Trading with Fundamentals
Most traders tend to use technical analysis to pick their entry and exit points when trading, and swear by those methods, but if it were really that good why are there so many variations? More importantly, why do so many technical traders lose money? The answer is quite simply that they are using charts to predict the probable future price movement, based on patterns. Now that is okay but it is only slightly different from a gambler who might say that, based on the fact that there are 36 number cards and 16 face cards (excluding the 10s), there is a 9/13 chance of drawing a numerical card and as such he will place his money on that.
Now that is acceptable if one were to view the accumulation of wealth as a gamble, but for the serious investor and trader, there has got to be a lot more than probabilities. I recall visiting a gambling website on the evening that England were playing Columbia in a recent friendly; as most people know you could place a bet on either team to win or you could wager that the match will end in a draw. Unfortunately, if your forecast were to turn out wrong you lose your money. But that is gambling and as they say: "You pay your money and you take your chances." However, there is an alternative way of making sure, easy and guaranteed money - it just requires a bit of work. In this case, by simply calculating the odds, the astute would have been able to work out that one could have placed bets on all three outcomes simultaneously and made money regardless of the outcome, albeit a return of only 3.5% to 4.8% of the total wagered. But a wise sage once said that nobody ever went broke taking a profit. The reason I use this example is to emphasise the point that even when one is involved in riskier markets/ventures it is still possible to make money with minimal risk.
This is where the fundamental trader comes into his own and, contrary to popular belief, one need not be a genius to be able to grasp and understand the way things work. What is required in any market is to be able to determine the price level at which an instrument is cheap, fair value or expensive. Based on the fact that I choose to trade shares and occasionally the UK and US indices, I will base this article on these instruments, but in truth, the same theories apply across most if not all markets.
Given that shares are a share of a business it stands to reason that as long as the profits keep going up and the cash registers keep ringing; the shares will follow suit. A very crude example is that if I own 10% of the local supermarket and the profits double over the next 5 years, I will expect my original investment to double as well (all things remaining equal).
The value of quoted shares is determined by supply and demand and whenever one or the other moves out of line, the price will end up being too low or too high. How do we determine this?
Let us assume that I am currently looking at the shares of Barclays Bank. I would start by comparing it with other banks such as HSBC, LloydsTSB, Royal Bank Of Scotland and NatWest. If we assume that the average PE ratio (price divided by earnings) of the banking sector is 12, then at any level higher than that Barclays shares are relatively expensive and at any lower level they are relatively cheap. I would now move on to another yardstick, which might be the dividend yield, and we might assume that the average yield of the banking sector is 3.8%. If Barclays shares currently yield 4.2% then they are relatively cheap on a yield basis and if they only yield 3% they are relatively expensive. There are other ratios that might be used like the Return On Capital Employed (ROCE); Book to Sales; Net Asset Value; Earnings Before Interest Tax Depreciation and Amortisation (EBITDA). The last one is, in my opinion, an absolute nonsense and one is better off ignoring it when trying to calculate fair value: it is a legacy of the Dot Com era (and a bad one at that).
If we were to assume that Barclays has a PE ratio of 10 and a yield of 4.2%, then so far so good, the next thing to take into consideration would be the company’s growth prospects. The best thing to do is check the last 3 years results, which might show that it has an average growth rate of 15%. Dividing the PE ratio of 10 by the growth rate of 15 gives a figure of 0.66, this is known as the PEG ratio (any figure below 1 is generally good value).
It seems that I am on to a winner here and the last thing I would need to check before I place the buy order is that the economy is not about to collapse bringing a substantial rise in bad debts. Once I am happy that this will not happen I buy the shares in the knowledge that sooner or later, the market will wake up to the fact that the shares were previously under priced.