Fundamental Analysis Getting Started 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.

The whole procedure above takes less than 30 minutes and a smart 15 year old could perform this basic exercise. The beauty of it is that you would not have lost any money during the Technology bubble. Some people were buying shares that were priced based on the number of times people viewed the website. Hello? Why would I buy a fashion boutique based on the number of people that look at the mannequins through the window? It is all about sales, cash flow, profits and assets. Why would any rational thinking individual pay 1000 times earnings or 100 times sales for a company that has no assets, that was started within the last 12 months and is run by a couple of high school dropouts? The astute were busy snapping up the cyclicals, utilities, mining, banking stocks etc. that were extremely cheap on fundamentals and yielding more than bank deposits. When the music stopped, the technology speculators ended up without chairs (and in some cases they lost their beds as well).

By the time the charts told them the shares were heading for the abyss, it was too late, somewhat akin to trying to flee from a tornado or tidal wave. Ask yourself if you would put your boat out to sea if you knew that this would occur: obviously not. Neither would you head for the ski slopes if you had been told about an impending snowstorm. Fortunately, fundamentals are like the weatherman: you receive advanced warnings of the impending direction of the markets.

Whenever I see shares that are way out of line with their fundamentals I latch onto them and get ready to pull the trigger. It does not always have to be a case of buying (going long), it could be selling (shorting) - one simply reverses the criteria. A good example is Google: the speculators are piling in as if they are the best thing since sliced bread and they are currently priced around $293 per share. Now if I did not consider them good value at $115, $150, $180, $200 or even $250, why would I buy them at $293? I am either a momentum trader along for the ride, a technical trader following the steep gradient on my chart or a fool looking for gold. Before anyone says "But what about the massive profits that could have been obtained?" remember that trading with hindsight is impossible. More importantly, I used to do some work for a bookmaker and he once said, "Son it is not about the winners that you miss but the losers you do not back." These shares are strictly for gamblers and those that have a high pain threshold and in my opinion there are much better trades elsewhere.

Trading based on fundamentals may not be exciting and you are very unlikely to grab any headlines but you certainly will not be parted from all your money. Sure and steady capital growth will be your reward and you will sleep well at night. I often laugh when I hear people say that they cannot leave trades running overnight because their stops might get hit but that is because they are taking on unnecessary risk. (Am I buying shares in BP or Exxon because they are good value or because I believe oil will hit $75 per barrel? Oil reaching those lofty levels should be a bonus). Sound trading based on fundamentals does not require tight stops: whenever they are hit, it means that the analysis was wrong or the company's fundamentals have changed. You take the knock on the chin and move on because there are lots more fish in the sea.

On a final note, one does not require deep pockets to trade in this manner, as one can use spread betting which offers gearing of at least 10:1, CFDs which offer 5:1 or outright stock purchases. Depending on the method used and the number of open positions, it is possible to start and be profitable with as little as £2,500 starting capital (or something in that region). If one is astute it is quite feasible to compound the money and turn it into a large amount of capital.
 
Last edited by a moderator:
LION63, I hear what you're saying but I'm affraid I still disagree with you. There is an edge to be had in the market for trading the investors point of view. This means doing as much analysis (if not more) than what an investor would do.

Anyway, its good to see more articles from members. When is Socrates going to write one and will I be able to understand it!
 
To me charting is metaphysics, whilst fundamentalism is empiricism.

You select the one that suits your mentality.

Whilst a chartist spends time deciphering charts, a fundamenatlist should be busy scuttlebutting. Each takes much labour and both provide a reward for the skilled operator.
 
Tuffty,

You are spot on with regards to trading the investors' point of view which is why I said that extra knowledge and information never harms anyone. I try and gather as much information as possible about a company before, during and after a trade in order to ensure that I leave no stone unturned but I try as much as possible not to let longer term criteria hinder shorter term trades.

An example is that if you wish to trade shares in an auto manufacturer and believe that you will obtain a reasonable return on your investment in the next 2 months or so, you should not be too concerned that the government might introduce road charging in 3 years time.

However, if you feel that on a discounted cash flow basis there is scope for a 50% potential rise in the share price of a company, surely in order to give one the best chance possible of obtaining this, the holding period would be much longer and the amount of analysis would also be substantially higher.

I can assure you that when Socrates writes an article it will be understandable, it might be long and contain lots of detail but it will be digestible. It will probably receive a lot of viewings as well, because the anti Socrates lobby will be out for blood.
 
