HOW-TO use the Fundamental Strength Indicator? (full guide)

7 мар.

Below is the complete instruction on how to use the Fundamental Strength Indicator.

Part 1: The Fundamental Strength of the Company

To understand what it is for, let's imagine that you manage a long-distance running team, and you need to recruit a team of excellent athletes. However, you don’t even know the names of these athletes or their contract amounts. You only have information about their health and athletic performance: hemoglobin and iron content in the blood, maximal oxygen consumption, steps-per-minute rate, speed, age, etc. Each player has their own large table with different parameters. And you have, let’s say, a thousand tables like that.

If you spend 3 minutes studying one table, it will take you 50 hours to analyze all the tables, which is just over 2 days of continuous work. And how long would it take to compare each athlete with the rest? Approximately 2 years of continuous work.

This is obviously no good, that is why you take a computer, enter all the data from the tables and start thinking about how you can reduce the time to compare one athlete with another. As a result of your brainstorming, you come to the following conclusions:

— Each parameter has its range of values, which can give you an idea of whether an athlete is suitable or not suitable for a marathon.
— The parameter may have its dynamics: it may increase from month to month, stay the same, or decrease.
— Each parameter can be assigned a score.

For example, the step-per-minute rate can be:

— 175 and above (+1 point)
— 165–174 (0 points)
— 164 and below (-1 point)

And you do that with each parameter.

What are these points for? To convert indicators that use different units into one measurement system. Thanks to this method, you can now compare apples to oranges.

Then, you sum up all the points per month and get one single number — let's call it athletic strength. You like your thought process, and you apply this algorithm to every athlete’s table.



Now, instead of dozens of parameters per month, you have one number (athletic strength) for each athlete. It looks like your task has been dramatically simplified. Next, to study the dynamics of athletic strength from month to month, you “ask” your computer to create a plot for each of the athletes.



This chart shows that Athlete #1's athletic strength has fluctuated chaotically in the first three quarters of 2022, possibly due to the lack of regular training. But then you observe a positive trend, where athletic strength has grown from month to month. It seems like the athlete has taken up training.

Then, to compare one athlete with another, you “ask” your computer to add the average value of athletic strength over the past six months (average pre-competition training period) to the existing plot. Now, you can use the most average recent value as a weighted score of athletic strength and compare athletes with each other based on this value.



Thanks to this solution, you accelerate the analysis process by a magnitude: one athlete – one number. It appears that you can then simply sort the table by the highest athletic strength weighted score and consider the best athletes. However, not wanting to sort the table every time the data is updated or when you get new athletes, you make a better decision.

The logic behind the points system implies that there is a maximum and a minimum possible number of points that one athlete can get. This allows you to create ranges of scores for athletes with excellent, mediocre, and poor training.

For example, let’s say the maximum is 15 and the minimum is -15. Athletes with a score of 8 to 15 will be considered as strong, 1 to 7 – mediocre, and 0 to -15 – weak.

That’s it! Now, thanks to this gradation, you can simply check which range the weighted athletic strength falls within, and decide whether each athlete will be admitted to the team.



I believe that now your primary selection will take no more than one working day (including a lunch break).

Now let's mentally replace athletes with public companies. Instead of data on health and athletic performance, we will have data from the companies’ financial statements and financial ratios.

Applying a similar algorithm, we will get the fundamental strength of the company instead of athletic strength.

I think it's time to show the Fundamental Strength Indicator. Let's launch! What do we see?

— First, it is a Histogram with bars of three colors: green, orange, and red. The width of the histogram depends on the depth of data from the company statements. The more historical data, the wider the histogram over time.



The green color of the bars means that the company has been showing excellent financial results by the sum of the factors in that period. According to my terminology, the company has a “strong foundation” during this period. Green corresponds to values between 8 and 15 (where 15 is the maximum possible positive value on the sum of the factors).

The orange color of the bars means that according to the sum of factors during this period the company demonstrated mediocre financial results, i.e., it has a “mediocre foundation”. Orange color corresponds to values from 1 to 7.

The red color of the bars means that according to the sum of factors in this period of time, the company demonstrated weak financial results, i.e., it has a “weak foundation”. The red color corresponds to values from -15 to 0 (where -15 is the maximum possible negative value on the sum of factors).



— Second, this is the Blue Line, which is the moving average of the Histogram bars over the last year (*). Averaging over the year is necessary to obtain a weighted estimate that is not subject to medium-term fluctuations. It is by the last value of the blue line that the actual Fundamental Strength of the company is determined.

(*) The last year means the last 252 trading days, including the current trading day.





