This post was originally published here.
Investors use a number of techniques to evaluate stocks before making a trade or long-term investment decision. The two core techniques used can broadly be divided into fundamental analysis and technical analysis. Both paths use different methodologies to try to predict movements in the market, and both can be quite valuable for helping investors to make decisions.
What Is Fundamental Analysis?
Fundamental analysis focuses on a company’s financial and market position, growth prospects, and financial performance. The concept considers all the economic factors involved in equity valuation. It looks at both financial statements and the company’s market position and the political or economic climate to help investors make long-term decisions. Usually, stocks are bought when a price falls below the share’s estimated intrinsic value, and then it is held for a longer time.
Fundamental analysis tends to move a little more slowly and concentrates on a company’s financial indicators and can utilize relative valuation such as Price/Earnings ratio (PE ratio) and/or absolute valuation such as free cash flow. It is invaluable for someone who is looking for a longer-term investment and is not worried so much about short-term market movements.
Fundamental analysis works in accordance with the investing technique of having a margin of safety. The idea is to buy a stock when it is worth more than its price on the market For fundamental analysis, for example, you might come up with an intrinsic value of 100. Which doesn’t mean you would buy the stock at 98 or 99. If you have decided to use a margin of safety of 15%, you would only buy the stock at 85 or below.
Fundamental analysis works off two central assumptions:
- The price of a given stock will eventually correct to its intrinsic value.
- Buying an undervalued stock and holding it for long enough should earn returns as the share price converges to its intrinsic value.
Hence, why fundamental analysis is popular with investors who employ the buy and hold value philosophy.
What Is Technical Analysis?
Technical analysis is a more short-term approach to investing. The concept analyzes charts, past stock pricing and volume data, and examines historical data to find patterns in an attempt to predict future trends. It is the analysis of a company’s technical indicators such as price movements and trading volume metrics, a business’s strength relative to its peers in the same sector/overall market, and other similar indices. Technical analysis is used for short-term trading rather than long-term investing and applies concepts such as the Dow Theory and trend following to determine what to buy and sell.
In technical analysis, there are three golden rules according to consensus in the market:
Rule 1: Stock prices reflect everything that has and might affect a company. All the information an investor needs is reflected in the market price.
Rule 2: Movements in pricing are not random. Stock prices move in trends, don’t fight them.
Rule 3: Price patterns always repeat—given enough time. The repetitive nature of price movements is down to market psychology: Investors are consistent in their reactions.
Investing vs. Trading
Many people make money in the stock market—otherwise, it wouldn’t be as popular as it is! Some make money by trading, and some by investing. Warren Buffett, for example, is an investing icon renowned for making billions thanks to long-term strategic investments. Buffett buys companies and holds onto their stock, sometimes for decades. He believes in taking a slow, steady long-term view. He even buys when others are too fearful e.g., in market downturns (assuming that his fundamental analysis suggested the purchase makes sense) and he patiently waits for the right time to sell.
Buffett’s wealth building strategy works in sharp contrast to legendary hedge-fund manager George Soros, who has also made billions but through trading and technical analysis. Soros has made several fortunes by taking advantage of the constant state of flux in the markets.
If you are a novice or long-term investor, then it’s a good idea to focus on fundamentals first. Investors that are interested in growth and value should consider whether the current price of a stock makes sense when examining the health and prospects of the company that they are evaluating.
Growth investors place a lot of emphasis on whether a company is going to be able to thrive and grow. It is not unusual for businesses to struggle in its early days, but if a company that is not profitable early on is still able to show growth in revenue, then that can often be enough to attract investors who believe that substantial profits are on the horizon long-term. Those investors may hope to see a scenario where the company breaks through those teething stages and thrives to become hugely profitable. Growth investors may be willing to hold for a long time, and as such fundamental analysis make sense for them.
Fundamentals are influential for value investors too, but the prevailing market condition will also play a significant role. The stock in question should be available in the market at a reasonable price (i.e., its PE ratio and the price-to-book value should be favorable). Value investing is about buying stocks when they’re undervalued (to the estimate of the true/intrinsic value) and using a margin of safety to that value. Value investors are interested in the past and current performance of a stock, and whether the fundamentals are sound.
So who looks at technicals? Well, once investors have found stocks that look appealing, technical analysis can help them to decide if the short-term trades being considered will work out in their favor. Technical analysis includes stock screening, charting, and examines moving averages and stochastic oscillators to give an idea of where a price is relative to its price range over a chosen period. If a stock is trading in a range which shows that the stochastics have moved into ‘overbought’ or ‘oversold’, then it can be seen as a sign of a potential price reversal on the horizon. Many investors use these as market signals for when to make trades.
When to Use Each Technique
Use fundamental analysis if you have a long investment horizon and you want to determine the intrinsic value of a stock. Use technical analysis for short-term market decisions when you want to decide whether this is the right time to buy or sell a position based on both current and past trends.
Both Techniques Have Value
If you are a short-term trader, then technical analysis, combined with stop losses and take profit orders can help you make informed decisions. If you’re a long-term investor, then basing your decisions on fundamentals, and ignoring short-term blips that drive those technical trades should serve you well.
Stock selection doesn’t have to be a minefield, but it is crucial to be flexible and open-minded. Avoid becoming emotionally attached to any one stock or sector. Base your equity valuations on knowledge and logic, rather than gut feeling, and try to stay disciplined. Even the best traders make bad trades, but those trades do not have to lead to disaster if you manage the risk in your portfolio and bankroll well.
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