Simon Gordon,

I beg to differ with your assertion that fundamental and technical analysis can be compared in any way whatsoever, they are two different concepts. Technical analysis is based on probabilities and past events it is a close relation of gambling and hence the high losing percentages obtained in almost all strategies. Granted there are a few individuals that are very very good at it and I have the utmost respect for them and there are a few on these boards but the majority do not know what they are doing and simply chase what seems like fast and easy money. They are looking for pay/reward without labour, it does not exist. How else does one explain the fact that less than 10% make money?

Fundamental analysis is not based on probability or hope, it is based on true/fair value for any given instrument at any given time. Sound analysis does not yield pathetic strike rates of 60% or less but a worse case scenario of 90%. The argument people put forward that it takes longer to close trades is obtuse on the basis that you participate in the market to make money and not to lose it.
 
ducati998 said:
SOCCY,



This while true is invalid as criticism, as within an article, no reasonable expectation can be exercised to be delivered the sum of all knowledge.



Incorrect.
Your description relates to "Fixed Income" or "Bonds"
A "Stock" carries equal expectation of both income and Capital appreciation, unless we move to "Growth Stocks" which may retain earnings, thus limiting the "income expectation" entirely.



And you have just muddled them.



They are not cursory, nor are they the sum total of an analysis. The "Limit" is imposed by the person utilising the information.



They do provide speed, and "comparative" elements, no argument here.



Why would we be perplexed when we understand and utilise said metrics everyday?
The "multiplier" contains huge amounts of "psychological" information, which provides much insight.



Incorrect.
Your reasoning is more subject to one of convenience, than of penetrating thought.



So far, so good. Your naive conclusions regarding "health" however exacerbate your incomplete understanding of what we ( Fundies ) actually do, and are looking for within an analysis.



And there will in many cases very definitive reasons for this that are apparent upon analysis.
However, I can accept your assertion in a general manner.



Fundamentals deal with far more than just the health of the company, and this is where your lack of knowledge is starting to show you up again.

Technicals most certainly do not deal with the "PRICE", they deal with momentum.
Such a basic and fundamental mistake, from one who claims such mastery.
If you cannot even define your own area of "expertise" what chance have you of defining "ours"



And how do you propose to reconcile "Price" with "Supply & Demand"?
Don't even bother coming back with a lame analysis of "Volume".



If it wasn't me, but it should have been.



I always liked "rape and escape"............in a Viking sense of course.



No, you are still totally confused.

If you think I am going to waste any of my valuable time involved in tit for tat arguments with you, well, you are very mistaken ducatti. I suggest that you scuttlebutt ( lovely wordle ~ thank you Simon Gordon) elsewhere.
 
SOCCY,

Still confused.

Each stock attracts a professional following. It is more correct to say that each prominent stock attracts a particular professional following. This particular professional following are trading this stock regularly. For them the fundamental condition of the stock is not wholly immaterial, but does not rank so very highly in tems of proirity from a technical point of view. This is because the professional following are concerned with the cycle of accumulating and distributing the stock in question. Their first priority is to ensure that the stock that they regularly trade in (versus investing in) is liquid, meaning it can be bought and sold without having to deal with wide spreads and erratic behaviour, it is available meaning that it can be acquired and disposed of in large chunks, that it is accomodating, meaning that meaningful amounts of money can be absorbed by the stock to make the operation worthwhile, and that it is prominent, meaning that it is not obscure ~ in other words that everyone will be left in no doubt that it moves, and that it can be cornered, meaning that the quantities available should not be so great as to cause a shortage and a surplus impossible.

The very liquidity of the stock would mandate a large capitalisation.
The large capitalisation, and accompanying liquidity, would mandate against any but the very largest institutions having the required capital to "manipulate" the stock. The second potential "manipulator" could be the Specialist on NYSE, or Market Makers on other exchanges.

Your premise lacks much logical continuity. You have contradicted yourself within your argument.............specifically,

Their first priority is to ensure that the stock that they regularly trade in (versus investing in) is liquid, meaning it can be bought and sold without having to deal with wide spreads and erratic behaviour, it is available meaning that it can be acquired and disposed of in large chunks, that it is accomodating, meaning that meaningful amounts of money can be absorbed by the stock

and,

and that it can be cornered, meaning that the quantities available should not be so great as to cause a shortage and a surplus impossible.

this contradiction, negates the whole argument being propounded.

We could alternatively reason that with time all stocks should catch up and rise if for inflationary reasons if not for any other. But an inflationary reason is not a good enough reason for stock selection.

Rubbish.
There are a number of studies that have shown "inflation" has nothing correlative to rising "earnings" and hence higher "valuations"

It is, REINVESTED EARNINGS, expanding the Capital base, while retaining the profit margin upon the expanded capital base.

