 Hi guys, it's MJ and in this video I want to talk about fundamental share analysis. Now fundamental share analysis is a little bit different to technical analysis which in my opinion is very questionable. I don't think the theory behind it is very accurate at all. But let's focus on fundamental share analysis and see if there's any flaws in the theory surrounding this type of analysis. The one thing it does say which I do agree with wholeheartedly is that the price of an individual company's share is affected by the level of supply and demand for those shares. So price is impacted by supply and demand. That's very important. Technical analysis will say that price is determined by some candlesticks and some graphs and some lines that no one really knows what they mean. Which is kind of weird. Fundamental share analysis at least says something sensible. It says price is determined by the supply and the demand of that share. Which means we can now break it down into supply and demand. Suppliers quite easy. Who controls the supply of the share? Well it's the company they get to decide how many shares they want to issue. Whether they're going to issue 5% of their company on the stock market, 10%, 30%, are they going to make it 1 share equals 1% or 1,000 shares equals 1%. The company at the end of the day, they determine the supply of the share. And they work with their accountants, with investment banks to determine the optimal amount of shares to supply. So supply is a little bit out of control, not out of your control, but it's more set in stone. It's the one that's a little bit more stable than say demand. Because demand is impacted by the people or by the investors, they bring in demand. Okay, so now what does demand depend on? Like I said, it depends on the investors. And the investors, they're basically focused on two things. They want high returns and they want low risk. So maybe let's write that there. They want high returns and they want low risk. They don't really care what your business does. Your business could be selling dog food. It could be creating a cure for some sort of disease. It could be a tourist thing around Mars. Investors don't care what the actual thing is, as long as the returns are high and the risk is low. Or if the returns are very high, they might take on a little bit of risk and they'll accept a low return if there's very, very small risk. But at the end of the day, they're focused on returns and on risk. Now, where does return come from? Return comes from two things. It comes from the dividends. This is think of it like an income return. They paid out depending on how profitable the company was and on the capital appreciation. There's one school of thought that says you should only focus on the dividends because you should never sell a share once you've bought it, once you've made the investment. You should rather focus on the dividends because capital, yeah. We won't get into that too much, but the idea is that you can get returns from dividends and from capital. Normally, some shares have a high dividend, have got a very low capital gain. Some shares have got a very high capital gain, but a very low dividend payout. And that relates to a whole bunch of various things, but we're not going to get too technical on that now. What we want to do is we want to look at the theory of fundamental share analysis and what financial factors it says impacts the price of the share by impacting demand, which is return and risk. Okay, so one other thing fundamental share analysis does or what it's supposed to entail is that it's got two stages to analyzing a company. So the first stage is you construct a model. And this is where actually are really helpful in this deal is because we're very good at constructing models. So it can be some sort of cash flow, future, you know, estimate future cash flows and earnings, dividends, models, type of things like that. The idea is that you construct a model and then you use the output of that model to see if the share is over or undervalued. If it's undervalued, you buy it. If it's overvalued, you short it. However, that is assuming that the market is inefficient. And that is a massive assumption and one that has been challenged a lot in the financial literature. So already it's on a bit of a shaky ground. Also, it's assuming that you can construct a model better than everybody else so that only you know if the that if the share is under overvalued. Because if we assume that everybody does fundamental share analysis, everyone constructs a model, everyone can see if it's over undervalued. Then people buy if it's if it's undervalued, which puts pressure, demand increases the demand, which since the supply is fixed, the price will come up so that it is perfectly valued. And that is why this assumption that the market is inefficient is a very big one. It's a very big one and it can be challenged a lot in the theory. Also, you need to be a little bit arrogant to think that you can build a model better than the rest of the market. So keep that in mind for those of you who trade the stock market or, you know, believers in fundamental share analysis and in your own models. So yeah, they build a model and then they use that output to determine whether the company is under or overvalued. Now, a wide range of techniques is used in practice, the choice of which may be influenced by the availability of information. I think that is the key thing here. It's information. If you have all the information about a stock, you're going to be in a much better position than someone who doesn't have as much information. And this is why it is illegal to have information that is not publicly known and to