Volume 2 - V.

Investment Analysis
Fundamental and Technical Analysis
What You Will Learn

In this chapter, you will learn how to think as an analyst by using statistical, market, and industry
information to value securities and to make the right purchase or sale recommendations. Imagine
that you are considering an investment in the stock of a cyclical company and reports indicate that
an economic slowdown is imminent. How could this information impact your decision and what effect
could it have on the investment? This chapter will give you the tools to help answer this and other
questions. Here you will learn about two methods of analysis. One is fundamental analysis with
which you study the factors that affect a security’s value, including macroeconomic factors, industry
conditions, individual company financial conditions, and qualitative factors. The other one is the
technical analysis, which is used to predict future stock price movements based on an analysis of
price action in the market, trading volume, and identifying recurring patterns.

By the end of this chapter, you should be able to:

 Compare and contrast fundamental and technical analysis.

 Describe how the three macroeconomic factors affect investor expectations and the price of
securities.
 Analyze how industries are classified and how industry classifications impact a company’s
stock valuation.
 Describe the tools used in technical analysis.

Fundamental Industry Analysis: Introduction

Fundamental industry analysis involves analyzing the demand for competing products or services,
the potential growth of the industry, the nature of the competitive environment and the characteristics
of the stock. How is fundamental industry analysis used to examine the value of the stock?

There are four ways by which to classify an industry:

 Product or service
 Stage of growth
 Competitive forces
 Reaction to the Economic Cycle

The following pages summarize the key points for each classification. At the end of this activity,
complete the questions to review your understanding of the concept.
Fundamental Industry Analysis: Classification by Product or Service

A company’s profitability is affected not only by company-specific factors, such as the value of the
product or service that it sells, but also by factors related to the sector in which it operates. Industry
trends must be understood and benchmarked against overall economic growth before the relative
performance of a company can be determined.

Once the industry is understood, a framework for company analysis is created and can be
completed. Company analysis must include factors that assess a company’s competitive advantages
in its sector (e.g., low-cost producer, technological superiority, distribution channels, or product
differentiation).

Fundamental Industry Analysis: Stage of Growth

Potential growth is also related to an industry's life cycle, which provides another basis for analysis.

Emerging
 Potential for rapid growth but may not yet be profitable
 May exhibit negative cash flow
 Identifying which companies will survive may not be easy

Growth
 Exhibit sales and earnings growth at a faster rate than most industries
 Above-average rates of earnings over several years
 Good prospects for future earnings and sales growth
 May offer little in the way of dividend payments but hold out the promise of capital gain
 Tend to exhibit high P/E ratios and low dividend yields

Mature
 Slower, more stable growth rates in sales and earnings
 Product differentiation difficult, increased price competition, falling margins
 Sufficient financial resources to weather difficult economic conditions

Declining
 Demand for product is slowing or declining
 Cash flow may be high
 Profits may be low

Fundamental Industry Analysis: Competitive Forces

Companies must understand the nature of the competitive environment if they are to successfully
achieve their objectives and establish appropriate strategies. There are five basic forces (Porter’s 5
Forces) that determine how attractive an industry is and in what ways it is likely to change:

1) Ease of entry
2) Degree of competition between existing firms
3) Threat of substitute products
4) Buyer's ability to exert pressure on selling price of products
5) Supplier's ability to exert pressure on the purchase price of inputs

If a company fully understands the nature of Porter’s five forces, and particularly appreciates which
one will have the most effect, it will be in a stronger position to defend against competitive threats
and to influence the forces with its strategy.

Factors to Consider

Force Factors to Consider Examples

New entrants to an industry can raise the Key barriers to entry include:
Ease of level of competition, thereby reducing its
attractiveness.  Economies of scale
entry
 Capital investment requirements
 Access to industry distribution channels
 Government-regulated prices

Degree of The intensity of rivalry between Competition depends on:

competition competitors in an industry will have an
between impact on profit margins and long-term  The relative strength of each company
existing firms profitability.  The structure of industry costs
 The degree of product differentiation
 Strategic objectives
 Exit barriers

Threat of The availability of substitute products can The threat of substitute products depends
substitute lower industry attractiveness and on:
products profitability because of the limit they put on
prices.  Buyers’ willingness to substitute for
another product
 The relative price and performance of
substitutes
 The costs of switching to a substitute