I will agree with you that fundamental analysis is very useful and in some instances crucial to determine the health of the instrument of interest, because in technical terms, a stock that is not healthy cannot be traded effectively.

You try selling that idea to all the Short-sellers, they just love to trade a falling "sick" stock.

and in terms of technical analysis this cannot be hidden and is immediately obvious if you are skilled at reading the chart.

I have serious doubts as to your chart reading skills, however,that is a moot point.

As to Fundamentals, you couldn't recognise one if it mugged you in broad daylight, in the middle of the highstreet, wearing an Enron baseball cap.

"Scuttlebutt" coined by Philip A. Fisher, a renowned Growth Investor, someone who obviously has intelligence.

cheers d998
 
What is the main type of market analysis used? Is it 'fundamental' or ' technical'? We know that the majority of the market is made up by investors, if the majority of the market uses 'fundamental' analysis, could you say that 'technical' analysis could not exist without the 'fundamentals'? Its just a thought! Rude.
 
I am not interested in your drivel ducatti, I am posting this without even reading what you post, I am that bored with you, what I posted stands, and that's it.
 
Socrates,

You are right that some shares are left behind in roaring bull markets despite their good fundamentals, but as you know, there are other criteria for avoiding these shares. It might well be that the company does not have real growth potential and just delivers a steady stream of earnings. Betas and variances should show the correlation between a company's shares and the underlying market. Obviously if I choose to buy a utility in a bull market I should know that at best they will chug along at a snail's pace.

If the stock is over valued on a fundamental basis then the trader simply shorts the stock and provided the homework is done properly, the rewards often tend to outweigh those of a long position.

Your point that the effects of inflation on stocks should not be reason for trading is very valid and would be a silly reason for anyone to trade/invest. In effect, they are actually losing money in real terms.

An unhealthy stock (dog) is very trade able and in many cases the best. When a trader discovers or locates one of these it is fairly easy to sell and make a decent return. Conversely, such shares will be over sold and at or near the bottom they represent very good value (in some cases) as recovery plays. By the time the average chart points all this out, the good fundamental trader is already in the trade making money.
 
Rudeboy,

The highest quantity of trades are executed by technical traders but the bulk of share volumes traded are by fundamental traders. The £/$ value of trades executed by fundamental traders far outweighs that of the technically biased.

Technical analysis could not exist without fundamentals and most technical traders place themselves in harm's way if they do not have a fair grasp of the fundamentals.
 
Lion, good point! But do you think that TA traders can ride the FA? I personally think it happens as a matter of fact? Good trading! RB.
 
Rudeboy,

You are totally right that technical traders can and do ride on the back of fundamental traders, some are so adept at it that it almost becomes a free ride. That is because they do a lot of homework and are quite aware of fundamental analysis, the difference between them and the purely fundamental traders is that they use charts to determine their entry and exit points.

tipuagha,

That is a great way to make your first post, the contents were very enlightening to all on these boards. Keep it up, you are on a distinguished path.
 
RUDEBOY said:
Charts are only formed by FA! What is the alternative? There is not any!

Charts are not formed by FA. Charts are formed by plotting price over time. Full stop.

Perhaps you mean price movement. Even still we are not at FA. Price movement is created by the coming together between buyers and sellers at mutually agreeable points.

What decides what price point is agreeable to a given trader/investor? For some it is FA. For others it's TA. For still others it's emotion. And for yet another group is the result of business decisions (hedging, etc.)
 
Oh well, I have to say I find it rather amusing, perhaps confusing, I'm not sure, that so much hostility exists between the followers of FA and TA. I feel rather unworthy to comment on this thread since I am devoid of any feeling, positive or negative towards FA. To me it is simply another approach and one which I chose not to follow. The only thing I would say,and it is in defence of FA, is that the concepts and methodologies employed in Fundamental analysis are sound and solid enough to stand in their own right and it debases it somewhat to involve it in a slanging match with another method.
Still each to their own.
 
LION63 said:
Socrates,

You are right that some shares are left behind in roaring bull markets despite their good fundamentals, but as you know, there are other criteria for avoiding these shares. It might well be that the company does not have real growth potential and just delivers a steady stream of earnings. Betas and variances should show the correlation between a company's shares and the underlying market. Obviously if I choose to buy a utility in a bull market I should know that at best they will chug along at a snail's pace.

If the stock is over valued on a fundamental basis then the trader simply shorts the stock and provided the homework is done properly, the rewards often tend to outweigh those of a long position.

