Defining the Fundamentals— What You Need
Most investors depend on financial information to judge companies. And why not? Dollars are how business keeps score, judges success, forecasts the future, and determines who is outperforming the competition. Fundamental analysis is the method of choice because it provides dependable, consistent information.
What can you expect from fundamental tests and why perform analysis at all? These questions are good starting points because they establish the very reasons to undertake analysis. Fundamental tests, more than anything else, provide a means for comparison. We can make judgments only by comparing one thing to another. We don't know what our preferences are until we loo
k at two or more alternatives. This is as true in the stock market as it is everywhere else. Fundamental tests are a consistent application of standards to several companies. We hope the results of those tests will guide us in our decisions to select one stock over another; and then to buy, hold, or sell.
But why perform analysis at all? Why not simply choose stocks by throwing darts at the stock listings? Some people make an argument that random selection of stocks is as effective a method as any other. The random walk theory, for example, says stock prices change in a random and unpredictable manner, and that the effect of new information on market prices cannot be predicted with any degree of certainty.
Anyone who seriously approaches investing has to question the wisdom of the random walk theory. It just makes sense that studying fundamental, intrinsic information about a company leads to an intelligent stock selection, while the failure to perform research may result in bad choices—a loss of money. Most people agree that doing research is better than not doing research.
A second theory concerning the market is the efficient market theory, which states that the current price of a stock reflects all known information about the company. The theory also states that as new information becomes known, it is factored into the stock`s price immediately. This theory assumes that some group—presumably the market as a whole—keeps track of information and immediately raises or lowers its estimation of market value. In reality, most people know that the stock market has a degree of chaos to it, and that such efficiency is suspect and unlikely.
Two more likely reactions to new information are to completely discount the information, thus not affecting the stock's market price, or to temporarily overreact, greatly affecting the price.
It is easy to theorize about market forces, supply and demand, and the psychological nature of the typical investor—all without really knowing how the market works. Such is the nature of any theory. If it were possible to know precisely how the market works, it might be easier to know how to pick stocks. Because prices change, often without obvious cause and effect, a degree of excitement surrounds stock market investing. That excitement makes it easy to fall into belief systems that have no basis in fact. It is important to remember, though, that the market prices of stocks reflect a perception of value rather than a reaction to any new logical or fundamentally based information.
Defining Fundamental Analysis
Fundamental analysis is a method of research that studies basic financial information to forecast profits, supply and demand, industry strength, management ability, and other intrinsic matters affecting a stock's market value and growth potential. The resulting information can help you maintain perspective. Certainly some aspects of price movement in the stock market are beyond logic, and baffling to anyone with a logical mind. The fundamentals—those intrinsic facts about a company—can be used to forecast financial performance and, to some degree, stock price movements. More investors use fundamentals than other methods. Nonfundamental methods are collectively known as technical analysis. The dedicated technical analyst (or "technician") shuns fundamentals, often on the premise that financial reporting is merely historical, yesterday's old information, and by its very nature, of no use. Accordingly, such information has nothing to do with how a stock's market price will move tomorrow or the next day.
Both fundamental and technical analysis use trends, but in different ways. The fundamental approach employs historical information (dividend rates, profits, or sales, for example) to forecast financial results. Technicians use trends. Technical analysis is highly visual and largely ignores the basic premise of supply and demand, believing instead that recent price trends (shown as charts) dictate future price movement. Essential to the charting theory is the idea of support level and resistance level. These levels are derived from a study of a stock's recent price changes. When the price moves below the support level (the lowest expected price) or above the resistance level (the highest expected price), that_is_called a breakout; that is, a price movement outside the established range. The concepts of support and resistance levels and breakou are summarized in Figure 1.1.
Even those who swear by the fundamentals should recognize that technical analysis serves a useful purpose. But not even the most faithful of number crunchers can ignore that widespread belief in a fundamental indicator that can move market prices far above or below intrinsic values. Such technical analysis and the resulting indicators, however, are only short-term in nature. Fundamental analysis can be a valuable tool if used as research for long-term prospects, but not for tracking day-to-day stock price movement, market reaction to news or rumor, and temporary popularity of one industry group over another.
FIGURE 1.1 Trading Range
KEY POINT
Most of the financial news we get emphasizes short-term opinion and trends. Long-term information is more valuable but harder to come by.
Successful investors must consider the long term, and that is where fundamental analysis is valuable. Even the most serious investors tend to listen to current gossip and news, though they have no intention of abandoning a well-structured long-term strategy. The market is in many respects a huge gossip mill, and those involved in it love to whisper and spread stories and rumors. Such behavior is emotional, not rational. This is important to keep in mind when attempting to place some logical value on most of the news you hear.
As a believer in fundamental analysis and its value, you must believe that you can make decisions in a rational, logical manner. If you have a strong bias against or for a particular company or industry, the value of fundamental analysis is already compromised. Information should be given the appropriate consideration based on its merits, without regard for the bias that we all bring to the process. Avoiding our biases is a valuable practice and not necessarily an easy one. You may begin by setting as a rule that you are seeking valid information, not attempting to confirm a bias. Otherwise, any form nf research is a waste of time. You may as well invest based on preconceived ideas and take your chances in the market, which is not at all uncommon. However, a bias is likely to impede success (i.e.., profit) rather than add to it. So a first assumption about fundamental analysis has to be that if you will use it, you need to remain objective.
A second assumption, of equal importance, must be that you can analyze and research as well as anyone else. You have no doubt experienced an attitude that professionals such as mutual fund and portfolio managers have more information than the rest of us, and that they know how to beat the averages. This attitude is promoted primarily by professionals. In fact, in one extensive study, only about 22 percent beat "average."
