Financial Modeling - A Part of Equity research

This has been sent to me by one of my students, Shivan Bakshi. I would like to share it with you.

 Financial modeling is the task of building an abstract representation (a model) of a financial decision making situation. This is a mathematical model, such as a computer simulation, designed to represent (a simplified version of) the performance of a financial asset or a portfolio, of a business, a project, or any other form of financial investment. Many financial models are inherently stochastic.

Financial modeling is a general term that means different things to different users. In the US and particularly in business schools it means the development of a mathematical model, often using complex algorithms, and the associated computer implementation to simulate scenarios of financial events, such as asset prices, market movements, portfolio returns and the like. Or it might mean the development of optimization models for managing and controlling the risk of a financial investment. In Europe and in the accounting profession financial modelling is defined as cash flow forecasting, involving the preparation of large, detailed spreadsheets for management decision making purposes.

While there has been some debate in the industry as to the nature of financial modeling : whether it is a tradecraft, such as welding, or a science, such as metallurgy, the task of financial modeling has been gaining acceptance and rigor over the years. Several scholarly books have been written on the topic, in addition to numerous scientific articles, and the definitive series Handbooks in Finance by Elsevier contains several volumes dealing with financial modeling issues.

There are non-spreadsheet software platforms available on which to build financial models. However, the vast proportion of the market is spreadsheet-based, and within this market Microsoft Excel now has by far the dominant position, having overtaken Lotus 1-2-3 in the 1990s. From this it is easy to see how the uninformed can equate Financial modeling competency with 'learning Excel'. However, the fallacy in this contention is the one area on which professionals and experts in the financial modeling industry agree.

The process by which a firm constructs a financial representation of some, or all, aspects of the firm or given security. The model is usually characterized by performing calculations, and makes recommendations based on that information. The model may also summarize particular events for the end user and provide direction regarding possible actions or alternatives. Financial models can be constructed in many ways, either by the use of computer software, or with a pen and paper. What's most important, however, is not the kind of user interface used, but the underlying logic that encompasses the model. A model, for example, can summarize investment management returns, such as the Sortino ratio, or it may help estimate market direction, such as the Fed model.

Fed Model: A model thought to be used by the Federal Reserve that hypothesizes a relationship between long-term treasury notes and the market return of equities. The Fed doesn't endorse this tool. In fact, it was named the"Fed model" by Prudential Securities strategist Ed Yardeni.
This model believes that returns on 10-year treasury notes should be similar to the S&P 500 earnings yield. Differences in these returns identify an over-priced or under-priced securities market.

Black Scholes Model: A model of price variation over time of financial instruments such as stocks that can, among other things, be used to determine the price of a European call option. The model assumes that the price of heavily traded assets follow a geometric Brownian motion with constant drift and volatility. When applied to a stock option, the model incorporates the constant price variation of the stock, the time value of money, the option's strike price and the time to the option's expiry.
Also known as the Black-Scholes-Merton Model. The Black Scholes Model is one of the most important concepts in modern financial theory. It was developed in 1973 by Fisher Black, Robert Merton and Myron Scholes and is still widely used today, and regarded as one of the best ways of determining fair prices of options.
There are a number of variants of the original Black-Scholes model.

Black Box Model: A computer program into which users enter information and the system utilizes pre-programmed logic to return output to the user. The "black box" portion of the system contains formulas and calculations that the user does not see nor need to know to use the system. Black box systems are often used to determine optimal trading practices. These systems generate many different types of data including buy and sell signals.

Black's Model: A variation of the Black-Scholes model that allows for the valuation of options on futures contracts. In 1976, Fisher Black, one of the developers of the Black-Scholes model (introduced in 1973), demonstrated how the Black-Scholes model could be modified in order to value European call or put options on futures contracts.

Heath-Jarrow-Morton Model - HJM Model: A model that applies forward rates to an existing term structure of interest rates to determine appropriate prices for securities that are sensitive to changes in interest rates. The HJM model is very theoretical and is used at the most advanced levels of financial analysis. It is used mainly by arbitrageurs seeking arbitrage opportunities.

Lintner's Model: A model stating that dividend policy has two parameters: (1) the target payout ratio and (2) the speed at which current dividends adjust to the target. In 1956 John Lintner developed this theory based on two important things that he observed about dividend policy:

1) Companies tend to set long-run target dividends-to-earnings ratios according to the amount of positive net-present-value (NPV) projects they have available.

