Getting Started in

INVESTMENTANALYSIS

Warren Brussee

John Wiley & Sons, Inc.

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Getting Started in

INVESTMENTANALYSIS

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The Getting Started In Series

Getting Started In Online Day Trading by Kassandra BentleyGetting Started In Asset Allocation by Bill Bresnan and Eric P. GelbGetting Started In Online Investing by David L. Brown and Kassandra BentleyGetting Started In Investment Clubs by Marsha BertrandGetting Started In Internet Auctions by Alan ElliottGetting Started In Stocks by Alvin D. HallGetting Started In Mutual Funds by Alvin D. HallGetting Started In Estate Planning by Kerry HannonGetting Started In Online Personal Finance by Brad HillGetting Started In 401(k) Investing by Paul KatzeffGetting Started In Internet Investing by Paul KatzeffGetting Started In Security Analysis by Peter J. KleinGetting Started In Global Investing by Robert P. KreitlerGetting Started In Futures, Fifth Edition by Todd LoftonGetting Started In Financial Information by Daniel Moreau and Tracey LongoGetting Started In Emerging Markets by Christopher PoillonGetting Started In Technical Analysis by Jack D. SchwagerGetting Started In Real Estate Investing by Michael C. Thomsett and Jean Freestone

ThomsettGetting Started In Tax-Savvy Investing by Andrew Westham and Don KornGetting Started In Annuities by Gordon M. WilliamsonGetting Started In Bonds, Second Edition by Sharon Saltzgiver WrightGetting Started In Retirement Planning by Ronald M. Yolles and Murray YollesGetting Started In Online Brokers by Kristine DeForgeGetting Started In Project Management by Paula Martin and Karen TateGetting Started In Six Sigma by Michael C. ThomsettGetting Started In Rental Income by Michael C. ThomsettGetting Started In REITs by Richard ImperialeGetting Started In Property Flipping by Michael C. ThomsettGetting Started In Fundamental Analysis by Michael C. ThomsettGetting Started In Hedge Funds, Second Edition by Daniel A. StrachmanGetting Started In Chart Patterns by Thomas N. BulkowskiGetting Started In ETFs by Todd K. LoftonGetting Started In Swing Trading by Michael C. ThomsettGetting Started In Options, Seventh Edition by Michael C. ThomsettGetting Started In A Financially Secure Retirement by Henry HebelerGetting Started In Candlestick Charting by Tina LoganGetting Started In Forex Trading Strategies by Michael D. ArcherGetting Started In Value Investing by Charles MizrahiGetting Started In Currency Trading, Second Edition by Michael D. Archer

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Getting Started in

INVESTMENTANALYSIS

Warren Brussee

John Wiley & Sons, Inc.

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Copyright © 2009 by Warren Brussee. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in anyform or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise,except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, withouteither the prior written permission of the Publisher, or authorization through payment of theappropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers,MA 01923, (978) 750-8400, fax (978) 750-4470, or on the web at www.copyright.com.Requests to the Publisher for permission should be addressed to the Permissions Department,John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their bestefforts in preparing this book, they make no representations or warranties with respect to theaccuracy or completeness of the contents of this book and specifically disclaim any impliedwarranties of merchantability or fitness for a particular purpose. No warranty may be created orextended by sales representatives or written sales materials. The advice and strategies containedherein may not be suitable for your situation. You should consult with a professional whereappropriate. Neither the publisher nor author shall be liable for any loss of profit or any othercommercial damages, including but not limited to special, incidental, consequential, or otherdamages.

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Library of Congress Cataloging-in-Publication Data:

Brussee, Warren.Getting started in investment analysis / Warren Brussee.

p. cm. — (The getting started in series)Includes index.ISBN 978-0-470-28384-4 (pbk.)

1. Investment analysis. I. Title.HG4529. B78 2009332.63’2042–dc22

2008022844

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

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This book is dedicated to Liam, Reed, Tess, Cara, and Emily. I hope they grow up with a love of logic and the power of the word!

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Contents

Acknowledgments ix

Element Key xi

Introduction

Getting a Feel for Your Own Investments xiii

PART 1

LOOKING AT INVESTMENT DATA 1

Chapter 1

Getting Good Data 3

Chapter 2

Identify Visual Correlations 15

PART 2

QUANTITATIVE DATA APPLICATIONS 37

Chapter 3

Types of Data 39

Chapter 4

Probability 47

Chapter 5

Plots and Distributions 55

Chapter 6

Testing Variables Data 65

vii

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Chapter 7

Testing Proportional Data 85

PART 3

QUANTITATIVE EVALUATION OF STOCKS, THE MARKET, AND INVESTING PRACTICES 89

Chapter 8

Is a Stock or the Stock Market Overpriced? 91

Chapter 9

Using Investment Analysis to Estimate When an Economic Bubble Will Break 101

Chapter 10

The U.S. Consumer Has Been Reducing Savings,Drawing Out Home Equity, and Increasing Debt.So, Should an Investor Be in the Stock Market? 111