Also remember that the main emphasis in the financial news is on short-term thinking, but that is not where the profits are to be made. Experts like to predict where the Dow Jones Industrials will be in six months or a year-but this provides no valuable information to serious investors.
KEY POINT
Long-term investing in the stock market produces profits. Short-term predictions may be interesting today, but they are of no informational value for long-term portfolio decisions.
To begin looking at fundamental analysis as a tool for getting useful information, you must recognize the limitations of short-term fads, predictions, and odds-beating games; and accept the premise that the market rewards investors over time. This reward is why the stock market is popular. Successful shareholders make the most money when they leave their investment capital in the market. Betting on the short term, following the crowd and its herd mentality, and listening to pundits who are only guessing, will never take the place of a sound, long-term strategy for rational, intelligent study and research.
You may ask, if short-term guessing is proven to be of no value, and if professionals consistently fail to beat the market average, then what good does it do to study financial statements? In other words, what do yesterday's results tell us about investments that will be "good" or "bad" tomorrow?
The answer is not a question of whether you will make a profit within a few weeks of buying 100 shares of stock; that is short-term thinking. Any stockbroker can readily list 10 or 20_well-managed blue chip companies whose long-term prospects are excellent, whose stock will probably rise, and whose dividend payments will no doubt remain competitive. The real value of fundamental analysis is comparative in narrowing the list of possible investments. By comparing financial information among several corporations, you can judge relative value, and make your own judgment about potential profits.
Many investors choose mutual funds because you can then invest in a number of companies or industries. Only with a vast sum of pooled capital can you invest in all of the companies you like, and thus achieve the advantage of diversification at the same time.
When you have identified a number of "good" choices - well-managed companies in strong competitive positions, with plenty of capital, good management, a long-standing reputation, and other market strengths—you may question the value in performing the analysis at all. Why not simply pick one of those well-rated companies? This is, by the way, precisely the method used by thousands of investors.
One of the principal advantages of studying the numbers is that it enables you to identify stocks that are currently undervalued by the market, those that may represent a buying opportunity with long-term potential. On the other hand, if you own stocks that are overvalued by the market, that may be a signal that it's time to sell.
These criteria may sound like short-term judgment calls, but remember that long-term decisions ultimately consist of monitoring and acting on short-term information. At some point, a long-held stock wears out its promise and becomes less attractive. With fundamental analysis, you can monitor your portfolio to know when to sell or hold. The decision to buy is often given great emphasis, but it represents only the first step in maintaining your portfolio. To succeed as an investor, you don't want to make any decisions haphazardly, including the decision to do nothing. Investors must monitor their portfolios constantly, so they can know if and when yesterday's strategies no longer apply.
Example: You purchased 300 shares of stock in a promising new technology company nearly ten years ago. At the time, the stock was selling for $1.25 per share. The stock has been valued at $15 per share for more than a year. The latest annual report seems to suggest that the company has reached a threshold in terms of size—number of employees, annual sales, profits—that it is unable to exceed. The various techniques you employ in watching fundamental trends tells you that this investment has topped out.
In this example, you were able to change a "hold" decision—the default position—to a "sell" decision based on trend analysis. The topping out effect—common for companies that are through growing—is not a negative in the same respect that net losses or loss of position in an industry would be. It is simply a sign that you have gotten all you can expect from that particular investment. The example applies not only to small stocks in initial growth phases, but equally well to large companies with long standing in the market, such as IBM or Navistar.
Rates of growth, degree of expansion, and capital limitations are some of the variables in fundamental analysis. You can judge these matters only by comparing companies' current and past financial records. This is where the intrinsic value of fundamental analysis outshines any technical indicators. Numbers do not lie. If a trend slows, stops, and reverses itself, the numbers are reflecting exactly what happened in recent weeks or months. Don't become caught up in the popular notion that the near future can be predicted by index levels or popular stocks. Only by performing focused fundamental analyses of real financial results is it possible to see short-term as well as long-term trends.
We tend to think of financial information as being scientific and pure. Based on the numbers alone, a case could be made that fundamental analysis is the science of market research. Unfortunately, fundamental analysis cannot be given a complete bill of health because the human element enters the picture. The professional analyst tends to make the waters murky in the same way that trendy analysis clouds the issue of current market health.
Example: One company has earned more than 9 percent net profit during the past three years, even though it only forecast an 8 percent annual profit. In the most recently ended year, the analysts predicted another 9 percent return; however, actual results came out at 8 percent.
This all too common example makes a point about the flaw in the use of fundamental analysis. Humans cannot resist the urge to make predictions. The 8 percent return, because it is lower than the expert forecast, would be seen as a negative and a short-term reduction in market value would result—even though the actual rate of net return is excellent.
KEY POINT
Positive or negative predictions are reflections of market perception rather than of real financial facts.
A company's stock rises or falls on a report that is at variance with a prediction. What is lost in all of this is the real meaning of the results. If a company can be reasonably expected to net 8 percent and the analysts predict 10 percent, then a 9 percent return will probably cause a negative reaction. Remember, the market reacts illogically, almost always overreacting to news.
KEY POINT
The tendency of the market to overreact gives you a great advantage. By adhering to the fundamentals and resisting the temptation to follow short-term trends, you are able to keep your head while others do not.
The analysts may see the example as a disappointing result compared to the past, and issue a negative report. The market would react negatively as well. In the minds of the analyst, less is always worse, and more is always better. In the real world, one needs to take a close look at real results in real markets.