trade on it. Because that's seen as cheating, as having an unfair advantage known as insider trading. But the thing is, why does insider trading make so much money? Because more information means you can make a better decision. But what is quite interesting is because people make money of insider trading, it kind of challenges and says that the market is inefficient. Because if it wasn't, then how could you have a better advantage if you have more information? So it's a very interesting thing that even though market inefficiency is a strong assumption to make, market efficiency is also a very strong assumption that has been challenged by the financial literature. So you can kind of see it's getting quite confusing here. Is the market efficient? Isn't it efficient? Is it semi-efficient? We don't really know. But the one thing is, it's information. And this is where, as a private investor, you're going to have a little bit of trouble. Because what we're going to see is that each company needs to be considered individually and there's some general factors that you need to consider. But there's some sources of where this information comes from. I mean, sometimes the information comes from the news. But we know that the financial press has got a lot of sensationalism, it's got a lot of opinions and it could be wrong. You could get it from public statements by the company. So the company could make a public statement. But we know that there could be a little bit of bias or propaganda in this. So I mean, one classic case was African Bank in South Africa. They were making a lot of public statements about the condition of their business and they're putting on a spin on the bad news to make it seem as if it wasn't really that bad. So always beware of public statements. And then I love this, the notice has got stuff like visits to the company, discussions with company management, discussions with competitors, these things known here as discussions with the managers. If I'm a big CEO of a multi-million dollar company and you're an investor who has maybe $2,000 disposable income, I'm not going to entertain you. I'm not going to take you out for lunch. I'm going to answer your questions when it comes to investing in my company. However, if you are a hedge fund manager or a pension fund manager who has say millions and millions of dollars under your disposal, well, gosh, I'm going to invite you on my private charts. I'm going to wine and dine you. I'm going to give you all the information that you need and make you feel really nice and wanted. Which kind of goes back to this whole insider trading thing, which is supposed to be illegal. But if we can go and have lunches with the CEO of the company, if we're big enough, then that's giving the big boys an unfair advantage over the little public trader in the streets. So, yeah, that's a bit weird. I mean, you can also get information from credit ratings, stock brokers, publications, trade press. There's a lot of sources of information. But remember that information here is not necessarily pure. It may have been tainted. So always look at the author, think of what is their reasoning for writing this information. Is there any bias behind it? But, yeah, that's one thing why I do talk like, yeah, maybe not investing in shares is the best idea. If you are just doing it by yourself because of this idea that information is power and big boys or big players have much better access to information because they have access to the CEOs of these companies. Okay, anyway, let's go back into... Let me find some space. Let's go back into the general factors to consider when analyzing a share. Okay, what are some of the general factors? Well, the note has got one, two, three, four, five, six, seven. It's got seven features. The one is management ability. The second one is quality of products. The third one is prospects for growth. The fourth one is competition. The fifth one is input costs. The sixth one is retained profits. And the seventh one is history. Okay, so let's go through the management ability. Okay, that's really great in theory. I mean, a company that has got a good manager will perform better than a company that has a bad manager. But as a fundamental share analysis, how are you to determine whether management's ability is good or not? Okay, it's almost impossible to do this objectively. I mean, if the guy's a chartered accountant versus the guy doesn't have a degree, then you might assume that the management ability of the chartered accountant will be better. But if there's two chartered accountants, one's got seven years experience, one's got six years experience, how do you determine which one's the best is experienced really that good? How important are degrees? Just because they've made previous mistakes, maybe they've learned from that. I mean, it's really, really difficult to determine which management's ability is. There's no scorecard that says, oh, this manager is nine out of 10 or this one's three out of 10. So because you can't really determine that, I mean, I wouldn't place that much emphasis on management's ability. You would think that the directors of the company have put in the best managers possible. So I wouldn't really go with management's ability. Okay, quality of product. I mean, if you had to choose between two companies, McDonald's or a fine dining company, chances are McDonald's will outperform that fine dining company. They've just got a better distribution. They've got a better system. They're just more of an aggressive business. Yet the quality of the product of the fine dining is much better than the quality of the product from McDonald's. So I don't really think quality