Fundamental analysis. Doing your own research. Understanding a stock. What does it all really mean?
This is a topic many people have dedicated their careers to. It’s a passion that has captured the imagination of many investors, with varying results. Solving the puzzle of the markets is a hobby that can pay. The markets can be cruel, but they are always fascinating.
A fundamental approach to investing is about understanding the financial performance, strategy and valuation vs the current price of a company. Where the price is below the fair value, there’s an opportunity to invest and potentially earn an outsized risk-adjusted return. Where the price is above the fair value, investors should avoid the stock.
Technical analysis has a similar goal: identifying opportunities. The approach is completely different though, focusing on chart patterns and key levels such as support and resistance lines or moving averages. I always think of fundamental analysis as strategy and technical analysis as tactics.
But as Sun Tzu wrote in The Art of War: “Tactics without strategy is the noise before defeat.” Before the fundamentalists among you feel too smug, he also said: “Strategy without tactics is the slowest route to victory.” It’s incredible how well this fits the fundamental vs technical relationship.
You can learn some handy technical trading techniques without a huge amount of effort. There are a number of accounts on X (formerly Twitter) that post trading ideas and associated explanations. There are some obscure methodologies and some that just seem like nonsense, but I’ve seen trading ranges and moving averages play out as predicted many times. The logic here is actually quite simple: if enough people believe that a stock will behave in a certain way, then it becomes a self-fulfilling prophecy because those people act accordingly. If R100 is a key support level based on the charts, there will be buyers at that level. Something bad would have to happen to push the company lower.
There are many potential catalysts for a break higher or lower than expected. Positive news, like a buyout offer, is difficult to predict. Negative news such as a tax problem or major customer dispute is even harder to predict, as there are usually no clues before something like this happens. With buyouts, there are at least certain conditions that make one more likely — for example, an existing large shareholder with the firepower to buy out minorities and a share price trading below fair value.
There are those words again: “fair value”. They clearly make an important difference and they have nothing to do with technical analysis, which is all about the price action. Fundamental analysis ignores the share price and looks at the company itself. In the absence of other obvious catalysts, such as the ones mentioned above, the difference between the share price and fair value can often provide an explanation for a breakout around a key technical level.
Fundamental techniques tend to be focused on financial ratios and trends. Basics such as revenue growth, margins and balance sheet ratios are key inputs for calculations of a reasonable earnings multiple based on risk and growth. This is then compared with the multiples that the company is trading on.
Aside from the financial analysis required to estimate the fair value, a really useful technique is to build your own bull and bear cases for the company. This forces you to think critically and consider different arguments, a useful skill when you have already formed a like or dislike for the company in question. It is a special skill to be able to build the opposite case to what you believe is true. In doing so, you can avoid the mistake of putting too much faith in a particular position. Highly concentrated portfolios are lovely when they work out and potentially ruinous when they don’t. Survivorship bias is a real problem when you read about these portfolios.
The financial results are nothing more than the outcome of the company’s strategy. If you put effort into understanding the strategy and the associated benefits and risks, you’ll be a long way down the road towards predicting what the future financial performance might be. Fundamental analysis is about far more than just a set of standard financial ratios that you use in a stock-screening process, or comparing a current multiple with the traded multiple. You need to really dig in.