PART 4

SPECIFIC ANALYSIS ISSUES RELATED TO RETIREMENT INVESTING 121

Chapter 11

Quick-Use Baseline Retirement Numbers 123

Chapter 12

Adjustments for a Pension, a Lower Savings Level, or a Reduced Retirement Budget 139

Chapter 13

Assumptions/Rationale in Savings Calculations 149

Appendix

Understanding Logarithmic Charts 163

Glossary 177

Index 181

viii CONTENTS

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ix

Acknowledgments

Iwould like to thank Chris Welker, Roy McDonald, and Jeff Kolt for theirvaluable feedback on the initial manuscript. Like most writers, at somepoint in writing I become blind to my words, and I read what I mean to say

rather than what I actually write. My reviewers shake me out of that fog withboth their helpful suggestions and polite corrections. This book would not bepossible without them.

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xi

Element Key

Examples: Numerous examples illustrate points made in the discussionsurrounding them and are designed to express ideas in practical terms.

Definitions: This symbol is found in boxed notations providing specific defin-itions of terms. These occur at the point of discussion with the book, makingdefinitions to the section being read. (All definitions are also summarized foryou in the glossary.)

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xiii

Introduction

Getting a Feel for YourOwn Investments

People don’t buy a car without looking at all viable options! Besides dri-ving multiple cars, buyers generally get information on gas mileage andreliability. They then compare prices of the cars that make their final list.

Sure, some emotion is part of the buying decision, but so is some real analysis ofdata. And, most likely, the buyer is using inputs other than those from the cardealers’ salesmen.

In contrast, when people decide to invest, they often just give their money toa mutual fund or money manager with little review, or buy stocks with no ideaof their real worth. They have been told by financial gurus to put their moneyinto the stock market on a regular basis and watch it grow; don’t sweat detailslike the price of stocks! Investors are told to just buy and hold, even though thatisn’t what money managers do.

The intent of Getting Started in Investment Analysis is to help people analyti-cally kick the tires of potential investment options rather than just blindly buystocks. This book won’t enable everyone to pick stock winners, but it will makean investor more of an active participant in what to do with his or her hard-earned money. Very elementary examination of charts, identifying correlations,and doing simple statistical tests will give an investor some feel for the viabilityor risk of an investment.

There are thousands of publicly traded stocks available for purchase, and thepositive aspects of these stocks are readily available in the communicationsreleased by each of the companies. Given this smorgasbord of stock choices, in

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addition to other investment options such as bonds and real estate, an investorcan afford to be very selective. When in doubt, find another investment! That’swhy, on reading this book, at times it may seem that the bar on stock purchaseis set very high. It should be! Due diligence should occur before you invest inanything. Consider the time and effort it took to save the investment fundsversus the relatively little effort it takes to make sure those funds are investedwisely.

Approximately 50 percent of families own stocks, either through 401(k) sav-ings plans, mutual funds, or individual stock purchases. Yet few people do theirown critical evaluation of these investments or the economy. They trust otherpeople to do this for them, even though those other people have obvious per-sonal interests that may be in conflict with the investors’. The priority ofinvestment managers is their own financial gain, not that of the peoplewhose funds they manage. It would be wise to always keep that in mind.

Investment managers often supply misleading information related to theirinvestments, striving to put their past performance in the best possible light.They periodically clean their stock portfolios so that the only stocks they ownare those that have gone up in price. Sometimes investment firms just shutdown poorly performing mutual funds so that their remaining funds all lookgood. They also compare their results with the S&P 500 stock index withoutincluding the dividends of the S&P 500, which is currently giving investmentmanagers close to a 2 percent artificial advantage in their comparison.

Companies project future sales and earnings in the most optimistic light.They give glowing reports on future business opportunities while minimizingrisks to their current businesses. In fact, Rate Financials, Inc., an independentresearch firm, estimates that one-third of the leading publicly traded companiesdo not accurately represent their financial condition. In their findings, only4 percent of leading companies were rated outstanding in the publication oftheir finances.

Private firms’ investment data are not the only data that may be suspect.Government information related to the economy is sometimes slanted to makethe economy look better than it really is. For example, the government mayemphasize the low core inflation rate, whereas the total inflation rate, the onethat really affects us, is usually much higher.

Investors often have a difficult time determining whether their investmentsare doing better than the stock market in general or even beating inflation.Many investors have trouble telling whether a stock’s price is changing becauseof random price variation or because of a meaningful change in a company’sperformance. They may even wonder whether they would be better off out ofthe stock market altogether, but the financial advice of so-called experts is tostick with stocks because, in the long run, these advisors promise that this is theonly way to go!

