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.

 

[pb]

Pretty basic stuff. A discussion on money/risk management and exit rules would have made it much more interesting.

 

[SOCRATES]

I have read the article and how discover you are an accountant. I did not know this. What I do know is that what you say about stock selection using fundamentals is not exactly complete, is it ?

There is much more to it than meets the eye.

What you are really describing is a tactic for selecting stocks on the basis of " rights to an income".

This is a very different proposition to "trading" in the stock.

I will proceed to explain exactly why this is the case.

When selecting a stock with a view to a rights to an income, the criteria required for successful selection for investment purposes are by necessity very different to the criteria required for trading it.

These two concepts are frequently muddled, and this is not the way to go about things, I respectfully submit.

I will explain further.

The investor looks to acquire a steady, safe, reliable return on capital, that is, as far as it is possible to do this. Additionally, the investor "hopes" or "expects" that the market price of the stock will rise in line with increased growth.

Inspection and comparison of Price Earning Ratios, Dividend Yields, Cover, between one stock and another are just cursory preliminaries, because they are what one might call "limited yardsticks".

But these limited yardstick have their use, which is to ascertain quickly within a group of stocks in a sector in which they are grouped, which ones are currently in terms of "current market price" more expensive than the others.

Many fundamentalists are perplexed by the obvious disparity existing in P/E Ratios between very similar stocks within a given sector in a very competitve commercial scenario. Surely if these stocks are competing companies and provide similar services, with similar margins, in the same marketplaces, with a similar infrastructure in terms of effective management, adequate resources, size and so on, should not their P/E Ratios be similar ?

The answer to this is negative and I will go on later to explain precisely why this is the case.

But before turning our attention on that, let us continue with the idea of stock selection for investment purposes. Investment means buying something, paying for it and keeping it. Trading is not necessarily investing, it may be speculation, which is buying something and not paying for it but using a credit line to underpin the purchase, but having no intention of keeping it at all but selling it on at a profit later on and pocketing the difference.

The health of the stock cannot accurately be assessed from the P/E Ratio. To do this properly, copies of the Balance Sheet, Profit and Loss Account, the Chairman's Statement, the Report of the Directors, the Report of the Actuaries, have to be acquired, for a recommended period of at least five years and examined carefully by applying principles of Investment Analysis in order to assess the past curent and potential future health of the enterprise and its ability to maintain growth and compete and remain profitable and continue to be able to pay out dividends commensurate with progress. This is not a P/E Ratio, this means taking the company apart, in the same way that a skilled mechanic will dismantle an engine and put it back together again.

Actually doing this excercise of (understatement) "reading a balance sheet" is a correct prerequisite to committing money to an investment in a stock. But there is no absolute guarantee that the stock is going to rise as a consequence of having a healthy corporate life and a sound set of figures regularly delivered and declared in its Annual Accounts.

This is because the Fundamental Condition of a Stock is totally divorced from the Technical Condition of the Same Stock. Fundamentals deal with the health of the company, whereas Technicals deal with the price of the stock in the market.~ they are driven by different and separate forces.

The first force is performance of the company itself in relation to its competitors and relevant to the general industry or sector in which it finds itself, and the second force, which is the force that drives the price, is Supply and Demand, or rather the fluctuating differences in intensity that exist between the two.

To give you an illustration of the disparity between these two, several years ago, I recall a company called BTR, which had a full order book, excellent products, good ratios for solvency, liquidity, quick, etc., a good NAV, very well nourished reserves, and a very good management team. For reasons that baffle nearly everybody, and most of all the Directors, the price of the stock in the market, in a bull market, by the way, not only did not keep up with the progress of the sector, but actually began to fall. This misery went on for three and a half years. During this time, the boardroom took on the semblance of a game of musical chairs. Directors came and went . The price continued to dribble down, despite all efforts by the management to improve what it was not necessary to improve (but they did not know this) until one day it had sagged to its lowest low, and stopped falling. It now began to rise and very soon recovered to its price of three years previously and went on to handsomely surpass it. The reason for this was not fundamental, the reason was that the stock had been marked down as part of a campaign mounted to accumulate it at a cheap price. When the campaign to accumulate it was complete and the stock finally cornered, up it went.

I hope and trust this is of help in clarifying that which needs clarifying.

As a footnote I will add that the criteria required for effective trading in an instrument are liquidity, movement and transparency, and not statistics or accounts.

 

[LION63]

It was not put together for the knowledgeable and astute like yourself it is for the beginner.

 

[SOCRATES]

Yes, of course Lion, I appreciate that, point taken.