2) Earnings increases are not always sustainable. As a result, dividend policy is not changed until managers can see that new earnings levels are sustainable.

Equity research

This has been sent to me by one of my students, Shivan Bakshi. I would like to share it with you.

 Equity research is divided into Buy side and sell side. Buy side analyst research on investment opportunity for their company and the sell side analyst research on the investment opportunity for the clients of their company which is very risky. Research and the Stock Market
Actually, the title of this article is a bit misleading because the role of research has not changed since the first trade occurred under the Buttonwood Tree on Manhattan Island. What has changed is the environments (bull and bear markets) that influence research.

The role of research is to provide information to the market. An efficient market relies on information: a lack of information creates inefficiencies that result in stocks being misrepresented (over or under valued). Analysts use their expertise and spend a lot of time analyzing a stock, its industry and peer group to provide earnings and valuation estimates. Research is valuable because it fills information gaps so that each individual investor does not need to analyze every stock. This division of labor makes the market more efficient.

Research in Bull and Bear Markets
If the role of research has always been so "noble", why is it currently in such a state of ill-repute? There are two reasons: firstly the current bear market gives us a new perspective to evaluate the excesses of the last bull market; secondly investors need to blame somebody.

In every bull market there are excesses that become apparent only in the bear market that follows. Whether it is tulips or transistors, each age has its mania that distorts the normal functioning of the market. In the rush to make money, rationality is the first casualty. Investors rush to jump on the bandwagon and the market over-allocates capital to the "hot" sector(s). The most recent examples being web-based grocery companies, online pet stores and fiber-optic capacity. This herd mentality is the reason why bull markets have funded so many "me-too" ideas throughout history.

Research is a function of the market and is influenced by these swings. In a bull market investment bankers, the media and investors pressure analysts to focus on the hot sectors. Some analysts morph into promoters as they ride the market. Those analysts that remain rational practitioners are ignored, and their research reports go unread. During the late 1990s the business media catered to the audience's demands and gave the spotlight to the famous talking heads that are now under investigation.

Seeking to blame someone for investment losses is a normal event in bear markets. It happened in the 1930s and the 1970s and is occurring today. Some of the criticisms are deserved, but the need to provide information has not changed.

Research in Today's Market
To discuss the role of research in today's market, we need to differentiate between Wall Street research and other research. Wall Street research is provided by the major brokerage firms (both on and off Wall Street). Other research is produced by independent research firms and small boutique brokerage firms.

This differentiation is important. First, Wall Street research has become focused on big cap, very liquid stocks and ignores the majority (over 60% based on our research) of publicly-traded stocks. This myopic focus on a small number of stocks is the result of deregulation and industry consolidation. In order to remain profitable, Wall Street firms have focused on big-cap stocks to generate highly lucrative investment banking deals and trading profits.

Those companies that are likely to provide the research firms with a sizable investment banking deals are the stocks that are determined worth being followed by the market. The stock's long-term investment potential is secondary. The second reason to distinguish Wall Street from other research is that most of the blame for the excesses of the last bull market is rightfully placed on Wall Street.

Other research is filling the information gap created by Wall Street. Independent research firms and boutique brokerage firms are providing research on the stocks that have been orphaned by Wall Street. Investors, now educated in the benefits of electronic trading, may not be willing to support boutique brokerage firms for their research by opening an account and paying higher commissions.

This means that independent research firms are becoming the main source of information on the majority of stocks, but investors are reluctant to pay for research because they don't really know what they are paying for until well after the purchase. Unfortunately not all research is worth buying. I have purchased reports from reputable sources only to find them inaccurate and misleading.

Who Pays for Research? Big Investors Do!
The ironic thing is that while research has proven to be valuable, individual investors do not seem to want to pay for it. This may be because, under the traditional system, brokerage houses provided research in order to gain and keep clients. Investors just had to ask their brokers for a report and retained it at no charge. What seems to have gone unrealized is that the commissions pay for that research.

A good indicator of the value of research is the amount institutional investors are willing to pay for it. Institutional investors hire their own analysts to gain a competitive edge over other investors. They also pay (often handsomely) independent research firms for additional research. Institutions also pay for the sell-side research they receive (either with dollars or by giving the supplying brokerage firm trades to execute). All this amounts to big money, but the institutions realize that research is integral to making successful investment decisions.

