Fundamental and Technical Analysis
The pros and cons of two diverse investing approaches.
My major in college was Finance, where I learned how to analyze stocks from a fundamental point of view. I’m still mostly a fundamental analyst, but in recent years, I have begun incorporating some technical analysis into my stock research. And having interviewed many financial pros through my work with the Money Show, I’ve discovered that most analysts—especially those that hold stocks, rather than trade them—use a combination of both types of analyses.
Let’s compare these two diverse schools of thought.
Fundamental analysis focuses on the company, as well as sector, market and economic events. It attempts to analyze the company’s future prospects and estimate the value of its shares, based on a wide variety of factors, including historical and forecasted financial ratios, competition, company management, prospects for its industry and the current as well as future economic developments.
On the other hand, technical analysis doesn’t give two cents about the value of a company, its financial characteristics or who runs it. Instead, technical analysts simply focus on supply and demand in the market to determine what direction, or trend, prices will continue in the future.
Both fundamental and technical analysts have conducted elaborate studies to prove that they alone are the only methodology for successful investing. Each school of thought has reams of data illustrating their success. But we’re not taking sides here. In my opinion, each type of analysis has its advantages and disadvantages. My purpose here is to just introduce the basic concepts of both fundamental and technical analysis to you.
Graham and Buffett—Legendary Value/Fundamental Investors
The most famous fundamental or “value” analyst is—hands down—Warren Buffett. He learned about investing from his Columbia University teacher, Benjamin Graham, the father of security analysis.
In 1934, at merely 40 years of age, Benjamin Graham (with his colleague, David Dodd) co-authored Security Analysis, the primer for Value Investing. Many editions later, the book has become the bible of security analysts nationwide.
Graham felt that too many investors were speculators, buying or selling simply because a stock or the market went up or down, investing in “hot” stocks, and margin buying—all trends of the era in which he grew up. He saw—with his own eyes—the debacle of the ’29 crash, the bank closings, and the utter loss of confidence in Wall Street. He knew that investors had lost sight of the reason that the stock market was established: to fund corporate expansion. He decided that to restore confidence, investors would have to change their thinking, and advised that, “If an investor wanted to enjoy a reasonable chance for continued better-than-average results, he must follow policies which are inherently sound and promising and are not popular on Wall Street.”
His definition of an investment: “Upon thorough analysis, an investment promises safety of principal and an adequate return.” Anything else was mere speculation.
In other words, Graham proposed that the foundation of sound investing should not change with the whims of trends or the winds of time, but should be altered only as a result of important economic and financial changes. Such events might include changes in interest rates, inflation, the trend toward conglomerization of corporations, or significant bankruptcies—all occurrences which might alter the way a stock is to be valued. That’s quite a different train of thought than what was then espoused by the “professionals.” You might imagine how popular that advice was with the Wall Street crowd!
Graham further stood the investment community on its head when he stated that “the rate of return should not depend on the old and sound principle that it should be more or less proportionate to the degree of risk an investor is ready to run. Instead, it should be dependent on the amount of intelligent effort the investor is willing and able to bring to bear on his task.” That was heresy on Wall Street — Graham was actually telling investors they could figure it out for themselves; they didn’t need the pros!
And Graham was most definitely not a market timer. He stated that “the only principle of timing that has ever worked well consistently is to buy common stocks at such times as they are cheap by analysis, and to sell them at such times as they are dear, or at least no longer cheap, by analysis.” In other words: It’s the company that counts, period.
He felt that a good investment should be a company that was worth considerably more than what its stock was selling for. He calculated this “value” of a company by estimating its future earnings as well as taking into account the worth of its assets; in other words, what the value of this business would be to someone interested in buying it.
And even though there were analysts (then as now) building mountains out of molehills with reams of ratios to analyze a single company, Graham felt that just a few—the most important— criteria would do the job.
Graham especially liked to invest in companies whose earnings were reasonably stable, with good growth prospects. Additionally, he required that they be conservatively financed, large companies that paid dividends, with price-earnings ratios of less than 25. And he found legions of such companies—many selling for less than their net working capital (current assets – current liabilities). But for some reason, the stock market and the market pros were underestimating, or undervaluing, the potential of the companies’ earnings, resulting in an “undervalued” stock price.