Supplier The cost of raw materials or other inputs The bargaining power of suppliers will be
pressures bought from suppliers can affect a high when:
company’s profitability. Suppliers could
 have the power to exert pressure by  There are a few dominant suppliers to
raising prices on inputs. the industry
 Products require specific,
technologically advanced inputs
 There are undifferentiated, highly
valued products

Buyer Buyers can influence company operations. The bargaining power of buyers is greater
pressures Buyers could exert pressure on a company when:
by pushing for improved customer service,
a better quality product, or lower overall  There are many dominant buyers in the
prices. industry
 Products are standardized

Fundamental Industry Analysis: Stock Characteristics

Industries can be classified as cyclical, defensive or speculative.

Cyclical
These industries tend to follow the economy’s boom and bust cycle:

 They are affected by swings in the prices of international commodities.

 Changes in the level of the Canadian dollar affect price movements.
 Revenue is generally higher in periods of economic prosperity and expansion and
lower in periods of economic downturn and contraction.

Example: Travel Industry: The travel industry in general and airlines in particular
are sensitive to economic cycles. Consumers are willing to spend disposable
income on vacation travel in good economic times; conversely, during bad
economic times, they are more cautious about spending and tend to take
vacations closer to home (if at all) and avoid relatively expensive airline travel.
Industry profitability generally reflects this pattern.

Other examples of cyclical industries include consumer durables (e.g., cars,

household appliances, furniture, and jewellery), residential construction, heavy
equipment, steel, chemicals, and mining.

Defensive
These industries tend to be more stable than cyclical industries during a recession:

 Their ROEs are relatively stable.

 Often called blue-chip.
  Long-term growth is stable.

Example: Pet Food : Pet food and pet care companies are not significantly
influenced by economic cycles. Research has shown that when times are tough,
pet owners may make certain accommodations for themselves but seldom do they
change how they care for their pets. Pet food and pet care companies tend to
have steady profit patterns but may outperform when economic growth slows.

Other examples of defensive industries include food and drug companies, utilities,
alcoholic beverages, banking, insurance, and healthcare.

Speculative
Emerging industries are often considered speculative:

 They show great profit potential.

Example: Energy Development:

Example: Energy Development

Energy development companies such as those developing non-fossil fuel and non
atom-splitting energy sources represent enormous potential in a world that is now
desperately seeking alternatives. But whether a company is based on renewable
energy (e.g., solar, wind, geothermal, or tidal power) or on alternative fuels (e.g.,
ethanol or hydrogen), current definable capital costs significantly impair
widespread substitution for existing energy sources. Also, profit is generally a
promise for the future.

Other speculative industries include natural resources exploration, biotechnology,

and early-stage technology companies.

Fundamental and Technical Analysis

Technical Analysis - Chart Analysis: Introduction

Technical analysts believe that all the information they need about a stock can be found in its price
and volume charts. Technical analysis is the process of analyzing market action in the past to predict
price trends in the future. In other words, it is the process of analyzing historical market action in an
effort to determine probable future price trends. Market action consists of three types of information:

 Movement of stock prices

 Volume of trading
 Variety in movement and volume at various times or over different periods of time

Technical analysts ignore all the external factors that, according to fundamental analysis, influence
the market. Technical analysis is based on three assumptions:
  Prices automatically reflect market influences, so fundamental analysis merely confirms what
the market already shows. The market will indicate the direction and extent of its next move.
 Prices move in trends that last for relatively long periods of time.
 Investor behaviour tends to repeat itself so that much can be learned about the future by
looking at the past.

The primary task of a technical analyst is to identify a trend in its early stages and carry positions to
take advantage of the trend until it reverses; this is by no means an easy task. Chart analysis is one
main method to achieve their aim.

Technical Analysis - Chart Analysis: Reversal Patterns

One of the most common reversal patterns seen in price charts is the head and shoulders pattern.
There are two types: head and shoulders bottom, also known as inverse head and shoulders, and
head and shoulders top.

Head and shoulders bottom pattern (shown below) contains three successive downward trends with
the middle one being the deepest, known as the head. The high price level points for each reaction
are connected to form the neckline. Depending on the relationship between the two reaction highs,
the neckline can slope up, slope down, or be horizontal. In this example, the neckline is upward
sloping, which is an indication that the market is bullish on the stock.