of product is that important. You know, Hyundai versus Aston Martin or one of these cell phone companies. I mean, Nokia versus Xomi or something like that. You can see quality of product doesn't necessarily, it's not the main thing. It's more distribution and all those other things. I also don't think that's that great. Prospects for future growth. Yeah, I guess you could use that. I mean, how do you know what the prospects are for future growth? You have to take a bit of a speculative position of understanding that demand for that product will continue to increase, that substitute good will not be innovated and dominate the market, that a new rule might limit growth. I mean, it's very difficult to do the prospects for growth accurately. Competition, I like this one. This one makes sense. Competition, but there's two types of competition. There is direct and indirect. You get this a lot. Let's say, I've got a friend, he's busy making an app and I say, well, who's your competition? He says, no, he has no competition at all. He's making a unique type of social media. No one else is in the space. He's got no direct competition. I'm like, yes, but let's think of your indirect competition. Facebook, Twitter, Instagram, you must remember that what your product is doing is trying to go towards people who want to get connected with other people. And though your product might do it in a unique way and might not have any direct competition, you have a lot of indirect competition. Economists sometimes call this substitute goods. And that's important. There might not be that many direct competitors, but there's always a lot of indirect competitors. So if someone comes to you and says, oh, there's no direct competitors for my business, that's maybe an indication that their management ability is not that correct. There's always, always going to be competition. There are so many substitute goods, even with, say, utilities like electricity. There's other things like lighting a candle to provide light, or maybe having a gas bri or doing something else. There's always indirect competition. Even with telecommunication companies that might have a monopoly, indirect could be using, say, the internet as a means of communication instead of the telecommunication network. So always be aware of indirect competition. Input costs, again, very, very, very important. I mean, basically these two you can look in together. Input costs and retained profits. I mean, a lot of people talk about, oh, my revenue's so high. Okay, revenue means nothing. It's all about your retained profits. If your revenue's high, but your input costs are also high, or even higher than that, you could be making a loss. So high revenue doesn't mean anything. It's more about your input costs and your retained profits. Input costs, you want them to be low or at least decreasing. Retained profits, you want them to be high or at least increasing throughout time. Which kind of brings us to our last thing, which is history. But I mean, you look at Apple's history, companies can pivot, they can change. So I don't think history is that important. Maybe the last few years is more important than the previous 10 or 20 years. But I think at the end of the day, you want to look at, you know, their retained profits and the competition. Okay, so now how do we determine profits and input costs and all these other things? Well, this is when we put on our accounting hats and we go look at the company's, you know, financial reports. Okay, so the financial accounting and accounting ratios. Let's try to check financial reports. Okay, I'm going to say this that straight up, if you're thinking, oh, I've learned, I've done a year or two of accounting or I've done this or I've got a degree in actual science, I can analyze shares better than everybody else. Okay, I'm going to tell you now that that's dumb and that's being very arrogant. Okay, there are guys that have been analyzing financial reports since we were in diapers. So we need to be incredibly arrogant and incredibly dumb if we think that we can analyze financial reports better than other people. So what I'm saying like that is that the older generation have more experience in doing financial reports. They can better determine whether a share is over or undervalued given that market is inefficient. So for you to go in and look at the financial reports for the first time and think that you can do better than them, that's arrogant and that's going to lose you a lot of money on the stock market. So I think the market is very efficient when we come to accounting ratios just because guys, this is the entire day job. If one of these accounting ratios go a little bit wobbly, they will change their position in the share and that will be reflected then in the price. And they see it as it happens, they stay up all night as those results come out and they do the analysis, they are always on top of it. So don't think you can beat the market by analyzing accounting ratios better than other people. And that goes again with the dividends and earnings cover, profit variability and growth, all these things. I mean, it's nice to look at the level of the borrowing and liquidity and say, oh, you know, borrowing, we don't want it to be, we want it to be low, but not too low so that they're not incorporating, you know, the tax benefits or liquidity, we want it to be high but not too high so that dilutes returnings. And we look at all these various things and we try to take a position on a share. I really don't think you should do that because like I said, there are better analysis out there than you, we've got more experience and the price will be reflecting what they're