If investors are unwilling to buy research how will the market correct the imbalance caused by the lack of coverage? The solution may be found by looking at the issue a slightly different way.

The Growing Role of Fee-Based Research
Fee-based research increases market efficiency and bridges the gap between investors who want research (without paying) and companies who realize that Wall Street is not likely to provide research on their stock. Fee-based research provides information to the widest possible audience at no charge to the reader because the subject company has funded the research.

It is important to differentiate between objective fee-based research and research that is promotional. Objective fee-based research is analogous to the role of your physician. You pay a physician not to tell you that you feel good but to give you his or her professional and truthful opinion of your condition. Legitimate fee-based research is a professional and objective analysis and opinion of a company's investment potential. Promotional research is short on analysis and full of hype. An example is the fax and email reports about the penny stocks that will supposedly triple in a short time.

Legitimate fee-based research firms have the following characteristics:

1. They provide analytical not promotional services.
2. They are paid a set annual fee in cash; they do not accept any form of equity, which may cause conflicts of interest.
3. They provide full and clear disclosure of the relationship between the company and the research firm so investors can evaluate objectivity.

Companies who engage a legitimate fee-based research firm to analyze their stock are trying to get information to investors and improve market efficiency. Such a company is making the following important statements:

1. That it believes its shares are undervalued because investor are not aware of the company.
2. That it is aware that Wall Street is no longer an option.
3. That it believes that its investment potential can withstand objective analysis.

Perhaps more importantly, the reputations/credibility of the company and the research firm depends on the efforts they make to inform investors. A company does not want to be tarnished by being associated with disreputable research. Similarly, a research firm will only want to analyze companies that have strong fundamentals and long-term investment potential.

Fee-based research has had to fight the stereotype of promotional research, but the market is starting to realize that fee-based research is a viable source of information. The National Investor Relations Institute (NIRI) was probably the first group to recognize the need for fee-based research. In January 2002 NIRI issued a letter emphasizing the need for small-cap companies to find alternatives to Wall Street research in order to get their information to investors. More recently, the NIRI is conducting a survey on research alternatives and will possibly have a session on this topic at their national conference this year.

Equity Research fullfilments

This has been sent to me by one of my students, Shivan Bakshi. I would like to share it with you.

 Securities research is a discipline within the financial services industry. Securities research professionals are known most generally as "analysts," "research analysts," or "securities analysts;" all the foregoing terms are synonymous. Securities analysts are commonly divided between the two basic kinds of securities: equity analysts (researching stocks and their issuers) and fixed income analysts (researching bond issuers). However, there are some analysts who cover all of the securities of a particular issuer, stocks and bonds alike.

Securities analysts are usually further subdivided by industry specialization (or sectors) -- among the industries with the most analyst coverage are biotechnology, financial services, energy, and computer hardware, software and services. Fixed income analysts are also often subdivided by asset class—among the fixed income asset classes with the most analyst coverage are convertible bonds, high yield bonds (see high-yield debt), and distressed bonds (see distressed securities). (Although technically not securities, syndicated bank loans typically fall within the domain of fixed income analysts, and are covered, as if they were bonds, by reference to the industry of their borrowers or asset class in which their credit quality would place them.)

In the broadest terms, securities analysts seek to develop, and thereafter communicate to investors, insights regarding the value, risk, and volatility of a covered security, and thus assist investors to decide whether to buy, hold, sell, sell short, or simply avoid the security in question or derivative securities (see: derivative). To gather the information required to do so, securities analysts review periodic financial disclosures (such as made by United States-listed issuers to the S.E.C.) of the issuer and other relevant companies, read industry news and use trading history and industry information databases, interview managers and customers of the issuer, and (sometimes) perform their own primary research.

Securities research falls into two broad categories: that provided by investment banks and that provided by independent equity research boutiques. The former group offer research as part of a broad set of financial services including broking and corporate finance. Independent equity research has largely sprung into existence as a result of scandals such as Enron, Lernout & Hauspie and Worldcom where investment banks wrote positive research despite deteriorating fundamentals or fraudulent management.

