
Again, even though the numbers that make up Debt-to-Equity and Pretax Margin are reported in SEC filings, for some reason (hence the anomaly) the information isn’t fully expressed in stock prices. Perhaps investors are over paying for glamour stocks with high debt and small margins. Maybe investors are trading more on emotions and less on facts. Either way, in the end, a firm has to make money and not be saddled with lots of debt. That’s why you can outperform the market by investing in companies with a low Debt/Equity and a high Pretax Margin. Don’t wait too long, however. Typically after three months the market starts to wise up and financial statement info becomes more exploited.
Here’s a way to see what companies have a low Debt/Equity and a high Pretax Margin:
First, create a liquid, investible set of the stocks with the largest 5000 market values and average daily volume greater than or equal to 100,000 shares (if there’s not enough liquidity, it’ll be hard for you to trade it).
Since it’s possible that equity for a company can be negative, choose from only companies with Equity > 0.
Next, select only those with Debt/Equity in the Bottom 10% (remember, we want low debt).
Finally, select the top # of stocks based on Pretax Margin
(Simply select the number of stocks you want with the highest Pretax Margin).
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Anomalies based on company fundamentals are just one of many types of investment anomalies. Other examples include anomalies based on analyst data, insider trading and earnings surprises to name a few.