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This book uses simple data analysis to assist investors in making their invest-ment choices. My earlier book, Statistics for Six Sigma Made Easy, simplified sta-tistics for the data analysis related to Six Sigma, a problem-solving methodologyused by many industries. Even though the Six Sigma process is often taught toengineers who have had statistics in college, most engineers do not regularly usestatistics in their daily work. So it was necessary in Statistics for Six Sigma MadeEasy to simplify the statistics so engineers could effectively use the Six Sigmamethodology. Getting Started in Investment Analysis does the same for evaluatingdata related to investing. Even though some of the readers of this book may havetaken statistics courses at some point in their education, this book assumes youhave no formal statistics or in-depth quantitative analysis training. My intent isto help investors make some overall judgment on the data related to their invest-ments without doing complicated statistical analysis. But where it is necessary,the process is made as painless and straightforward as possible. Only high schoolmath and access to Microsoft’s Excel are needed to do all the analysis shown inthis book.

Walter Isaacson, in his book Einstein, notes that Einstein’s “success camefrom questioning conventional wisdom.” In the investment book The OnlyThree Things That Count, by Fisher, Chou, Hoffman, and Cramer, it says that“the only way to beat the market is to know something that other investorsdon’t.” Although this book won’t help you attain breakthroughs on the order ofEinstein’s or always enable you to know something that other investors don’t,its methods will often help you see things in data that other investors miss, andit does this by helping you analyze good data. There is a saying in Six Sigmathat “In God we trust; all others must bring data.” In general, that is the sort ofcriteria to use in evaluating stocks or any other investment.

Recognizing Meaningful Changes in Valid Data

The first thing an investor must realize is that almost all data are biased. Sothe goal is to filter out the worst data and to adjust the remaining data to makeit easier to analyze. For example, an investor often wants to know if a stock’sprice increase was meaningful and, if so, what caused that change. To deter-mine this, the investor must separate random price changes from those changeswith an assignable cause, like a promising new product. This will put theinvestor in a much better position to judge whether the price change is likely tocontinue.

One of the ways to start identifying underlying causes of change is to corre-late related data by using historical charts. However, even if multiple changesdo correlate, investors must still satisfy themselves as to whether a likely

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cause-and-effect relationship exists. Only then can investors make the best judgment as to what is likely to happen in the future.

There is an oft-told story about mistaking correlation with true cause andeffect. In the nineteenth century in Europe, someone documented a strong cor-relation between stork sightings and childbirths. Only later was it realized thatthe reason more storks were seen at the time of human births was that peoplestoked up their fireplaces as the birth times approached, which attracted thestorks, who built their nests near the warm chimneys. Now, this did not makethe correlation invalid. But if some other factor, like lack of food in the area,suddenly caused the storks not to come, the birth rate would not have beenaffected. There is always a temptation to assume that correlations prove causeand effect. Of course, that doesn’t diminish the value of identifying correla-tions, since correlations are often the start of the process of identifying the truecause of an event.

Retirement Savings Have UniqueChallenges

Many investment savings are for retirement. The last section of this bookfocuses on the very unique quantitative problems related to investing for andduring retirement. What makes this such a challenge is that, besides the normalissues related to picking investments, we have to deal with the future value ofmoney, how much money must be saved, minimizing risk, and how long some-one is likely to live in retirement. And of course, we cannot ignore pension andSocial Security issues, which affect investment needs.

Data Analysis

Microsoft’s Excel is sufficient for all the analysis, graphing, and statistics usedin this book. However, to do this analysis you must first make sure thatExcel’s Data Analysis is loaded into your computer. To verify this, bring upMicrosoft’s Excel on your computer. On the header on the top of the screen,click on Tools. A list of options will appear. If Data Analysis is one of them,then you are in fine shape! If not, under Tools, go to Add-Ins. Check theboxes for Analysis Toolpak and Analysis Toolpak VBA, then OK. If this is notavailable, you will have to insert the Microsoft Office Professional disk andinstall it. You may have to close and then reopen Excel to see Data Analysis asan option.

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This book is useful without doing the data analysis shown because a lot ofthe concerns about investing are not quantitative. However, using Excel dataanalysis makes the process of picking investments far more robust and unemo-tional.

Summary of the Book’s Goals

Getting Started in Investment Analysis will do the following:

• Show you how to critically judge the quality of stock or investment dataand then separate the good data from the bad.

• Help you glean insights from valid investment data by using graphs andlooking for correlations.

• Enable you to understand the additional complications related to retire-ment investing.

• Assist you in doing simple quantitative data analysis by utilizingMicrosoft’s Excel and high school mathematics.

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1Looking at

Investment Data

Part

All data are suspect! Therefore, before any kind of quantitative analysis canbe done, the data have to be validated. Wrong data must be discarded,misleading data corrected, and correct data cherished. Part 1 chapters

give guidelines for and examples of this task.

Chapter 1: Getting Good Data

• Valid source

• Consistent source

• Consistent basis

• Real data (without inflation) versus regular data

• Manipulated data versus hard data (example: earnings versus dividends)

Chapter 2: Identify Visual Correlations

• Identify potential key process input variables (KPIVs)

• Incorporate time shifts (like inventory changes)

• Look for multiple correlations

• Can never prove cause with past data

• Inflation

1

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