— Third, these are operating, investing, and financing Cash Flows expressed in Diluted net income. These flows look like thick green, orange, and red lines, respectively.



— Fourth, this is the Table on the left, which shows the latest actual value of the Fundamental Strength and Cash Flows.



Indicator settings:
In the indicator settings, I can disable the visibility of the Histogram, Blue Line, Cash Flows (each separately), and Table. It helps to study each of the parameters separately. It is also possible to change the color, transparency, and thickness of lines.




The movie Moneyball was released in 2011, where Brad Pitt plays the role of Billy Bean, the sports manager of the Oakland Athletics baseball team. With a small budget, he managed to assemble a high-scoring team based on the analysis of player performance. As a result, this approach was applied by other teams in the league, and Billy Bean received massive recognition from the professional community.

Part 2: Benchmark Business Model

One day, when I had already grasped the concept of the Fundamental Strength of a company, I was returning home from vacation. I was in a taxi and the driver was listening to an audiobook. As the drive took longer than an hour, I had nothing to do but listen to the story. I liked the content. It was a fictional novel with a plot centered around the main character named Alex Rogo. He is a manager of one of the three enterprises of the UniCo corporation.

Even though Alex spends all his time and energy on work, things are not going very well for the company: over the past six months, the company has only had losses. This leaves Alex's executives no choice but to give him an ultimatum: if he can’t radically improve the situation in three months, the enterprise will be shut down, and he will be left without a job. At the same time, Alex's wife is tired of her husband’s absence in her personal life, so she decides to leave him. Anyway, the story's beginning turned out to be very dramatic, and I wondered how Alex would cope with all this.

Luckily, in this stressful time, he meets his former physics teacher Jonah, who now consults companies regarding efficient production. Alex tells his old acquaintance about what’s going on and how he managed to increase labor productivity at the enterprise after purchasing new robots. However, the losses continue to hang over his head like the sword of Damocles.

After listening to Alex's story, Jonah wisely suggests that the problem with his enterprise lies in the management is concerned about anything but the main goal of their business, which is creating money or profit. Jonah explains to Alex that all management ideas related to expanding the sales market, using new technologies, or improving product quality can lead the company to a disaster if fundamental things are not considered. In his opinion, management should only focus on three indicators:

— Throughput, which is the rate at which a company makes money through sales.
— Inventory, which is all the money invested by the company in assets: premises, equipment, patents, raw materials, etc.: that is, in something that can then be sold.
— Operational expenses, which are all the money a company spends turning investments into cash, or something that can’t be sold, such as the salary of employees, the cost of rent, payment for delivery services, etc.

Thus, the management’s job is to make improvements that will ultimately lead to an increase in Throughput and a decrease in Inventory and Operational expenses.

For example, Alex’s purchase of robots to increase the number of products produced has led to an increase in production. However, suppose you look at it through the prism proposed by Jonah. In that case, we actually have the following picture: Inventory has increased, Operational expenses have not decreased (no one has been fired), and the robots can’t contribute to sales growth in any way (the Throughput is not increasing). As a result, this was not an improvement, but a deterioration.

The accumulation of such bad decisions eventually leads to the unprofitability of the company. Conversely, continuous improvements that will increase the Throughput and reduce Inventory and Operational expenses will inevitably lead to achieving the main goal – making money.

After I got home, I tried to find this book on the Internet. It turned out that it was written by physicist and philosopher Eliyahu M. Goldratt back in 1984. The novel is called The Goal.

That’s when I realized that if the company's management adheres to the approach described by Goldratt, then after a while, we will most likely see a fundamentally strong company. And the Fundamental Strength Indicator clearly shows how much the management has succeeded along this path.

For example, according to Goldratt, an increase in Throughput should lead to an increase in Earnings per share (EPS) and Total revenue. The reduction in Inventory may be linked with a decrease in Inventory to revenue ratio. Optimization of Operational expenses will definitely reduce the Operating expense ratio. All these parameters are considered when calculating the Fundamental Strength of the company.

So, let's move on to the methodology for calculating the Fundamental Strength Indicator.
The main idea that inspired me to create this indicator is: "Even if you buy just 1 share of a company, treat it like buying the whole business". Guided by this approach, you can imagine what kind of business an investor is interested in owning and simultaneously determine the input parameters for calculating the indicator.