Research analysts produce reports and typically issue a recommendation: buy ("overweight"), hold, or sell ("underweight"). These reports can be accessed from a number of sources, and brokerages will often offer the reports free to their customers.^[1]

Career path: Entrance into the profession, which is generally very well paid and prestigious, is highly competitive. Those who enter the profession at the junior level, typically have an undergraduate degree from a leading college or university and one to a few years of experience in some other discipline of finance or (lacking such experience) an MBA or other relevant advanced degree. Those who enter the field in a junior capacity, can progress to a senior capacity in a fairly brief period of time (two to four years) if they prove themselves talented; often such advancement is greatly aided by earning a Chartered Financial Analyst charter (which requires passage of three, successively more difficult examinations over a period of not less than nineteen months). Many securities analysts have directly entered the profession at a more senior level; such persons typically have an MBA or other relevant advanced degree and a number of years of progressively responsible experience either in another finance profession, or in the industry which they will be covering as an analyst.

Employment: Securities analysts are generally employed in one of three capacities: sell-side analysts (who work for a broker-dealer and indirectly for broker-dealer's trading customers), buy-side analysts (who work for institutional investors, such as hedge funds, mutual funds, pension funds, proprietary trading operations of banks and brokers, endowments, and insurance companies), and independent analysts, who work for firms which sell research to sell-side and/or buy-side firms, but who do not themselves engage in securities transactions.

Buy-side analysts generally do their work in private; publishing research reports and issuing public opinions on a security is generally confined to sell-side and independent analysts. However, the amount of formally-published sell-side research is generally thought to be declining, as it becomes more difficult for brokers to gain a clear revenue stream from the investment. (The direct connection between securities research and the underwriting of new issues, which enabled research analysts to claim a share of investment banking fees, was severed as a result of government investigations into excesses of some sell-side analysts in the late 1990s; see, for example, Henry Blodget).

Qualifications: In the US, as of 2002, investment professionals seeking to become sell-side equity research analysts must pass the Research Analyst examination jointly administered by NASD and NYSE. The exam is divided into two parts: the 86 and 87. The Series 86 Research Analyst exam is the Quantitative portion consisting of material from introductory economics, and financial accounting. Initially, successful completion of the CFA level I & II exams provides a waiver for the Series 86 exam, but not the Series 87 examination. Now, the waiver opportunity has lapsed and the Series 86 exam which is challenging for an experienced analyst must be taken. The Series 87 Research Analyst exam is the Regulatory portion consisting material from the Securities Exchange Act of 1933, Securities Exchange Act of 1934, NASD and NYSE Rules. The Series 7 examination/license is a pre-requisite for the Research Analyst exams.

Industry Rules: Buy-side and independent research are generally unregulated. Sell-side research is subject to regulation by the securities authorities of the locales where it is performed. The large majority of all sell-side research is performed either in the United Kingdom or the United States. UK sell-side research is regulated by the Financial Services Authority. US sell-side research has a more complex regime of regulation. The U.S. Securities and Exchange Commission has prescribed certain relevant rules (among them Regulation AC and Regulation FD) but has generally delegated research regulation to the self-regulatory organizations. The principal SROs (the National Association of Securities Dealers and the New York Stock Exchange) have issued detailed regulations of equity research, and much more cursory regulation of fixed income research. (With respect to the latter, the NYSE and the NASD have re-delegated the substance of regulation to the broker-dealer trade group Securities Industry and Financial Markets Association as the merger successor of the Bond Market Association, to whom the role was originally assigned.) The impact upon securities research regulation of the pending merger of the NASD with the regulatory arm of the NYSE is as of yet uncertain.

In the immediate aftermath of the excesses of the 1990s referred to above, Eliot Spitzer, Governor of the State of New York, asserted a significant role in policing securities research performed by New York-based analysts; it is unclear whether oversight by the New York State Attorney General will become a long-term meaningful component of securities research. The going-forward conduct provisions of a master settlement agreement between (on the one hand) most of the aforesaid U.S. regulators and (on the other hand) many of the largest U.S. broker-dealers, is an important source of ongoing regulation, with the force of law for the broker-dealers who are party to it, and a strong, if not formally legally binding effect, on broker-dealers not party to it.

Fundamental analysis done by Research Analyst

This has been sent to me by one of my students, Shivan Bakshi. I would like to share it with you.

Fundamental analysis is the cornerstone of investing. In fact, some would say that you aren't really investing if you aren't performing fundamental analysis. Because the subject is so broad, however, it's tough to know where to start. There are an endless number of investment strategies that are very different from each other, yet almost all use the fundamentals.