Graham’s success was legendary. During his most active years—from 1936 to 1956—he consistently posted annual returns of 20% plus, while the S&P 500’s performance ran around 14%.
And his legend lives on in Warren Buffett. While Benjamin Graham introduced Value Investing to the investment community, his student Warren Buffett actually formed a company whose sole purpose is to “value invest.” Buffett is chairman of Berkshire-Hathaway (BRK-B)—a company that is essentially a portfolio of the stocks of businesses he has bought over the past 57 years. And along the way, he has expanded on Graham’s version of Value Investing.
Like Graham, Buffett looks for those companies that are undervalued, in terms of today’s numbers. He certainly looks at future earnings but doesn’t rely solely on them to make a buying decision. He expresses this concept by saying, “Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results.” His secret to Wall Street riches is simple: “You try to be greedy when others are fearful, and you try to be very fearful when others are greedy.” Alternatively stated: Don’t follow the crowd.
Buffett feels that research is the key; nothing beats old-fashioned elbow grease. He disregards “hot tips,” sets his goals and targets for the company at the time he buys the stock, and believes that too much diversification—what he calls the Noah School of Investing, or buying two of everything—is not prudent. In fact, Buffett tends to take rather large positions in the companies that he owns in his Berkshire-Hathaway group, and keeps his portfolio fairly lean, in terms of the number of companies.
That focus on a smaller group of investments led to one additional criterion that Buffett added to Graham’s model and ultimately made his trademark—he believes in really getting to know the companies in which he invests. That means personal visits and conducting ongoing communication with the decision-makers. But Buffett takes that step even further. He also gets to know the company’s customers, suppliers, and its competitors.
Another expansion of Graham’s strategy is Buffett’s addition of qualitative factors to the investment equation. While Graham certainly considered whether or not management was strong, efficient, and cost-conscious and that the company’s products seemed worthwhile, Buffett also looks at more intangible qualities, such as franchise or brand name value. For example, before he bought Disney stock for the first time, he factored in the value of Disney’s huge movie library, which did not show up in Disney’s financial statements at that time.
This led to Buffett changing Graham’s concept of the worth of a business, by adding such intangibles to a company’s book value, which is basically defined as a company’s assets minus its liabilities, or the capital that has gone into a business, plus retained profits. Together, the actual balance sheet figures plus the intangibles add up to the “intrinsic value” of the company.
And lastly, Buffett enlarged Graham’s definition of risk to include the risk of paying more than a business would prove to be worth.
Buffett has often been maligned in the media for his conservative investing practices. In the late ‘60s, he was attacked for staying out of the “hot” electronics sector and retaining his old-line retail stocks. But he had the last laugh then, just as he had during the recent technology boom.
And Buffett has the juice to back up his strategy. Since he took control of Berkshire Hathaway in 1964, the stock has generated 20.9% annualized returns—more than double that of the S&P 500.
As I mentioned earlier, while there are many ratios you could use to evaluate a company, Graham felt you really needed no more than a handful. Certainly, there are sector and industry ratios that will help you better define your analysis, but for the most part—after my three decades in the markets—I agree with Graham.
And now I want to share with you my favorite fundamental analysis ratios.
The 7 Critical Steps to Profitable Investing
You only need to turn on the TV to see gurus and best-selling authors who can’t wait to sell you their latest stock market gimmicks that promise you “instant millions.” Their ‘guaranteed’ technical trading systems, proprietary methodologies, complex economic models, and even some that chart astrological systems, are generally not worth the paper they are written on.
In my years of investing, I have yet to see any of these “systems” consistently beat a good old-fashioned look at a company, its industry and how it relates to the current and projected economic realities.
If a business is fundamentally strong (i.e. it actually makes money), has a diversified product line, and is in a solid position in its market, you are 90% of the way to finding a good investment. The remaining 10% is a matter of looking at a few parameters – no matter what the company does – to determine if it’s the best stock for your investment dollars.
Here, I want to discuss seven key metrics you should review before buying any stock. These indicators should help you get most of the way in understanding a company, its operations, and its underlying business.
1. Institutional activity. Pension funds, mutual funds, hedge funds, insurance companies and corporations that buy and sell huge blocks of shares can create tremendous volatility in prices. To lessen this risk in your investments, try to buy shares in companies where institutions own less than 40% of their shares. You can find this information at http://finance.yahoo.com.
