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.
 
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Rhody Trader said:
Actually, buying and selling are what move markets. One could even say that the intent to buy/sell also moves markets in that the bid/ask (which exists in every market) is a reflection of transactional intent.

What I think you mean is that fundamentals and emotion (psychology) lead to buying and selling (or the intent to do so). They do, but so do technicals (among other things). If I am employing a break-out strategy, then my buying/selling is technically driven. Could it be that the price move creating the break-out is fundamentally and/or emotionally driven? Absolutely. But my contribution to the mix (as small as it might be) is not. And given the number of technical trader around, one has to include that in the mix. That is why technical analysis is sometimes referred to as self-fulfilling.
Your reply is sincere and well meaning. The problem is that this is precisely what he does not want to hear, so I advise you not to persist. He is likely to come back and start arguing with you endlessly. I tell you this because this is what he tries to do with me, but in my case, I don't engage, I just make my statements, and I stick to them, and that's it.

Kind Regards.
 
To be honest Socs, i would say Ducatti is a die hard TA fan? Reason! He does not seem to know his FA that well? RB.
 
Yes, but I am not telling him anything either., because anything he sees he contradicts, and, I have to go out and trim my hedge now, a huge job, see you later perhaps.
 
For me investing in the market is the skill of judging expectations, be that using TA or FA.

Andy Kessler sums it up shrewdly in Running Money:

'Stocks are a voting mechanism, pure and simple. They are a collective vote of expectations of each company's future fundamentals. If investors think business will improve, that earnings estimates rise, then the stock is going up. If investors think the end is near, a company is about to roll over, a stock will go down. It doesn't mean that those fundamentals ever happen.'

Scuttlebutting requires an indepth network of specific industry contacts who can act as an early warning system. But the average investor cannot build such a network due to capital deployment constraints.

Looking at a chart is a quick way to see how the voting is going.
 
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Who is this Kessler chap ? He sounds like an interesting theorytician ? Is he an acredited academic ?
 
"Former research analyst and investment banker Andy Kessler ran a successful hedge fund from 1996 to 2001 out of a dumpy, one-room office with cheap desks, above an art store in Palo Alto, Calif., with his partner, Fred Kittler. Kittler, we learn midbook, worked at J.P. Morgan managing tech portfolios while Kessler was an analyst there. "

and makes money with a quirky style of writing on finance...sort of a JK Rowling on Hedge Funds
 
Simon Gordon

'Stocks are a voting mechanism, pure and simple. They are a collective vote of expectations of each company's future fundamentals. If investors think business will improve, that earnings estimates rise, then the stock is going up. If investors think the end is near, a company is about to roll over, a stock will go down. It doesn't mean that those fundamentals ever happen.'

While this quote certainly applies to many, it does not apply to all.

Scuttlebutting requires an indepth network of specific industry contacts who can act as an early warning system. But the average investor cannot build such a network due to capital deployment constraints.

I would say due to time constraints, and possibly accessability to some of the sources. I don't see where "Capital deployment" has any real relevance.

chump

"Former research analyst and investment banker Andy Kessler ran a successful hedge fund from 1996 to 2001 out of a dumpy, one-room office with cheap desks, above an art store in Palo Alto, Calif., with his partner, Fred Kittler. Kittler, we learn midbook, worked at J.P. Morgan managing tech portfolios while Kessler was an analyst there. "

And just look at the timeframe............1996 bull market............2001 blowout.
His partner managed tech portfolios.

and makes money with a quirky style of writing on finance...sort of a JK Rowling on Hedge Funds

And those that can do, those that can't teach.
Cheers d998
 
chump said:
"Former research analyst and investment banker Andy Kessler ran a successful hedge fund from 1996 to 2001 out of a dumpy, one-room office with cheap desks, above an art store in Palo Alto, Calif., with his partner, Fred Kittler. Kittler, we learn midbook, worked at J.P. Morgan managing tech portfolios while Kessler was an analyst there. "

and makes money with a quirky style of writing on finance...sort of a JK Rowling on Hedge Funds
Ah, yes, thank you Chumpy, I now remember this pair, featured in Stocks and Commodities several years ago.
 
It is very difficult for the small trader to get any sort of edge using FA (especially with FTSE 100 Stocks) as remember that many of these stocks could have 20 analysts working full time scrutinising the company using FA.
Even then this is no guarantee which way the stock is going to head. I use FA but only to limit my possible losses because a company paying a fairly well covered dividend with other factors being OK is probably not going to sink like a stone, I think of it as a safety net principle. Whereas with a high flying growth stock there is no such safety net.
I still believe that TA tends to even the playing field for the small investor and is the better way of picking stocks. IMHO. What I say is whatever works for you do it. I believe one of the best market forecaster in the USA is Arch Crawford and he bases his forecasts on astrology !!!! Like I say whatever works for you in the stock market there is no right way and wrong way only winners and losers.
 
