Monday, June 14, 2010

Hooke, Security Analysis on Wall Street

I rarely venture into the realm of fundamental analysis on this blog, but I am pleased to make an exception for Jeffrey C. Hooke’s book Security Analysis on Wall Street: A Comprehensive Guide to Today’s Valuation Methods (Wiley). A second edition of the original 1998 text has just been released. For some bizarre reason the publisher sent me the first edition as a review copy. I assume that the second edition updates the stocks used as examples and addresses both newer methodologies and recent market concerns. If it improves in any way on the 1998 text, that’s great. All I have to assume for this review is that it doesn’t diminish the qualities of the first edition.

To many traders and investors security analysis seems like one big yawn. The most they do is plug some values into an online stock screener and, voilà, out comes a list of great trade ideas that for some strange reason seldom pan out. Hooke’s book demonstrates beyond a shadow of a doubt that security analysis is not boring. In clear, easy to understand prose it takes the reader from the basics to special cases such as natural resource stocks and distressed securities.

Throughout Hooke is commonsensical and hands-on. He shows how analysts work and some of the practical and theoretical difficulties they encounter. Let me highlight one problem here—figuring out how to forecast future sales. Sales projection techniques, he states, fall into three categories: time series, causal, and qualitative.

The time series method assumes that the future will be like the past and hence is popular in calculating projections for stable industries like food and utilities. Analysts use tools familiar to technical analysts such as moving averages and trendlines. But there are obvious weaknesses in this method. First, it cannot predict turning points in a company’s performance and, second, it does not take into account business cycles.

Causal techniques “forecast a company’s sales by establishing relationships between sales and variables that are independent of the corporation” (p. 204) such as housing starts or demographics. Quantifying these relationships requires regression formulas and econometric calculations. Causal forecasting is useful when analyzing established companies with a reasonably long operating record.

Finally, there are qualitative techniques that should be used in developing projections for every company. They are mandatory in the case of pioneer or growth companies offering new products and services where “the sales forecaster is left with expert opinions, market research studies, and historical analogies as his analytical tools. Sometimes, the result is nothing more than educated guesswork.” (p. 205) But at least it’s educated.

I particularly enjoyed Hooke’s chapters on modern approaches to valuation (intrinsic value, relative value, and acquisition value) even though I suspect that they have been significantly updated in the second edition. But I doubt that he will change the math in the section “How High Is Up?” He writes: “If you buy a 50 P/E stock today and plan on selling it at a 20 P/E (which is still above average) in five years (when the issuer’s business is likely maturing), the earnings per share of the company must quintuple for you to realize a market-type [that is, 14%] return.” (pp. 240-41) Investors in the bubble, where P/Es could easily get into the 100s, might have saved themselves a lot of financial grief by reading this single sentence from Hooke’s book. I’m certain that readers of the second edition will be able to profit (or avoid downside risk) equally well.

I can highly recommend this book for anyone who does position trading or investing, even the confirmed technical trader. It provides methodologies for finding investment opportunities and continually reassessing positions. With some educated guesswork the reader might even outperform those analysts who wait until a stock has cratered before changing their buy recommendation.

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