Investment Discipline
Our investment research revolves around two traditional schools of study. The most recognizable to most
investors is fundamental analysis. In this area, we are looking at the numbers. We're analyzing
economic data on the macro side and earnings/profitability numbers on our specific companies.
As well, we have developed our Economic Model™ to help us to help us discern whether or not the economic
environment is conducive to growth or vulnerable to contraction. We all know that capital markets
move in anticipation of what will happen in the economy and not necessarily on the data we are seeing
today. For that reason, we feel our model is a tremendous indicator of what will happen with the
economic environment, not simply what is happening now.
Our second school of study is technical analysis. In this area, we are studying the historical price
movements of the markets and the individual issues that comprise them. Further, in this area, we study
market sentiment and what the internals of the market are telling us.
Fundamental Analysis
Fundamental Analysis is the method of evaluating securities by attempting to measure the intrinsic
value of a particular stock. It’s the study of everything from the overall economy and industry
conditions, to the financial condition and management of specific companies (i.e. using real data to
evaluate a stock's value). The method utilizes items such as revenues, earnings, return on equity and
profit margins to determine a company's underlying value and potential for future growth. In essence,
you can think of fundamental analysis as “kicking the tires” for the companies we would potentially
invest in.
One of the major assumptions under fundamental analysis is that, even though things get mispriced in the
market from time to time, the price of an asset will eventually gravitate toward its true value. This
seems to be a reasonable bet considering the long upward march of quality stocks in general despite
regular setbacks and periods of irrational exuberance. The key strategy for the fundamentalist is to
buy when prices are at or below this intrinsic value and sell when they get overpriced
There are several key areas surrounding the fundamental discipline at Delta Advisory Group, Inc.
- Management – Quality starts at the top. We look for management with long-term goals and direction as
well as a means with which to accomplish their goals. Management should promote a defined business
objective and a strategy that implements well. As well, it is imperative that management applies
high standards of corporate governance and views its shareholders as co-owners of the business.
Make no mistake about it, Wall Street holds a grudge. If corporate management is finagling earnings
or operating in “the gray area”, we forego investment in that firm. At some point, shady management
will catch up to a company, no matter what the earnings potential is. Thus, we are looking for
forthright leaders and upstanding teams to lead our team and we will settle for nothing less.
- Top Down vs. Bottom Up – Our strategy is to identify industry leaders, or companies vying for a
leadership position in a growth industry. To this end, our research can be broken into two schools
or disciplines: Top/Down Analysis and Bottom Up Analysis. Our research arm uses both. On one hand,
Top/Down Analysis begins with a broad base, macro, view of the world and its’ economies. We search
for emerging trends and the countries or industries that will benefit from these budding themes.
After we’ve established the areas we want to focus on, we begin to search for quality within the
theme. We run proprietary screens that we feel will uncover the companies who will benefit the most
from the pending move.
On the other hand, Bottom Up Analysis starts with the company itself. With this type of analysis,
you are beating the bushes and looking for quality issues regardless of sector or global location.
For example, we may run screens that give us stocks with > 15% earnings growth and a P/E ratio less
than 35. The screen would give us stocks that fit the fundamental condition. With bottom up analysis
you are looking for the company first and not the macro picture. However, this type of analysis often
leads us “upward” to the discovery of groups that may have additional quality stocks.
- Earnings Growth & Consistency – The economy drives earnings and earnings are what drive the market.
We feel that by investing in companies that have above-average prospects for earnings and
profitability we will have above average growth in our portfolios. Further, earnings consistency
is one of the most overlooked factors in analyzing a company’s ability to grow. Most fundamental
investors tend to strictly look at a companies growth potential without taking into account the
companies track record of delivering on that potential. In our estimation, it’s not enough to simply
have earnings growth, or, for that matter, earnings consistency. It is imperative that a firm be able
to give strong growth and that it be able to consistently hit the target that is set forth for them.
It’s our belief that earnings consistency in our companies will offer performance consistency in our
portfolios.