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Quite a bit that I would agree wth there Denny..frankly when it comes to fundamentals I prefer to focus on the wider picture rather than the specific company ..for instance...in the UK at this time the cumulative effect of rising costs (from various directions) on the individuals spending power is as serious as I can remember for over a decade....rising income won't be riding to the rescue any time soon because as tight as the labour market is the individual is still aware that management is applying increases based on govt inflation figures even though those figures are a nonsense...against that backcloth there is a very real expectation that the govt will be applying a further squeeze in it's ever increasing need for funds to support it's planned public spending amongst other things...and if that is not enough (and no I'm not a pessimist)...it cannot have escaped those alert that we are really not able to generate any wealth producing jobs to speak of in the private sector..in fact we are losing them at a disturbing rate...so if this is the wider picture where is the growth coming from that will let UK companies move on from here ? Very few companies will be good enough to rise against a tide like this flowing in the opposite direction hence why I don't focus on fundamentals of specific companies..
 
D998 - here is a live example.

ATH a coal miner has operations in Scotland and potential sites in France.

Proper FA should mean, I think, I visit as many sites as possible, subsribe to coal industry magazines and attend exhibitions/conferences on the subject. I should also be visiting the competition on the premise that I am an investor with mucho capital who should be given access to board directors.

I should also contact electricity generators to get feedback on ATH - the Drax power station for example.

I could go to the local pub in a mining village and ask the workers how it is to be an employee of ATH - this entails a trip to Scotland.

I would call Coal Pro and seek knowledgable industry bods who can give me insight.

This is just scratching the surface of scuttlebutting and it needs capital and time.

Obviously for the Private Investor this is virtually impossible.

The figures given by analysts and brokers are just that figures and a true fundamentalist would try to dig as deep as possible, for to punt money on the figures is high risk gambling.

The only way to shorten the odds is to dig like hell.
 
Simon Gordon

Proper FA should mean, I think, I visit as many sites as possible, subsribe to coal industry magazines and attend exhibitions/conferences on the subject. I should also be visiting the competition on the premise that I am an investor with mucho capital who should be given access to board directors.

Read "Coal Industry magazines".......absolutely, no argument.
Visit sites, attend conferences............possibly, certainly would do no harm.
Visiting the competition........................again no harm.

All this and much more is currently completed by "professional analysts" and their reports are widely available.

I could go to the local pub in a mining village and ask the workers how it is to be an employee of ATH - this entails a trip to Scotland.

You could, and may very well unearth useful information.

would call Coal Pro and seek knowledgable industry bods who can give me insight.

Again, no argument.

This is just scratching the surface of scuttlebutting and it needs capital and time.

It certainly requires time, but much "research" can be done via telephone, e-mail etc, that I'm not sure of the "capital" requirements.

Obviously for the Private Investor this is virtually impossible.

Some may well be, especially if you are working a full time day job. However much is "do-able" if the investor is serious about his investments.

The figures given by analysts and brokers are just that figures and a true fundamentalist would try to dig as deep as possible, for to punt money on the figures is high risk gambling.

To which figures are you referring ?
Or, is it generic ?

However your post illustrates very well a point that many may not be aware of, and that is some of the fundamentally different branches of Fundamental Analysis that exist.

The "Scuttlebutt" form of research was developed by P.Fisher, and he was a "Growth Stock" investor, planning to hold very long term.

Another branch, of which I am a participant, is the "Asset Stripper" or "Liquidator". I look for undervalued stocks, that provide an imbalance within the financial structure of the company that I can exploit for profit. I have no interest in owning the company for the long haul. Just long enough to realise my profit.

The methodologies between these and other fundamentally driven strategies is somewhat disparate.

cheers d998
 
That's all very well if markets were rational. They simply aren't because people are not rational. There is no doubt fundamental analysis works, but it does mean you will get to miss out on the greatest opportunities.
Technical analysis coupled with fundamental analysis reminding yourself that markets are not rational? Now you are talking about a powerful comination.....
 
Ken2win: I find the article is very helpful for the understandig who we are and what we are doing trading on Stock Exchange Markets. FA works perfectly on Emerging Markets, just we should not be afraid of them.
 
Very good, trading by the charts is a complete waste of time you will never make serious money unless you consider what drives the market. G Soras did NOT go by the charts when he shorted the pound, he went by the evidence in the market and won the biggest bet of all time.

JB
 
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