Head and shoulders top is similar but reversed.

Technical Analysis - Chart Analysis: Continuation Pattern

Continuation patterns are pauses on price charts, typically in the form of sideways trading, before
the prevailing trend continues.

Continuation patterns are simply an extension of the basic tenet of technical analysis that prices tend
to move in trends for relatively long periods of time.

One of the most recognized continuation patterns is the symmetrical triangle. Each side of the
triangle is equal in length and slope. A gradual and symmetrical narrowing brings the pattern to the
tip of the triangle, where volume and price volatility are low. A breakout, particularly an upside one,
should be accompanied by high volume.

Once a triangle pattern is complete, the potential price target can be estimated. There are two
measurements that can be taken: the height of the triangle at the base, or the width of the triangle:

Technical Analysis - Chart Analysis: Quantitative Analysis

Quantitative analysis, the study of moving averages, is a form of technical analysis that has been
greatly enhanced by the growing sophistication of computers. Quantitative analysis is used to
supplement chart analysis, either by identifying or confirming trends, or by giving an early warning
signal that a particular trend is starting to lose momentum.

Moving averages can present the technician with a perspective on a market that the study of charts
cannot provide. For example, a chart may indicate that a particular market is trending higher, but a
study of market momentum may show that although prices are rising, momentum is waning.
Fundamental analysis studies capital market conditions, economic conditions (both national and global),
industry conditions, and the condition of individual companies. Except for trading activity on the securities
markets, fundamental analysts study everything that can have an effect on a security’s value

A support level, the low of the trading range, is the price at which the majority of investors start sensing
value, and therefore are willing to buy (demand is strong), and the majority of existing holders (or
potential short sellers) are not willing to sell (supply is low).

A resistance level, the top of the trading range, is where most investors are willing to sell a security and
most buyers are unwilling to buy it. At this point, supply exceeds demand and prices tend to fall.

The triangle represents a fairly even struggle between buyers and sellers. The buyers move in up to the
mid-point and the sellers move out down to the mid-point. This activity repeats itself back and forth until
one side proves stronger. It is a continuation pattern.

Technical Analysis - Chart Analysis: Summary

Technical analysis is the process of analyzing historical market action in an effort to determine
probable future price trends. After working through this chapter, you’ll have a better understanding of
how to analyze the future value of the stock price using chart analysis.

Before you proceed, take a minute to look over these questions. Can you answer them all? Are there
some questions you are less sure about? If you have doubts about your knowledge you should go
back and study that section of the chapter. When you are confident to answer all questions move
ahead to the review questions.

 What is the purpose of fundamental analysis?

 What is the most important factor affecting the price of a corporate security?
 What is the purpose of technical analysis?
 What is the primary belief about the markets that technical analysts hold?
 Can you define the Efficient Market Hypothesis?
 Can you describe the major assumption of the Random Walk Theory?
 Can you describe the Rational Expectations Hypothesis?
 What are the three forms of the Efficient Market Hypothesis and can you describe each
form?
 Can you describe the two most important tools of fiscal policy?
 How do each of these tools affect the Canadian economy?
 What is the main problem with a large government debt?
 How is monetary policy used to impact the Canadian economy?
 Can you explain yield curve tilting?
 What impact does inflation have an economy?
 How are industries classified by product?
 Can you name some sectors by which Canadian industries are classified?
 Can you describe the four life cycle classifications of an economy?
 What are the five basic competitive forces that determine the attractiveness of an industry?
 Can you describe each of those five basic competitive forces?
 Can you compare cyclical industries and defensive industries?
 What are speculative industries?
 What are the three primary sources of market action information according to technical
analysts?
 Can you compare fundamental analysis to technical analysis?
 Is one better than the other?
  What does chart analysis refer to?
 What is the difference between a support level and a resistance level on a chart?
 Can you describe a head-and-shoulders pattern?
 What is the significance of the neckline in head-and-shoulders top formation?
 What is the significance of a symmetrical triangle?
 Can you define what a moving average is, and what it can signal on a chart?
 Would you be able to calculate a 10-day simple moving average?
 What do contrarian investors believe?
 What role can cycle analysis play in forecasting market movements?

