A Review Of Fundamental Analysis for Covered Call Writing

Fundamental analysis is our first step in evaluating securities for use in the covered call writing strategy. It is a method of evaluating a company’s stock by examining its financial statements, including earnings and sales. The 3 major financial statements are the medium by which a company discloses its financial health. We only accept equities with strong earnings and sales growth because these are the type of companies favored by the institutional investors (mutual funds, hedge funds, banks and insurance companies).

Major financial statements

The major screens we use for fundamental analysis are the IBD 50, the IBD SmartSelect and the Money Central’s Scouter screens. The financial aspects of these screens are gleaned from the information found within the 3 major financial statements provided by the corresponding companies:

• Balance sheet
• Income statement
• Statement of cash flows

It is not necessary for us to study these statements but it is instructive to note where the information is originating from. In the US, 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. The 10-K (annual) and 10-Q (quarterly) are the most well-known.

Ratio valuation

We have all heard of PE ratios and price-to-book ratios. These are two of many financial ratios which are mathematical calculations using figures taken from the financial statements and they are used to gain an idea of a company’s value and financial performance. Ratios will give more meaning and perspective to data points in the financial statements. For example, if 2 companies each had earnings of $1 million last year but one had a previous year’s earnings of $500,000 and the other of $2 million, wouldn’t the first company with growing earnings be worth more than the second?

Let’s use a football analogy since the pre-season is upon us. If 2 NFL quarterbacks each threw for 15 touchdowns last year, are they the same? What if quarterback A also had 15 interceptions while B had only 5? B is now looking a lot better. What if B had a completion percentage of 60% while A had one of 45%? B is definitely our man. By comparing multiple data points, the individual stats are made more meaningful.

What Fundamentals does the BCI System Utilize?

It considers plenty, although it doesn’t take us all that long to calculate. First, let’s look at the IBD 50 stocks and the fundamentals evaluated:

• Return on Equity
• Earnings per Share rating
• Annual EPS % change
• Last Quarter EPS % change
• Next Quarter EPS % change
• Last Quarter Sales % change

In addition, we run the stocks through the SmartSelect (Green Alert) ratings. The “EPS Rating” compares a company’s earnings per share growth on both a current and annual basis with other publicly traded companies. It compares the company’s most recent two quarters of EPS growth with its 3-5 year annual growth rate.

Furthermore, the Scouter Rating factors in many of the fundamental qualities of equities that have proven statistically to be predictive of stock performance in the past. In other words, we have all bases covered when it comes to fundamental ratios and analysis.

Scouter rating and fundamental analysis

Conclusion

Although fundamental analysis is only the first step in screening for outstanding covered call writing candidates, it is a critical one. This is because companies with strong financial statements and ensuing positive ratio valuations are favored by the institutional investors and that dramatically improves our chances for a favorable outcome. See Chapter 3 in Encyclopedia… for more details of fundamental analysis.

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Market tone:

Positive economic reports this week have some economists upgrading expected GDP. Here are the reported results:

• Consumer credit (a report of the dollar value of consumer debt, including categories such as credit card use and store charge accounts, known as revolving debt,  as well as longer-term loans for autos, education, recreation vehicles, etc. , known as nonrevolving debt. The level of consumer credit is considered a barometer of consumers’ financial health and an indicator of potential spending patterns) rose in June by $13.8 billion due to demand for car and student loans
• The US trade deficit decreased in June to $34.2 billion, well below the $43.5 billion expected. This was the lowest stat since October, 2009 and a significant sign for increased demand for American-produced products and an increase in domestic oil production
• Exports rose 2.2% from May, the largest increase since September, 2012
• Imports declined by 2.5% causing the trade gap (a report of the difference between the dollar value of exports and imports. Foreign trade is an important component of aggregate economic activity, representing a significant portion of gross domestic product. Also, the level of
  exports is an indicator of the global competitiveness of U.S. industries) to decline by 22.4%
• The ISM Non-Manufacturing Index rose to 56.0 in July well above the 53.0 anticipated, the 43rd monthly increase
• Initial jobless claims for the week ending August 3rd came in at 333,000, slightly below the 336,000 expected

For the week, the S&P 500 declined by 1.1% for a year-to-date return of 20%, including dividends.

Summary:

IBD: Uptrend under pressure

BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1

I hope you’re having an enjoyable summer and look forward to meeting many of you as I travel the country presenting my seminars. Thanks so much for your continued support.

My best to all,

Alan ([email protected])

www.thebluecollarinvestor.com