 

[LION63]

Socrates,

At the time I was posting no4, your lengthy post had not appreared and it was a response to Pratbh's post. Your post requires reading before any response can be made.

 

[SOCRATES]

Yes, bear in mind that some member ventured the opinion that I have no understanding of fundamentals whatsoever. I do not know who the member is, because it appeared as a vote on my reputation score.
Of course, I am absolutely tickled pink by it.

 

[QQQShort]

Intrinsic value, based on discounted future cash flows, is a more precise and versatile measure than those discussed in the article.

Also, it is important for an investor to understand the businesses in which they are placing their capital. A brief review of a few high-level ratios is not sufficient to properly determine valuation, although they might be helpful in narrowing the field for review.

 

[LION63]

Socrates,

It is not a "tactic for selecting stocks on the basis of rights to an income", as you have alluded, it is used for investing and trading (but not day trading). The criteria for trading is the same as for investing, any position taken for less than 2 to 3 years cannot be deemed investing, it is trading pure and simple.

I am not talking about receiving dividends but using dividends as a means to value shares. Nevertheless, to imply that shares cannot be traded based on dividends and their payment dates is inaccurate as many funds/institutions do this quite successfully.

The point you made about hoping or expecting a rise in share prices based on increased growth is totally wrong, as longs as earnings are real the share price will reflect the improved performance. It might not be immediate but it will follow as night follows day.

PE ratios, dividend yields, cover etc. might well be limited in their application but they are the starting point when it comes to stock selection. The disparity that tends to exist between similar stocks can be down to any number of reasons - customer loyalty, brand recognition, growth prospects, management, product pipeline, geographic location etc. The companies in a sector cannot be exactly the same and the market will price them differently. Some shares will be chased aggressively and thus have higher PE ratios whilst others might not be flavour of the month. The fundamental trader/investor is looking to exploit these inefficiencies.

Why does a trader have to use credit lines, gearing or margin? What difference should it make if the stock is purchased outright? Many traders risk only 1% of their account per trade so why do they need to lodge $250,000 with their brokers? They could achieve the same by placing £10,000 in their accounts. Is anyone implying that those that purchase stocks outright do not know what they are doing? It is a matter of choice.

Once you start delving into 5 years' trading records, actuaries' reports etc., you are no longer trading, you are investing; positions are not open long enough for one to need that kind of research. What you are describing is analysis for investment purposes. If one has established based on basic fundamental analysis that a company's shares are relatively cheap compared to the rest of the market and that they are highly unlikely to go bankrupt in the next 12 months, then they are bought. It does not matter if they are still in business in 2 years time. When buying a tobacco company's shares, I am not interested in what legislation might be passed in 2008.

The example that you gave of BTR would and could have been avoided by fundamental traders, only those that were negligent or using other criteria to trade would have lost money. BTR was a conglomerate that had issued shares for one acquisition after another, earnings growth had slowed down and there was a dearth of suitable acquisitions. When the way conglomerates accounted for acquisitions was called into question, they lost their high ratings which meant lower share prices; this now meant that they could not consume any more targets and the shares lost all appeal and fell further. They started recovering because they wer dismembered and it affected all of the companies in the sector - Hanson, Lonrho, BTR, Williams Holdings etc. How many of them still exist in their old form? None.

Your post shows why most traders do not use fundamentals - It seems like too much work for too little reward over too long a time frame. However, this is a misconception and it can be very rewarding and stimulating.

 

[SOCRATES]

Intrinsic value, based on discounted future cash flows, is a more precise and versatile measure than those discussed in the article.

Also, it is important for an investor to understand the businesses in which they are placing their capital. A brief review of a few high-level ratios is not sufficient to properly determine valuation, although they might be helpful in narrowing the field for review.

Intrinsic value is not market value,

Market value is the price at which buyers and sellers are willing to exchange a stock against payment.

Intrinsic value is the value of the enterprise as a going concern and viewed as the rights to an income.

Discounted cash flow is only able to put a net present value on expected income flows discounted back to the present and cannot take into account the vagaries of alteration in price behaviour due to fluctuations in imbalances between supply and demand functions.

Therefore DCF can only show whether as a rights to an income, the acquisition of those rights, in comparison to whatever else is available, when a yadstick for this is established, is expensive or cheap in comparison to this yardstick, which could be the income from a fixed interest instrument.

I agree that for an investor it is necessary to understand the nature of the business in which the capital is being placed.

For a trader, strictly speaking, this is not necessary, as the focus of attention of a trader should be whether the stock is being accumulated or distributed and hence his interest should be on the supply demand function and not on being familiar with the ins and outs of the business, that is the instrument, being traded.