The Rational Expectations Hypothesis assumes that people are rational and make intelligent economic
decisions after weighing all available information

Samra believes that the Canadian dollar is going to decline in the future. What type of industry would
you recommend she invest in?

Correct.

Most cyclical industries benefit from a decline in the value of the Canadian dollar because exports
become cheaper for international buyers. However, the rate of expansion or contraction in the U.S.
business cycle is still the single greatest influence in determining the profitability of cyclical companies.
Currency values remain an important secondary factor.

Identify the issues that support the argument that capital markets are inefficient.

1. New information is not available to everyone at the same time.

2. Investors react in the same way, making it difficult to execute trades as all investors want to
be on the same side of the market.
3. Investor psychology causes investors to act irrationally and it can be difficult to predict what
they will do.
4. Everyone can make accurate forecasts.

Many studies have been conducted to test the three stock market theories. Some evidence supports the
theories, whereas other evidence supports capital market inefficiencies. Those inefficiencies may occur
for any of the following reasons:

 New information is not available to everyone at the same time.

 Investors do not react in the same way to the same information.
 Not everyone can make accurate forecasts and correct valuation decisions.
 Mass investor psychology and greed may at times cause investors to act irrationally.

Technical analysis is the study of historical stock prices and stock price behaviour to identify recurring
patterns in the data. Technical analysts study price movements, trading volumes, and data on the number
of rising and falling stock issues (among other factors) over time looking for recurring patterns that will
allow them to predict future stock price movements.

Nikola has been watching the chart pattern of a stock she is interested in for some time. She has
noticed that the stock price has hovered around a support level for several weeks. What investment
decision might she make?
A support level might develop after a price decline. Supply and demand forces for the stock are fairly well
balanced at this point. Investors start to sense that the stock is bottoming and well priced. Demand
increases for the stock will create upward pressure on the stock price. This is a good time to buy the
stock.

Company ABC releases earnings data that contains the surprise announcement that profits will be
up sharply by 10% instead of the expected 2%. If you are a believer of the efficient market
hypothesis, what effect on the price of ABC shares would you most likely expect to see?

The efficient market hypothesis assumes that profit-seeking investors in the marketplace react quickly to
the release of new information. As new information about a stock appears, investors reassess the intrinsic
value of the stock and adjust their estimation of its price accordingly.

Identify why high levels of government debt can be a problem when the government tries to affect
the rate of economic growth.

The main problem with a large government debt is that it restricts both fiscal and monetary policy options.
Fiscal and monetary decisions affect the overall level of interest rates, the rate of economic growth, and
the rate of corporate profit growth. All these factors affect the valuation of stocks. High levels of
government and consumer indebtedness impair the government’s ability to reduce taxes or increase
spending.

What impact does economic growth have on bonds?

When economic growth begins to accelerate, bond yields tend to rise. If inflation begins to rise during an
expansion, the Bank most often raises short-term interest rates to slow economic growth and contain
inflationary pressures. This action may lead to a more moderate economic growth rate or even a growth
recession (i.e., a temporary slowdown that does not become a full recession).

Arshpreet has analyzed the economy and believes Canada’s economy may decline or even fall into
a recession over the next two years. He has $20,000 to invest and is interested in investing in a
defensive security that is sensitive to interest rates. Identify the type of company you would
recommend to him.

Defensive industries have a relatively stable return on investor equity and tend to do relatively well during
recessions. The term blue-chip denotes shares of top investment-quality companies, which maintain
earnings and dividends through good times and bad. This record usually reflects a dominant market
position, strong internal financing, and effective management.

Many investors consider shares of the major Canadian banks to be blue-chip industries; however, bank
stock prices are typically sensitive to changes in interest rates. As interest rates rise, banks must raise the
rate they pay on deposits to attract funds. At the same time, a large part of their revenue is derived from
mortgages with fixed interest rates. The result is a profit squeeze. Bank stock prices are particularly
sensitive to changes in long bond yields

Personal tax rates are increased by 10%. What impact will this have on the behaviour of individuals?