2. Analyst coverage. Another indication of future share volatility is the number of Wall Street analysts covering a stock. Analysts—like the big institutions—have a herd mentality. When one sells, often, so do the rest, resulting in great numbers of shares changing hands, and usually leading to price declines. It’s best to avoid companies with more than 20, or fewer than two analysts following them. (You need some analyst interest, or you may be waiting a long time for price appreciation, even in the strongest and most undervalued company). You can locate the number of analysts at http://finance.yahoo.com; then select Analysis. Many times, the companies in which you are interested will also publish which analysts cover their stock, on their Investor Relations page.
3. Price-earnings ratio (P/E). The price of one share of a company’s stock divided by four quarters of its earnings per share (usually the last four quarters, the trailing P/E ratio), the P/E ratio is of utmost importance in determining if a company’s shares are overvalued or undervalued. For the best perspective, go to https://www.screener.reuters.wallst.com/stock/us/index?quickscreen=gaarp, enter your stock symbol, then select Financials and compare the current P/E of the company to its average P/E for the last 3-5 years, to its estimated future P/E and to the average P/E of its industry or sector.
One note: If a company’s P/E is more than 35, be careful – it might be too pricey. You may want to stick with companies that are trading at lower P/Es, particularly if you are fairly new to investing. Almost any financial website will feature trailing P/E ratios and forward P/E ratios for a given stock. Reuters has almost 50 comparative ratios on its site.
4. Cash flow. One of the most important parts of a financial report is its Statement of Cash Flows, which is a summary of how the company made and spent its money. Go to http://finance.yahoo.com, Financials, then to Cash Flow and select Annual or Quarterly, depending on which period you want to review. Then find Total Cash Flow From Operating Activities, which represents the cash the company took in from its primary business operations. If it sells clothes, it’s the cash collected from selling clothes.
It’s important that this number be positive, or at least trending positive over the course of a year. After all, if the business isn’t making money from its primary product—not from investing in real estate or the stock market—you probably want to pass it by.
5. Debt/equity. This ratio is how much debt per dollar of ownership the business has incurred. Compare the firm’s historic debt/equity ratios, so you can find out if its debt level over the past few years has been rising too rapidly. Debt isn’t bad, as long as it is used as a springboard to grow sales and earnings. Next, contrast the company’s ratio with its competitors and its industry so you can further determine if your company’s debt position is reasonable. These ratios can also be found at https://www.screener.reuters.wallst.com/stock/us/index?quickscreen=gaarp, under the Financials
6. Growing sales and income. A rule of thumb that has always served me well: Buy shares in companies whose sales and net income are growing at double-digit rates. I cannot emphasize this enough, as appreciation in stock prices is generally precipitated by growth in earnings (which usually follows expansion of sales). It’s certainly possible to buy stock in a company that has no earnings growth (a new business, or a tech company in the late ‘90s, for example) and still make money on the shares—short term—but it’s not a formula for serious, successful long-term investing. This ratio can also be found on https://www.reuters.com/finance/stocks/overview, on the Financials
7. Insider activity. Investors will also want to review the buying and selling activities of a company’s insiders—its top officers and directors. A sudden rush to sell large quantities of the firm’s shares may be a good indicator that the business is falling on rough times. Likewise, a large increase in purchases may mean good news is on the way. The website, https://www.nasdaq.com/, under the Insiders tab, lists all the recent insider activity at the company, as well as the number of shares remaining after the sale—an extremely important figure.
I would like to leave you with one last thought on using these indicators: Remember that no one ratio will determine the validity or potential of your investment. It’s of utmost importance that you take a complete look at a company’s financial strength and its future prospects, by conducting a thorough analysis—over time—usually a 3-5-year track record.
With these seven critical factors in hand, it won’t be long before you feel very comfortable in analyzing stocks in almost any industry.
My Favorite Technical Analysis Indicators
There are myriad approaches to technical analysis, including theories such as Elliott Wave, Pivot Analysis, and Candlestick Charting—complex theories that are beyond the scope of our mission here. Suffice it to say, they are all strategies of predicting price movements, but the study of them is best left to more advanced traders.
Instead, I want to introduce you to some of the most widely-used technical indicators that will help you get started in learning about technical analysis.
While technical analysts use many tools, price charts are key, as they will help in searching for patterns of upward and downward trends, as well as overall market and industry sentiment.