His concern is that the instrument should have movement and be liquid, and not concern himself with details of cash flow, profitablility, Net Asset Value, etc.,as all these matters are irrelevant from the trading point of view~ except ~ in circumstances in which the intrinsic value of the instrument is so damaged as to make it untradeable, such as it being suspended from its listing on an exchange, but that is a finer point and a different matter altogether.

Suspension does not at this stage enter the discussion. It is a separate issue.

 

[LION63]

QQQShort,

How many traders understand "discounted future cash flows"? Where are traders going to find and obtain such data? Surely if an individual wishes to trade shares for a short period, this cannot be of much relevance to their stock picking.

Why would a trader need to trawl through extensive data and information in order to decide if it is worth trading in the shares of company X? I have never found it a worthwhile exercise unless I am investing in the shares. If you are seeking a 5 -20% return within 1 day to 3 months, it will not yield any extra profit, worse still, it becomes a chore and all the good trades have passed you by.

 

[SOCRATES]

Socrates,

It is not a "tactic for selecting stocks on the basis of rights to an income", as you have alluded, it is used for investing and trading (but not day trading). The criteria for trading is the same as for investing, any position taken for less than 2 to 3 years cannot be deemed investing, it is trading pure and simple.

I am not talking about receiving dividends but using dividends as a means to value shares. Nevertheless, to imply that shares cannot be traded based on dividends and their payment dates is inaccurate as many funds/institutions do this quite successfully.

The point you made about hoping or expecting a rise in share prices based on increased growth is totally wrong, as longs as earnings are real the share price will reflect the improved performance. It might not be immediate but it will follow as night follows day.

PE ratios, dividend yields, cover etc. might well be limited in their application but they are the starting point when it comes to stock selection. The disparity that tends to exist between similar stocks can be down to any number of reasons - customer loyalty, brand recognition, growth prospects, management, product pipeline, geographic location etc. The companies in a sector cannot be exactly the same and the market will price them differently. Some shares will be chased aggressively and thus have higher PE ratios whilst others might not be flavour of the month. The fundamental trader/investor is looking to exploit these inefficiencies.

Why does a trader have to use credit lines, gearing or margin? What difference should it make if the stock is purchased outright? Many traders risk only 1% of their account per trade so why do they need to lodge $250,000 with their brokers? They could achieve the same by placing £10,000 in their accounts. Is anyone implying that those that purchase stocks outright do not know what they are doing? It is a matter of choice.

Once you start delving into 5 years' trading records, actuaries' reports etc., you are no longer trading, you are investing; positions are not open long enough for one to need that kind of research. What you are describing is analysis for investment purposes. If one has established based on basic fundamental analysis that a company's shares are relatively cheap compared to the rest of the market and that they are highly unlikely to go bankrupt in the next 12 months, then they are bought. It does not matter if they are still in business in 2 years time. When buying a tobacco company's shares, I am not interested in what legislation might be passed in 2008.

The example that you gave of BTR would and could have been avoided by fundamental traders, only those that were negligent or using other criteria to trade would have lost money. BTR was a conglomerate that had issued shares for one acquisition after another, earnings growth had slowed down and there was a dearth of suitable acquisitions. When the way conglomerates accounted for acquisitions was called into question, they lost their high ratings which meant lower share prices; this now meant that they could not consume any more targets and the shares lost all appeal and fell further. They started recovering because they wer dismembered and it affected all of the companies in the sector - Hanson, Lonrho, BTR, Williams Holdings etc. How many of them still exist in their old form? None.

Your post shows why most traders do not use fundamentals - It seems like too much work for too little reward over too long a time frame. However, this is a misconception and it can be very rewarding and stimulating.

LION, we are going to be discussing this for the next three months at this rate, I don't mind if you don't mind either.

It seems to me you have both things muddled. I am not referring to intraday trading at all.
Intraday trading is a smash and grab activity, using very short timeframes and very fast tactics.

The institutions are obligated to pursue their clumsy tactics by virtue of their sizes and the huge amounts of money they are obligated to place in the market on a daily basis. The independent trader and the private investor is not hampered by the restraints suffered by the institutions. The institutions are not able to buy and sell freely like the private investor or independent trader is able to because their very size is an encumberance. This is why you will see how it is that the institutions holding very large tranches of stock have to take every rise and every dive as the sizes that they hold are not immediately marketable, because before they can be effectively disposed of, a suitable counterparty has to be found capable of absorbing such vast allocations. This is not practicable in a fast moving, modern, liquid market. It is not possible in a fast falling market either, that is why you read when a bear market is in full flood, that "millions have been wiped off share values today". What you omit to be told is that it is your money being wiped, as a consequence of this money originating from savings, investments, deposits, and insurance premiums. Therefore you needn't worry about the institutions being particularly clever or apt to being able to take immediate advantage of market conditions as they develop as an independent trader or private investor can and should.