- Valuations – In order to maximize long-term returns, it is essential to pay a reasonable price for a
quality company. Investors often disagree on what is a reasonable price. However, it is our belief
that moderately overpaying for a stock should not be too damaging to the portfolio over the long-term.
If the fundamental estimated earnings base comes to fruition, it is our belief that this will eventually
be reflected in the stock price. Our key valuation determinants include a company’s long-term growth rate in
earning power, the consistency and stability of estimated growth, its profitability, financial condition and
projected cash flow. These quantitative and qualitative characteristics should be attractive relative to a peer
group of companies and to the general market.
Technical Analysis
Technical Analysis is the method of evaluating securities by analyzing statistics generated by market
activity, such as past prices and volume. On the technical side, we do not necessarily attempt to
measure a security's intrinsic value. From this type of analysis we use charts to identify patterns
that can suggest future activity.
There are several ways in which we use technical analysis in our portfolios. From the macro perspective,
we use technical analysis to analyze the position of the broad based indices in an effort to gauge the
position of the economy and/or markets. Take a look at the chart below to see an example of how technical
analysis can be used with indices. This is a chart of the S&P 500 from 2000 to 2005. As you can see
from the chart, this broad index was in a bear market correction for the better part of 2000-2002.
However, in early 2003, the market broke from this downtrend and told us the economy was on the mend.
This breakout signaled that the equity markets were transitioning from a bear market to a bull market
and were in for a period of out-performance. That said, it was an early clue that we should consider
raising our equity exposure. Coincidentally, in late 2002, we were also beginning to see more positive
trends from fundamental factors such as GDP growth, consumer confidence and manufacturing.
Next, we also use technical analysis to look for buy points in specific issues. Again, it’s our firm
belief that fundamental analysis can and should be used in combination with technical analysis.
Fundamental analysis is typically the method by which we “kick the tires” of a company while technical
analysis will be the tool we use to time our entry and locate key sector rotations. A pure technician
would tell you that the chart will tell you what the fundamentals are doing and to some extent we believe
this to be true. However, we base all of our investment decisions on a combination of both schools of
study.
Take a look at the chart below to see an example of how we might use technical analysis to direct us to
an entry point for an issue that we’ve already qualified from the fundamental side. The chart below
is for Wells Fargo Company (WFC), a super regional bank. From looking at the chart, it is evident
that WFC was in a down trend from late 2000 to late 2001. During this time frame, many analysts came
out in defense of the stock and we saw a slew of upgrades in 2001 (I’m sure your opinion of analysts
and their upgrades is similar to ours). However, even in the face of those upgrades and estimate hikes,
the stock continued to fall. Understand, during this time frame, we also believed the stock offered
upside. However, the stock continued lower as Institutions and short sellers, in a bad market continued
to distribute the issue. In late 2001 something changed. The stock broke thru its descending line of
resistance and thus broke out of its year long downtrend. This was the time to buy into WFC. The
fundamentals were strong, the trend had changed and institutions were coming in on the buy side.
This is where technical analysis will assist us in entering an equity position or fund.
Last, technical analysis allows us to take advantage of certain market mis-pricings in the form of
short-term trades. Understand, we don’t use short-term trading in all of our accounts. We will only use
this type of trading for clients in our Growth & Aggressive Growth categories whose taxable situation
allows for short-term gains and whose risk tolerance is compatible with this type of profile. As well,
we don’t hold ourselves out to be day-traders, we don’t guess the markets. However, from time to time,
we will find inconsistencies and attempt to exploit them for gain.
Take a look at the chart below of KB Home, a Homebuilder. This particular chart shows a very good
example of a technical pattern called an ascending triangle . There are many patterns that, like this
one, not only give buy signals but also give you measuring implications and thus an exit point. This
particular ascending triangle flashed a buy signal around $17 and gave us a measuring implication of
$4. Thus, we would look to exit the position around $21.
Once again, let me stress that we don’t believe Fundamental Analysis or Technical Analysis, by
themselves, to be an end all. They can and should be used together. Many on Wall Street believe that
you should strictly use one school or the other school when doing research. However, we believe both
can be used, hand in hand, to give a more effective and disciplined money management approach.