The biggest part of fundamental analysis involves delving into the financial statements. Also known as quantitative analysis, this involves looking at revenue, expenses, assets, liabilities and all the other financial aspects of a company. Fundamental analysts look at this information to gain insight on a company's future performance.
But there is more than just number crunching when it comes to analyzing a company. This is where qualitative analysis comes in - the breakdown of all the intangible, difficult-to-measure aspects of a company

When talking about stocks, fundamental analysis is a technique that attempts to determine a security’s value by focusing on underlying factors that affect a company's actual business and its future prospects. On a broader scope, you can perform fundamental analysis on industries or the economy as a whole. The term simply refers to the analysis of the economic well-being of a financial entity as opposed to only its price movements.

Fundamental Analysis: Qualitative Factors - The Company: Even before an investor looks at a company's financial statements or does any research, one of the most important questions that should be asked is: What exactly does the company do? This is referred to as a company's business model – it's how a company makes money. You can get a good overview of a company's business model by checking out its website or reading the first part of its 10-K filing .
Sometimes business models are easy to understand. Take McDonalds, for instance, which sells hamburgers, fries, soft drinks, salads and whatever other new special they are promoting at the time. It's a simple model, easy enough for anybody to understand.

Other times, you'd be surprised how complicated it can get. Boston Chicken Inc. is a prime example of this. Back in the early '90s its stock was the darling of Wall Street. At one point the company's CEO bragged that they were the "first new fast-food restaurant to reach $1 billion in sales since 1969". The problem is, they didn't make money by selling chicken. Rather, they made their money from royalty fees and high-interest loans to franchisees. Boston Chicken was really nothing more than a big franchisor. On top of this, management was aggressive with how it recognized its revenue. As soon as it was revealed that all the franchisees were losing money, the house of cards collapsed and the company went bankrupt.

At the very least, you should understand the business model of any company you invest in. The "Oracle of Omaha", Warren Buffett, rarely invests in tech stocks because most of the time he doesn't understand them. This is not to say the technology sector is bad, but it's not Buffett's area of expertise; he doesn't feel comfortable investing in this area. Similarly, unless you understand a company's business model, you don't know what the drivers are for future growth, and you leave yourself vulnerable to being blindsided like shareholders of Boston Chicken were.

Fundamental Analysis: Qualitative Factors - The Industry:

Market Share-
Understanding a company's present market share can tell volumes about the company's business. The fact that a company possesses an 85% market share tells you that it is the largest player in its market by far. Furthermore, this could also suggest that the company possesses some sort of "economic moat," in other words, a competitive barrier serving to protect its current and future earnings, along with its market share. Market share is important because of economies of scale. When the firm is bigger than the rest of its rivals, it is in a better position to absorb the high fixed costs of a capital-intensive industry.

Industry Growth-
One way of examining a company's growth potential is to first examine whether the amount of customers in the overall market will grow. This is crucial because without new customers, a company has to steal market share in order to grow.

In some markets, there is zero or negative growth, a factor demanding careful consideration. For example, a manufacturing company dedicated solely to creating audio compact cassettes might have been very successful in the '70s, '80s and early '90s. However, that same company would probably have a rough time now due to the advent of newer technologies, such as CDs and MP3s. The current market for audio compact cassettes is only a fraction of what it was during the peak of its popularity.

Competition -
Simply looking at the number of competitors goes a long way in understanding the competitive landscape for a company. Industries that have limited barriers to entry and a large number of competing firms create a difficult operating environment for firms.

One of the biggest risks within a highly competitive industry is pricing power. This refers to the ability of a supplier to increase prices and pass those costs on to customers. Companies operating in industries with few alternatives have the ability to pass on costs to their customers. A great example of this is Wal-Mart. They are so dominant in the retailing business, that Wal-Mart practically sets the price for any of the suppliers wanting to do business with them. If you want to sell to Wal-Mart, you have little, if any, pricing power.

Regulation -
Certain industries are heavily regulated due to the importance or severity of the industry's products and/or services. As important as some of these regulations are to the public, they can drastically affect the attractiveness of a company for investment purposes.

In industries where one or two companies represent the entire industry for a region (such as utility companies), governments usually specify how much profit each company can make. In these instances, while there is the potential for sizable profits, they are limited due to regulation.