Traders use indicators in three ways: To alert, to confirm and to predict price movements. Learning to read them is more of an art than a science. And while there are many high-priced, mechanical trading systems out there that purport to eliminate the human element from trading, most experienced, professional traders still rely on the skills they have honed over decades of trading in good, bad and ugly markets.
Therefore, I am simply going to give you a brief picture of a few of the most used indicators, accompanied by their common interpretation. One thing I’ve found—just as in fundamental analysis—one indicator alone does not an analysis make. With those caveats in mind, following are a few of the basic technical indicators commonly used in technical analysis:
Trendlines are used by traders to determine the direction of the market movement. Prices move in three directions: up, down, and sideways. By looking at historical prices—via plotting a trendline—you can decipher a pattern. Traders see uptrends when their trendline connects a series of successively higher highs and lows, and downtrends when the line connects a series of successively lower highs and lows.
Trendlines connecting the highs can also be drawn to indicate the top of the established trend or channel and indicate the major zones of resistance. Resistance is the price level at which selling is so strong that it prevents the price from rising further. As the price gets closer to resistance, sellers become more inclined to sell and buyers less inclined to buy. When it reaches resistance, the theory is that supply will overshadow demand and prevent the price from breaking through resistance.
Likewise, trendlines connecting the lows create a line of support, the price level at which demand is so strong that it prevents any further price declines. As the shares become cheaper, buyers are more willing to buy, and sellers become less inclined to sell. When the price reaches support, demand overshadows supply and prevents the price from falling below support.
Moving Average (M/A) is an average of the price of a stock over a stated period. That period can be basically whatever you want it to be, but many technical analysts use the shorter periods like 20- and 40-day averages, and fundamental analysts like me prefer longer periods, such as 200-day averages. There are four different types of moving averages: Simple (also referred to as Arithmetic), Exponential, Smoothed and Linear-Weighted. The most common and simple interpretation is this: When the price rises above its moving average, a buy signal is indicated, and when the price falls below its moving average, a sell signal is indicated. (See Figure 19)
Accumulation/Distribution (A/D) is determined by the changes in price and volume. It is used to confirm price changes by measuring the respective volume of sales. When the indicator increases, it means accumulation (buying) of a particular security is related to an upward trend of prices, and vice-versa. Divergences between the Accumulation/Distribution indicator and the price of the security are an indication of a price change. If the indicator is increasing and the price of the stock is falling, traders expect that a turnaround in the price will take place.
You may have heard the term Oscillator, which is an indicator that fluctuates above and below a centerline or between set levels as its value changes over time. Oscillators can remain at extreme levels (overbought or oversold) for extended periods, but they cannot trend for a sustained period. There are several types of oscillators:
Moving Average Convergence/Divergence (MACD) is a centered oscillator that fluctuates above and below zero and indicates the correlation between two moving averages—the difference between a 26-period and 12-period Exponential Moving Average (EMA). The further they move away (diverge) from each other, the higher the reading. Traders use these signals to buy when the indicator bottoms and turns up and sell when the indicator peaks and turns down. The MACD has been most effective in wide-swinging trading markets. (See Figure 20)
Relative Strength Index (RSI) is an oscillator that ranges between 0 and 100. It compares the average price change of the advancing periods with the average change of the declining periods. A reading greater than 70 would be considered overbought and a reading below 30 would be considered oversold. The 14-day, 9-day and 25-day RSI’s are widely used. (See Figure 21)
The Stochastic Oscillator is a momentum indicator that relates the current closing price to the high/low range over a set number of periods. Closing levels that are consistently near the top of the range indicate accumulation (buying pressure) and those near the bottom of the range indicate distribution (selling pressure). Typically, a reading above 80 indicates an overbought condition and a reading below 20 indicates oversold.
This is just a brief overview of a handful of technical indicators used by traders. Believe me, there are scores more! I hope these will serve to whet your appetite, and if nothing else, you may find you can maximize your portfolio performance by employing just a few of them to help you determine optimal buying and selling ranges.
Over time, as you become more experienced, you will, undoubtedly, select your favorite ratios—both fundamental and technical—that work best for your investing style and strategy. Just remember—one indicator doesn’t tell the complete story, so make sure you continue doing your homework, looking at the complete picture, before you make an investment.