doing. Unless you take the opinion that everybody is irrational and the market is super inefficient and that you alone are the smartest person on earth, then maybe. Which are growth in asset values, comparative figures for other similar companies. I mean, the price will reflect this. The price reflects these accounting ratios. They've been out for a long time. Everybody understands that, well, when I mean everybody, I mean, everyone trading stocks and does it professionally has a good understanding of this type of thing. So it is very difficult to make money on the stocks by looking at the accounting ratios. But that doesn't mean that you cannot make money because there's another area that the notes haven't even looked at that most people don't really look at. And it's one thing that being an actuary does give you a big advantage in. Remember what we were talking about? We've been talking all the time about returns, accounting ratios, dividend earning cover, growth in asset value, comparative figures for other companies. That's all been focused on return, return, return, return. Why? Because return is easy to quantify. It's easy to create a measure for it. But what about risk? What about risk? Now, risk, I mean, we're going to see much later on the course. It's very, very difficult to measure. Risk, there's not like, oh, this has got a 30% risk. What does that mean? Are you talking about short tail risk? Are you talking about just downside? Are you talking about value at risk? Risk is very, very tricky. But that gives us the opportunity. So if you do want to trade stocks, and this is not financial advice, it's just an opinion. If you do want to trade stocks, look rather at the risk rather than the accounting ratios. Accountants, chartered accountants, people with experience can do that much better than us. Let's leave that alone. Let's rather look at their risk management structure. And this is difficult, I mean, you do kind of need maybe to do subject ST9 or otherwise known as F106 to get a full comprehension of it. But what do we mean by risk management structure? Well, by this, I mean, let's look at the corporate governance. How have they shared the responsibilities between executives? As the one executive who's got too much control, that's a flag for concern. Also, I want to know what are the policies and procedures? Have they got a crisis reaction plan? Is something bad going to happen because they don't have something in place? Do they have safety nets? Is there an efficiency of communication? Does the board of directors meet regularly? Does the shareholders like the CEO? Does he talk to his workers? What is the communication? How is front and back office split? Is there a possibility for fraud? Can someone manipulate it? Can someone go against regulations which can cause further problems? What is their insurance agreement? Is it efficient? Are they over-assuring? Are they under-assuring? What risks are they still holding on for themselves? We want to look at their risk management from an enterprise level because maybe they are putting an inefficient insurance scheme. Also, I want to look at what is their basis risk in their hedging strategy. Do they even have a hedging strategy? If they do, what derivatives are they using? What extra risks or what risks don't those derivatives cover? There's so much you can go into on risk management. In fact, that's why there is an entire subject on it. So I can't even do it as part of a little video. But if you want to maybe play the stock market, fundamental share analysis does the turn on return and on risk. Return, like I said, it's kind of being over-evaluated. So look at the risk side. You can maybe even look at another way you can look at it is who are the other shareholders? The other shareholders will give you quite a good indication from the demand side. These are the investors over here. Who are the other shareholders? What are their objectives? Are they pension funds who want stability? Are they chasing the dividends? Are they chasing the capital growth? What are they currently doing? Are they buying more? Are they selling? How emotional are they? Are they foreign investors? Are they spooked up by currency risk? Who are the other shareholders in a company figure out what they want and if you can play them properly you can understand the demand side which ultimately leads to the price side. So there is a way to make money of the stock market but you have to be creative. You have to be at the things that other people aren't looking at and these things are generally more difficult to look at hence why they don't look at it and that is risk management and the other shareholders rather than trying to figure out the accounting ratios and going from a very much standard fundamental share analysis. So I think overall that is a bit of the flaw in fundamental share analysis is that on this side accounting rate shows the market is efficient and so it's difficult to beat but on this side over here risk management and other shareholders we don't really know that much about it so this area here is inefficient and it's only when the market is inefficient can you have an overvalued or undervalued opportunity for you to make a profit. So when constructing your models focus on risk management or at least take that into consideration and who knows you might do quite well on the stock market is massive risk. You could buy into all these shares and then the next day there could be a world recession and you lose all your money. So do be warned about that and I'll see you guys next time for my next video. Thanks so much for watching and hit subscribe because these videos will be coming out daily. Cheers.