For me, a benchmark business is:

— A business that operates efficiently without diminishing the return on shareholders' investment. To assess the efficiency and profitability of a business, I use the following financial ratios(*): Diluted EPS and Return on Equity (ROE). The first two parameters for calculating the indicator are there.
— A business that scales sales and optimizes its costs. From this perspective, the following financial ratios are suitable: Gross margin, Operating expense ratio, and Total revenue. Plus three other metrics.
— A business that turns goods/services into cash quickly and does not fall behind on payments to suppliers. The following financial ratios will fit here: Days payable, Days sales outstanding, and Inventory to revenue ratio. These are three more metrics.
— A business that does not resort to significant accounts payable and shows financial strength. Here I use the following financial ratios: Current ratio, Interest coverage, and Debt to revenue ratio. These are the last three parameters.

(*) If you are keen to learn more about these financial ratios, I suggest reading my two articles on TradingView:
Financial ratios: digesting them together
What can financial ratios tell us?

Next, each of the parameters is assigned a certain number of points based on its last value or the position of that value relative to the annual maximum and minimum.
For example, if the Current ratio:

— greater than or equal to 2 (+1 point);
— less than or equal to 1 (-1 point);
— more than 1 but less than 2 (0 points).

Or for example, if Diluted EPS:

— near or above the annual high (+2 points);
— near the annual minimum and below (-2 points);
— between the annual maximum and minimum (0 points).

And so on with each of the parameters. As a result, the maximum number of points a company can score is 15 points. The minimum number of points a company can score is -15 points. These levels are marked with horizontal dotted lines: the green line is for the maximum value, and the red line is for the minimum.



I track the number of points for each day of a company's life on a three-color Histogram. The resulting average value for the last year is on the Blue Line. For me, it is the last value of the Blue Line that determines: this is the actual Fundamental Strength of the company.

As an additional filter, for example, when comparing two companies where all other conditions are equal: I use the dynamics of Cash Flows expressed in Diluted net income. These are the thick green, orange, and red lines over the Histogram.

Examples:

Below, I will evaluate various companies using the Fundamental Strength Indicator.

Tesla, Inc.


The indicator shows that since 2020, Tesla Inc. has been steadily increasing its Fundamental Strength (from 3.27 in Q1 2020 to 12.79 in Q1 2023). This is noticeable both by the color change of the Histogram from orange to green and by the rising Blue Line. If you look in detail at what has been happening with the financials during this time, it's clear what meaningful work the company has done. Revenues have almost quadrupled. Earnings per share have increased 134 times. At the same time, Total debt to revenue fell almost 10 times.



Keurig Dr Pepper Inc.


The company, formed in 2018 by the merger of Keurig Green Mountain and Dr Pepper Snapple Group, has failed to deliver outstanding financial results, causing its Fundamental Strength to fall from 4.63 in Q1 2018 to -0.53 in Q1 2023. During this period, the decline in diluted earnings per share was accompanied by higher debt and deteriorating liquidity.



Costco Wholesale Corporation


Wholesaler Costco has been surprisingly stable in its financial performance and with steady growth in both earnings and revenue. This is the reason the Histogram bars are exceptionally green throughout the calculation of the indicator. The Fundamental Strength has not changed in three years and is high at 11 points.



Part 3: Company Cash Flow Dynamics

The other day I came across an interesting article about the work of the Swiss company Glencore International AG in the 1990s. This company specializes in trading raw materials, and at that time it was actively trading with the countries that had left the USSR. None of those countries had foreign currency, and trust in local currencies had not yet appeared, so it was necessary to exchange commodities for commodities like in the Middle Ages. For example, to sell copper in Kazakhstan, a Swiss company bought raw sugar in Brazil, then took it to Ukraine for refining, then the refined sugar was exchanged for Siberian oil in Russia, then the oil was exchanged for copper ore in Mongolia, which was then sent to a plant in Kazakhstan to create copper suitable for sale on the world market. As we can see, money was used here only at the moment of purchase of raw sugar and sale of copper, the rest of the chain of transactions was an exchange of goods for goods. It turns out the following scheme:

Money - Raw sugar - Refined sugar - Oil - Copper ore - Copper - Money'

Of course, all of this made sense when Money' (with a stroke) equaled big money. Otherwise, the cost of preparing and executing such a complex transaction simply wouldn't have paid off.

This example once again convinced me how significant a role money plays in any company's operations. Can you imagine the chaos that a business can become without money and having to make up similar supply chains? Money simplifies and accelerates all processes in a company, so competent management of these flows is the basis of an effective business.

If you compare a company to a living organism, Cash Flow(*) is its circulatory system. It is thanks to this system that the company is supplied with everything it needs to produce goods or services.

(*) If you are keen to learn more about Cash Flows, I suggest reading my two articles on TradingView:
Cash flow statement or Three great rivers
Cash flow vibrations

Considering that cash flows play a fundamental role in the activity of any company, it is reasonable to assume that their analysis will give us the necessary information to decide.