In other industries, regulation can play a less direct role in affecting industry pricing. For example, the drug industry is one of most regulated industries. And for good reason - no one wants an ineffective drug that causes deaths to reach the market. As a result, the U.S. Food and Drug Administration (FDA) requires that new drugs must pass a series of clinical trials before they can be sold and distributed to the general public. However, the consequence of all this testing is that it usually takes several years and millions of dollars before a drug is approved. Keep in mind that all these costs are above and beyond the millions that the drug company has spent on research and development.

All in all, investors should always be on the lookout for regulations that could potentially have a material impact upon a business' bottom line. Investors should keep these regulatory costs in mind as they assess the potential risks and rewards of investing.

Fundamental Analysis: Financial Statements - The Balance Sheet
The balance sheet represents a record of a company's assets, liabilities and equity at a particular point in time. The balance sheet is named by the fact that a business's financial structure balances in the following manner:

Assets = Liabilities + Shareholders' Equity    

Assets represent the resources that the business owns or controls at a given point in time. This includes items such as cash, inventory, machinery and buildings. The other side of the equation represents the total value of the financing the company has used to acquire those assets. Financing comes as a result of liabilities or equity. Liabilities represent debt (which of course must be paid back), while equity represents the total value of money that the owners have contributed to the business - including retained earnings, which is the profit made in previous years.

The Income Statement
While the balance sheet takes a snapshot approach in examining a business, the income statement measures a company's performance over a specific time frame. Technically, you could have a balance sheet for a month or even a day, but you'll only see public companies report quarterly and annually.

The income statement presents information about revenues, expenses and profit that was generated as a result of the business' operations for that period.

Statement of Cash Flows
The statement of cash flows represents a record of a business' cash inflows and outflows over a period of time. Typically, a statement of cash flows focuses on the following cash-related activities:

·        Operating Cash Flow (OCF): Cash generated from day-to-day business operations

·        Cash from investing (CFI): Cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment or long-term assets

·        Cash from financing (CFF): Cash paid or received from the issuing and borrowing of funds

The cash flow statement is important because it's very difficult for a business to manipulate its cash situation. There is plenty that aggressive accountants can do to manipulate earnings, but it's tough to fake cash in the bank. For this reason some investors use the cash flow statement as a more conservative measure of a company's performance.

10-K and 10-Q
Now that you have an understanding of what the three financial statements represent, let's discuss where an investor can go about finding them. In the United States, the Securities And Exchange Commission (SEC) requires all companies that are publicly traded on a major exchange to submit periodic filings detailing their financial activities, including the financial statements mentioned above.

Some other pieces of information that are also required are an auditor's report, management discussion and analysis (MD&A) and a relatively detailed description of the company's operations and prospects for the upcoming year.

All of this information can be found in the business' annual 10-K and quarterly 10-Q filings, which are released by the company's management and can be found on the internet or in physical form.
The 10-K is an annual filing that discloses a business's performance over the course of the fiscal year. In addition to finding a business's financial statements for the most recent year, investors also have access to the business's historical financial measures, along with information detailing the operations of the business. This includes a lot of information, such as the number of employees, biographies of upper management, risks, future plans for growth, etc.

Fundamental Analysis  Valuation: The premise of the discounted cash flow method is that the current value of a company is simply the present value of its future cash flows that are attributable to shareholders. Its calculation is as follows:

       
·      
For simplicity's sake, if we know that a company will generate $1 per share in cash flow for shareholders every year into the future; we can calculate what this type of cash flow is worth today. This value is then compared to the current value of the company to determine whether the company is a good investment, based on it being undervalued or overvalued.

Ratio Valuation : The calculations produced by the valuation ratios are used to gain some understanding of the company's value. The ratios are compared on an absolute basis, in which there are threshold values. For example, in price-to-book, companies trading below '1' are considered undervalued. Valuation ratios are also compared to the historical values of the ratio for the company, along with comparisons to competitors and the overall market itself.

 Conclusion:  Whenever you’re thinking of investing in a company it is vital that you understand what it does, its market and the industry in which it operates. You should never blindly invest in a company.

One of the most important areas for any investor to look at when researching a company is the financial statements. It is essential to understand the purpose of each part of these statements and how to interpret them.

Technical analysis

This has been sent to me by one of my students, Shivan Bakshi. I would like to share it with you.

Technical analysts seek to identify price patterns and trends in financial markets and attempt to exploit those patterns. While technicians use various methods and tools, the study of price charts is primary. Technicians especially search for archetypal patterns, such as the well-known head and shoulders or double top reversal patterns, study indicators such as moving averages, and look for forms such as lines of support, resistance, channels, and more obscure formations such as flags, pennants or balance days.