By changing tax levels, governments can alter the spending power of individuals and businesses. Higher
taxes on corporate profits, generally speaking, reduces the amount businesses can pay out in dividends.
The resulting reduction in personal income will leave individuals with less disposable income, which
curtails their spending and their savings; similarly, the reduction in dividend payments makes it unlikely
that individuals will increase their investment in blue-chip investments.
Company Analysis
What You Will Learn

In the previous chapter, we examined fundamental analysis from a macroeconomic and an industrial
perspective. In this chapter, we shift focus on company analysis to help you examine company-
specific factors that can influence investment decisions and determine the investment potential of
the issuing company itself. Having these skills are critical to your success as an investment
specialist and here we show how fundamental analysts examine financial statements, apply various
financial ratios to determine whether a company is a good prospect for investment, and use
company analysis to measure the actual or expected profitability of the securities issuer.

Learning Objectives
By the end of this chapter, you should be able to:

 Identify the factors involved in performing company analysis to determine whether a

company represents a good investment.
 Explain how to analyze a company’s financial statements using trend analysis and
external comparisons.
 Assess company performance using financial ratios.
 Distinguish among the criteria used in assessing the investment quality of preferred
shares.

Company Analysis
What You Will Learn

In the previous chapter, we examined fundamental analysis from a macroeconomic and an industrial
perspective. In this chapter, we shift focus on company analysis to help you examine company-
specific factors that can influence investment decisions and determine the investment potential of
the issuing company itself. Having these skills are critical to your success as an investment
specialist and here we show how fundamental analysts examine financial statements, apply various
financial ratios to determine whether a company is a good prospect for investment, and use
company analysis to measure the actual or expected profitability of the securities issuer.

Learning Objectives
By the end of this chapter, you should be able to:

 Identify the factors involved in performing company analysis to determine whether a

company represents a good investment.
 Explain how to analyze a company’s financial statements using trend analysis and
external comparisons.
 Assess company performance using financial ratios.
 Distinguish among the criteria used in assessing the investment quality of preferred
shares.
NFR Inc. - Company Analysis: Introduction

One of the key learning objectives for this chapter is to describe the types of ratios and evaluate
company performance using these ratios.

In this activity you will review the financial statements of NFR Inc., a fictitious Canadian retail
company, and evaluate the company’s performance by analyzing key financial ratios.

Note: Even though the CSC exam does not require you to calculate individual financial ratios for a
company; it is important that you are able to recognize the components of each ratio to better evaluate
company performance.

NFR Inc. - Company Analysis: NFR Inc. Background

NFR Inc. is a Canadian distributor and retailer of hardware, home renovation, sporting goods, and
gardening products. The company operates a network of 400 franchised, affiliated, and corporate
stores of various sizes and formats. With more than 16,000 employees working across Canada and
more than 10 million square feet of retail space, the NFR store network generates close to $6 billion
in annual retail sales.

For the year ended December 31, 20XX, the company reported comprehensive income of $214
million on gross profit of $718 million. Gross profit rose 6% from the previous year, reflecting the
company’s growth strategy through acquisitions.

NFR Inc. Consolidated Statement of Comprehensive Income

As at Dec. 31, 20XX
($000)
Revenue 1,310,000
Cost of Sales (592,000)

Gross Profit 718,000

Other income 5,000

Distribution costs (143,000)
Administrative expenses (332,000)
Other expenses (2,000)
Share of profit of associates 3,000
Income tax expense (35,000)

Profit 214,000

Total comprehensive income 214,000

As at Dec. 31, 20XX

ASSETS ($000)
Property, plant and equipment 575,000
Goodwill 175,000
Investment in associates 215,000

Total Non-Current Assets 965,000

 Inventories 200,000
Prepaid expenses 25,000
Trade receivables 325,000
Cash 125,000

Total Current Assets 675,000

Total Assets 1,640,000

EQUITY AND LIABILITIES

Share capital 430,000
Retained earnings 255,000
Non-controlling interest 50,000

Total Equity 735,000

Long-term debt 285,000

Deferred tax liabilities 220,000

Total Non-Current Liabilities 505,000

Taxes payable 75,000

Trade payables 255,000
Short-term borrowings 70,000

Total Current Liabilities 400,000

Total Equity and Liabilities 1,640,000

Notes:
As at December 31, 20XX, NFR had 68,100,000 weighted average number of shares
outstanding. The current market price of the shares is $60.