Analyzing Stocks

Stock selection is the starting point for covered call writing. Options are valued based upon market value of the stock in comparison to striking price and expiration date of the option. So options do not contain any fundamental or technical features of their own.

Avoid the mistake of failing to question whether the particular stock is a good match for you, given your risk tolerance level, long-term investing goals, and available capital.

Options traders are especially vulnerable to the temptation to buy stocks for the wrong reason—namely, to take advantage of high-priced option opportunities.

Smart Investor Tip

Don't look for fundamental or technical indicators in option; instead, study the attributes of the underlying stock.

Risks are unavoidable attributes of investing. To spot excessive risks, follow these general rules of thumb:Standard & Poor's has changed its method for valuing companies, and its revised definition of core earnings is helpful in getting around many of the creative methods used in the past to inflate earnings and mislead investors. The S&P definition of core earnings is "the after-tax earnings generated from a corporation's principal business."

Smart Investor Tip

Calculating core earnings does not mean noncore line items disappear; but in calculating long-term trends, only core earnings should be considered. The noncore items are one-time occurrences and are not relevant to your fundamental trend.

Under this definition, many items are excluded from earnings, including nonrecurring gain or loss from the sale of capital assets, pro forma earnings such as gains on pension investments, and fees related to mergers and acquisitions. In the past, the inclusion of these items inflated reported profits, so that the market had unrealistic and inaccurate ideas of a company's operating results.

The definition includes many expenses and costs that have been excluded or capitalized in the past, such as restructuring charges, write-down of amortizable operating assets, pension costs, and purchased research-and-development costs. One of the most substantial and glaring flaws of the past has been leaving out employee stock option expense, which can be a huge number; but that flaw is gradually changing as many corporations have begun expensing stock options granted each year. As long as corporations left these and similar items out of the picture, stockholders were given a very unrealistic view of operations.

Smart Investor Tip

Standard & Poor's provides many useful articles and reports concerning core earnings. Check and then search on "core earnings" to find a current list of articles.

The move by S&P to arrive at a standardized definition of the real earnings number is a positive trend. It enables like-kind comparisons between many different corporations, without the very real concern for inconsistent treatment and interpretation of revenues or costs and expenses. The S&P definition makes more sense than the more widely used EBITDA, which is earnings before interest, taxes, depreciation, and amortization. EBITDA was originally intended to serve as a measurement of cash flow or cash-based earnings for a company; however, this measurement is flawed.

Under EBITDA, no provision is included to account for purchasing of capital assets or paying down debts. Rather than a clarifying calculation, EBITDA has been used more as a way to make things appear better than they are. For example, when accounts receivable levels are rising, EBITDA does not make a distinction between cash sales and credit sales—an area where revenues have been exaggerated in some cases and where it is all too easy to alter the true numbers to inflate earnings.

Smart Investor Tip

EBITDA, a well-intended calculation, has been widely misused to distort the numbers. For this reason, it should be rejected as a formula in your analytical study of a company.

As a starting point in the analysis of corporate reports, identifying core earnings helps you to analyze many different companies on a truly comparative basis. Going beyond that, you also need to quantify what analysts call the quality of earnings. While this term has many definitions, it is supposed to mean earnings that are reliable and true, as opposed to those that are overly optimistic or inflated. For example, if a company reports income based on accounts receivable that might never be collected, that is not a good quality of earnings. The definition should include revenues that are likely to be collected and not created out of accruals, acquisitions, or accounting tricks.

In addition to the importance of selectively identifying companies based on quality of earnings, make use of specific fundamental tests. Fundamental analysis—the study of financial information, management, competitive position within a sector, and dividend history, for example—provides you with comparative analysis of value, safety, stability, and the potential for growth in the stock's long-term value. Financial and economic information, corporate management, sector and competitive position, and other indicators involving profit and loss, all are part of fundamental analysis. The fundamentalist studies a corporation's balance sheet and income statement to judge a stock's long-term prospects as an investment. Other economic indicators may influence your decision to invest or not.

The fundamentals should be reliable. If we cannot rely on what is being reported, what good is any form of analysis? Any study involving the fundamentals has to involve analysis on two levels. The traditional level includes trend analysis, for the purpose of identifying changes in financial strength and competitive position. Second is an equally important study of financial ratios, for the purpose of ensuring that a company is not artificially inflating earnings in order to deceive investors.

The fundamental analyst believes in the numbers. However, part of a scientific analysis has to include verification of the core data as a starting point. The fundamental analyst has to be able not only to interpret the information, but also to use some basic forensic accounting skills to make sure the numbers are real. Those skills include a study of the basic ratios in a search for suspicious or questionable changes. If such changes are discovered and not adequately explained, that discovery is a warning that something could be wrong.

The technician will be less interested in the forensic aspects of current or past information. Technical analysis involves a forward-looking study relating almost exclusively to price of the stock, market forces affecting that price, and anticipation of changes based on supply and demand, market perception, and trading ranges. The technician uses financial data only to the extent that it affects a current price trend, believing that this trend provides the key to anticipating the future price movement of stock. Market analysts believe that price change is random, especially short-term price movement; but some technicians, notably the chartist, prefer to believe that patterns of price movement can be used to predict the direction of change in the stock's price.

The fundamental approach is based on the assumption that short-term price movement is entirely random and that long-term value is best identified through a thorough study of a corporation's financial status. The technical approach relies on patterns in price of the stock and other price-related indicators associated more with the market's perception of value and less with financial information. Obviously, a current report on the corporation's net income will affect the stock's market price, at least temporarily, and technicians acknowledge this. However, their primary interest is in studying pricing trends.

Both theories have value, so it makes sense to apply fundamental and technical analysis in your analytical program. You monitor the market to make the four important decisions: buy, hold, sell, or stay away. Analysis in all of its forms is a tool for decision making, and no analysis provides insights that dictate decisions exclusively. Common sense and judgment based on experience are the extra edge that you can bring to your investment decisions. Successful investing is the result of being right more often than being wrong.

Smart Investor Tip

There are no formulas that will make you right all of the time. Investing success comes from applying good judgment, increasing your chances of being right about market decisions.

Never overlook the need to continuously track your stocks. Call writers may be inclined to ignore signals relating to the stock when, if they were not involved with writing options, they might tend to watch their portfolio more diligently. Call writers are preoccupied with other matters: movement in the stock's price (but only insofar as it affects their option positions); chances of exercise and how to avoid or defer it; opportunities to roll forward; and other matters concerning immediate strategies. As important as all of these matters are for call writers, they do not address the important questions that every stockholder needs to ask continuously: Should I keep the stock or sell it? Should I buy more shares? What changes have occurred that could also change my opinion of this stock?

The time will come when, as a call writer, you will want to close an open call position and sell the stock. For example, if you own 100 shares of stock on which you have written several calls over many months or years, when should you sell the stock and get out? For a variety of reasons, you might conclude that the stock is not going to hold its value into the future as you once believed. Even if you buy stocks for the long term, you may need to rethink your positions through constant evaluation, whether you write calls or not. It would be a mistake to continue holding stock because it represents a good candidate for covered call selling, when in fact that stock no longer makes the grade based on the analytical tests that you use to pick stocks as a starting point.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2020. Content published with author's permission.

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