Technical analysts also extensively use indicators, which are typically mathematical transformations of price or volume. These indicators are used to help determine whether an asset is trending, and if it is, its price direction. Technicians also look for relationships between price, volume and, in the case of futures, open interest. Technicians seek to forecast price movements such that large gains from successful trades exceed more numerous but smaller losing trades, producing positive returns in the long run through proper risk control and money management. Technical analysis employs models and trading rules based on price and volume transformations, such as the relative strength index, moving averages, regressions, inter-market and intra-market price correlations, cycles or, classically, through recognition of chart patterns.

Technical analysis ignores the actual nature of the company, market, currency or commodity and is based solely on the charts, that is to say price and volume information. Technical analysis is widely used among traders and financial professionals, and is very often used by active day traders, market makers, and pit traders. Technical analysts believe that prices trend. Technicians say that markets trend up, down, or sideways (flat).

Technical analysis is not limited to charting, but it always considers price trends. For example, many technicians monitor surveys of investor sentiment. These surveys gauge the attitude of market participants, specifically whether they are bearish or bullish. Technicians use these surveys to help determine whether a trend will continue or if a reversal could develop; they are most likely to anticipate a change when the surveys report extreme investor sentiment. Surveys that show overwhelming bullishness, for example, are evidence that an uptrend may reverse – the premise being that if most investors are bullish they have already bought the market (anticipating higher prices). And because most investors are bullish and invested, one assumes that few buyers remain. This leaves more potential sellers than buyers, despite the bullish sentiment. This suggests that prices will trend down, and is an example of contrarian trading.

Globally, the industry is represented by the International Federation of Technical Analysts (IFTA). In the United States, there are two national organizations: the Market Technicians Association (MTA), and the American Association of Professional Technical Analysts (AAPTA). The United States is also represented by the Technical Security Analysts Association of San Francisco (TSAASF). In the United Kingdom, the industry is represented by the Society of Technical Analysts (STA). In Canada the industry is represented by the Canadian Society of Technical Analysts.

Charts used by Technical Analyst:

·       OHLC - Open High Low Close charts plot the high and low of the price movement vertically and the open and close horizontally. Used to graph range and outliers.

·       Candlestick chart - Similar to OHLC, but open and close are filled. Often Black or Red candles represent a close lower than the open. While White, Green or Blue candles represent a close higher than the open.

·       Line chart - Connects each closing interval together on a line

Some concepts in Technical analysis:

·       Average true range - averaged daily trading range, adjusted for price gaps

·       Chart pattern

·       Dead cat bounce - the phenomenon whereby a spectacular decline in the price of a stock is immediately followed by a moderate and temporary rise before resuming its downward movement

·       Elliott wave principle and the golden ratio to calculate successive price movements and retracements

·       Momentum - the rate of price change

·       Point and figure charts - charts based on price without time.

Overlays are generally superimposed over the main price chart.

·       Resistance - an area that brings on increased selling

·       Support - an area that brings on increased buying

·       Breakout - when a price passes through and stays above an area of support or resistance

·       Trend line - a sloping line of support or resistance

·       Channel - a pair of parallel trend lines

·       Moving average - lags behind the price action but filters out short term movements

·       Bollinger bands - a range of price volatility

·       Pivot point - derived by calculating the numerical average of a particular currency's or stock's high, low and closing prices

Price-based indicators:

These indicators are generally shown below or above the main price chart.

·       Accumulation/distribution index—based on the close within the day's range

·       Advance decline line — a popular indicator of market breadth

·       Average Directional Index — a widely used indicator of trend strength

·       Commodity Channel Index - identifies cyclical trends

·       MACD - moving average convergence/divergence

·       Parabolic SAR - Wilder's trailing stop based on prices tending to stay within a parabolic curve during a strong trend

·       Relative Strength Index (RSI) - oscillator showing price strength

·       Stochastic oscillator, close position within recent trading range

·       Trix - an oscillator showing the slope of a triple-smoothed exponential moving average, developed in the 1980s by Jack Hutson

Volume based indicators:

·       Money Flow - the amount of stock traded on days the price went up

·       On-balance volume - the momentum of buying and selling stocks

·       PAC charts - two-dimensional method for charting volume by price level