For this reason, an additional parameter was added to the Fundamental Strength Indicator: the dynamics of Cash Flows expressed in Diluted net income(*).

(*) Since the value of income can be negative, the Diluted net income module is taken, that is, without the "minus" sign.

Why do I use income as a unit of measure of Cash Flows? Because it is a good way to make the scale of indicator values the same for companies from different countries, with different currencies. It also allows you to use a single value scale for both Cash Flows and Fundamental Strength.

So, let's take a look at how the dynamics of Cash Flows look like in the Fundamental Strength Indicator. These are three lines of different colors, which are located over the Histogram. Each of the flows corresponds to a specific color:

— Operating cash flow: green line;
— Investing cash flow: orange line;
— Financing cash flow: red line.

In this way, I can track the dynamics of the company's Cash Flow over time.



To interpret the dynamics of Cash Flows, I pay attention to the following patterns:

— How the cash flows are positioned in relation to each other;
— In which zone each of the cash flows is located: in the positive or negative;
— What is the trend of each of the cash flows;
— How volatile each of the cash flows is.

As an example, let's look at several companies to interpret the dynamics of their Cash Flows.

John B. Sanfilippo & Son, Inc.


This is the most ideal situation for me: operating cash flow (green line) is above the other cash flows, investment cash flow (orange line) is near zero and practically unchanged, and financial cash flow (red line) is consistently below zero. This picture shows that the company lives off its operating cash flow, does not increase its debt, does not spend a substantial amount of money on expensive purchases, and retains (does not sell off) assets.

Parker Hannifin Corporation


With stable operating cash flow (green line), the company implements investment programs by raising additional funding. This is noticeable due to an increase in financial cash flow (red line) and a simultaneous decrease in investment cash flow (orange line) with a significant deepening into negative areas. Apparently, there is not enough operating cash flow to realize the planned investments. One has to wonder how sustainable a company can be if it invests in its development using borrowed funds.

Schlumberger N. V.


The chaotic intertwining of cash flows outside the Fundamental Strength range (-15 to 15) is indicative of the company's rich life, but to me, it is an indicator of high riskiness of its actions. And as we can see, Fundamental Strength has only begun to strengthen in the last year, when the external appearance of cash flow has normalized.

Thus, when the Fundamental Strength of two companies is equally good, I use an additional filter in the form of Cash Flow dynamics. This helps me to clarify my interest in this or that company.

What is the value of the Fundamental Strength Indicator:
— allows for a quantitative assessment of a company's financial performance in points (from -15 to 15 points);
— allows you to visually track how the company's financial performance has changed (positively/negatively) over time;
— allows to visually trace the movement of main cash flows over time;
— accelerates the process of selecting companies for your shortlist (if you are focused on financial results when selecting companies);
— allows you to protect yourself from investing in companies with weak and mediocre fundamentals.

Mandatory requirements for using the indicator:
— works only on a daily timeframe;
— only applies to shares of public companies;
— company financial statements for the last 4 quarters and more are required;
— it is necessary to have the data from the Balance sheet, Income statement, and Cash flow statement, required for the calculation.

If at least one component required for calculating the Fundamental Strength is missing, the message "no data to calculate the Fundamental Strength correctly" is displayed. In the same case, but for the operating cash flow, the message "no data to calculate the Operating Cash Flow correctly" is shown, and similarly for other flows.



Risk disclaimer:
When working with the Fundamental Strength Indicator and the additional filter in the form of Cash Flows, you should understand that the publication of the Balance sheet, Income statement, and Cash flow statement takes place sometime after the end of the financial quarter. This means that new relevant data for the calculation will only appear after the publication of the new statements. In this regard, there may be a significant change in the values of the Indicator after the publication of new statements. The magnitude of this change will depend both on the content of the new statements and on the number of days between the end of the financial quarter and the publication date of the statements. Until the date of publication of the new statements, the latest relevant data will be used for calculations.

I would like to draw your attention to the fact that the calculation of Fundamental Strength and Cash Flows requires the availability of data for all parameters of the valuation model. It uses data that is exclusively available on TradingView (there is no reconciliation with other sources). If at least one parameter is missing, I switch to another company's analysis to continue using the indicator.

Thus, the Fundamental Strength Indicator and an additional filter in the form of Cash Flows make it possible to evaluate the financial results of the company based on the available data and the methodology I created. A simple visualization in the form of a three-color Histogram, a Blue line, and three thick Cash Flow lines significantly reduces the time for selecting fundamentally strong companies that fit the criteria of the selected model. However, this Indicator and/or its description and/or examples cannot be used as the sole reason for buying or selling stocks or for any other action or inaction related to stocks.