Your point that the effects of inflation on stocks should not be reason for trading is very valid and would be a silly reason for anyone to trade/invest. In effect, they are actually losing money in real terms.

An unhealthy stock (dog) is very trade able and in many cases the best. When a trader discovers or locates one of these it is fairly easy to sell and make a decent return. Conversely, such shares will be over sold and at or near the bottom they represent very good value (in some cases) as recovery plays. By the time the average chart points all this out, the good fundamental trader is already in the trade making money.
Hello Sir, and thank you for your reply. Actually your viewpoint on a patently unhealthy stock( a dog) is a very interesting one and I am going to think deeply about what you point out about this in order to properly give it the attention that this idea merits. It may be one of those that slips the net. I am going to constructively put my attention on this idea and will come back to you as soon as I have arrived at some sort of properly firmed up conclusion.
Many thanks again.
 
Socrates,

I look forward to hearing the conclusions that you come up with as they can only add to my limited knowledge and improve the bottom line.

Regards.
 
You could take the view that FA is the WHAT component of analysis (that is what is the anticipated fair value for this can of beans) and TA is the WHEN component that will see when this anticipated fair value is realised...if it is actually realised at all ..and there is the crux of course it is all simply conditional no what type of analysis you use.
 
chump said:
You could take the view that FA is the WHAT component of analysis (that is what is the anticipated fair value for this can of beans) and TA is the WHEN component that will see when this anticipated fair value is realised...if it is actually realised at all ..and there is the crux of course it is all simply conditional no what type of analysis you use.
Good morning Sir,

actually you are making a very valid point here. I will concede that attention devoted to the Net Present Value or Intrinsic Value and the Anticipated Fair Value of a stock or an instrument ought not to be neglected, not only for the intellectual excercise that it yields in its own right, but also for verification that the instrument under fundamental scrutiny is healthy.

However, and additional to this, and from the point of interest from the point of view of technical analysis a chart showing price and volume will indicate the status of an instrument that is said to be "in play".

I am willing to expand on this.

In darksiding terms, an instrument is said to be "in play" when it is actively being traded. The key clue is whether the instrument has professional participation in it or not, and if there is professional participation, then to what extent and with what regularity, you see.

Any instrument that lacks consistent professional participation is suspect, and is to be avoided, in preference to an instrument that has.

This professional participation as you know appears as volume.

For professional participation to be present the volume has to be consistent and preferably substantial.

This presence is not continuous, alternating with periods in which, for different reasons the volume is either not so great or even minimal, it does not materially matter, because the point of initial interest is whether the instrument is capable of attracting professional interest in the first instance. This is the single most important factor to initially consider.

Now, as I ventured to explain in a previous post on this thread, and we will attack the question from a slightly different angle in order to properly profile the matter. An instrument that is not healthy is not going to be traded consistently, This is because ot three major ultimate or extreme risks, being the risk of (a) delisting (b) suspension (d) illiquidity.

Any instrument which is at risk of any of these three major dangers is going to be avoided by the proffessional interest in it and that proffessional interest is going to rapidly evaporate and migrate to another instrument that fulfils the criteria required as a consequence of proffessional requirement.

As an instrument, aside from its three fundamental values as listed above, is actively traded, this trading activity in the instrument has a profile. By this I mean that the instrument will have a following. The proportional percentile distribution of this following in terms of professional interest versus public interest is what determines the character of price behaviour in it.

An instrument that is healthy will consistently attract a professional following, that will actively trade in it continuously or nearly continuously. This professional following is visible and detectable by virtue of the volumetric impact it engenders. This volumetric impact affects the price, naturally, but what is more important is that by its very presence underwrites whether the instrument is in play or not, you see.

Now let us take this up one notch.

In consequence of what I explain above, the fundamental considerations utilised in stock selection are not altogether invalildated, but they are to some extent eclipsed. This is because skilful reading of the chart, meaning gaining the "footprint" of the behaviour and likely behaviour of the instrument is able to clearly reveal phases of accumulation and distribution in it, which are professioally instigated and executed, with military precision.

Each instrument has its own footprint. Each footprint is distinctive. This is because the professional interest in it specific. The specificity of proffessional interest is what gives the footprint its character. Thus character change implies change in proffessional interest. Change in proffessional interest occurs for a reason. It does not matter what that reason may or may not be, but the shift in emphasis is the clue.

This sudden shift in emphasis is immediately revealed in the price action. This price action is recorded on a chart. The volume attributable to this action (or the absence of it) is also shown. Together, they indicate to the skilled observer what is the most likely probable outcome, and all of this in real time, as and when the action is developing.

Kind Regards,
 
Top