Now that I have in outline explained this to you, it follows that the valuation placed on a security as the consequence of analysing it be it in its totality by a full fundamental examination by taking its published accounts virtually apart or by applying a discounted cash flow technique to arrive at a Net Present Value as a basis for establishing a price from the point of view of the rights to an income, or whether employing a cursory technique of selection of which stocks are dear and which are cheap by comparing P/E Ratios or Divi Yields or Cover or Earnings Ratios or whatever do not account for the Technical Posiition of the Stock.

The technical position refers to the supply demand situation relevant to the stock. The price is driven by supply demand and not the merit of the dividend, or the earnings, or the cover, or the company or the directors themselves. They are two separate issues. This is the point I am making.

Furthermore another point I am making is that clearly fundamentals and technicals are separate issues as they deal with different aspects, and for this reason ought not to be muddled or misapplied.

You explain this above in your post when you state that "some shares will be chased aggressively and thus have higher P/E ratios whilst others might not be the flavour of the month" . "The fundamental trader/investor is seeking to exploit these inefficiencies".

The "inefficiencies" as you call them are supply # demand phases within schedules as part of campaingns to accumulate or distribute stock for profits but within a framework of supply and demand and not within a framework of fundamental valuations.

The investor invests and the trader trades.

This discussion can go on for a long time, much longer than most members could expect...

The question of gearing as a result of margin versus the idea of outright purchase I have already explained in my previous post. The distinctions between trading, investing and speculation are very clear since they serve different puposes and requirements. I am not going to go over all that ground again.

With regard to the example of BTR I disagree with you completely. The price was driven down by the supply demand function particular to the stock at the time, and not by intrinsic characteristics. Fundamental analysis would certainly have shown the burgeoning situation developing as you describe, but the price had to be determined not as a consequence of consulting the balance sheet but by following the hidden activity that successfully was able to drive the price down as part of a concerted campaign to ultimately profit from price differences.

That was the true object of the excercise, the fundaments as a backdrop providing the perfect excuse and the perfect opportunity for a very long and determined and succesful bear raid.

Finally, I have to agree with you as to why fundamentals are not popular, because of the work involved. But I also think that a deep understanding of fundamentals in terms of incisive balance sheet analysis should be of benefit to eveyone interested in this topic, be they investors, traders or speculators.

The ability to read a balance sheet and to be able to get to the root of things in minutes is an invaluable asset, no doubt about it, it ought to be taught in schools as part of the National Curriculum.

 

[Tuffty]

LION63, In your answer above (post 13) you seem to assume that the decision of buying and selling of stock can't be based on more than one 'discipline'. By discipline I mean investing and trading. I believe this assumption to be wrong.

 

[QQQShort]

QQQShort,

How many traders understand "discounted future cash flows"? Where are traders going to find and obtain such data? Surely if an individual wishes to trade shares for a short period, this cannot be of much relevance to their stock picking.

Why would a trader need to trawl through extensive data and information in order to decide if it is worth trading in the shares of company X? I have never found it a worthwhile exercise unless I am investing in the shares. If you are seeking a 5 -20% return within 1 day to 3 months, it will not yield any extra profit, worse still, it becomes a chore and all the good trades have passed you by.

Lion,

You are correct ... i did not earlier understand your article to be limited to traders (a mistake created by trying to post comments while helping kids get ready for school) ... my apologies.

It seems unlikely, though, that valuation plays will consistently result in profits in 3 months or less by using a static threshold such as PEG = 1.0. Admittedly, my thoughts are based more on intuition than extensive research. The concept of trading using fundamentals is nonetheless intriguing.

 

[QQQShort]

Intrinsic value is not market value,

Market value is the price at which buyers and sellers are willing to exchange a stock against payment.

Intrinsic value is the value of the enterprise as a going concern and viewed as the rights to an income.

Discounted cash flow is only able to put a net present value on expected income flows discounted back to the present and cannot take into account the vagaries of alteration in price behaviour due to fluctuations in imbalances between supply and demand functions.

Therefore DCF can only show whether as a rights to an income, the acquisition of those rights, in comparison to whatever else is available, when a yadstick for this is established, is expensive or cheap in comparison to this yardstick, which could be the income from a fixed interest instrument.

I agree that for an investor it is necessary to understand the nature of the business in which the capital is being placed.

For a trader, strictly speaking, this is not necessary, as the focus of attention of a trader should be whether the stock is being accumulated or distributed and hence his interest should be on the supply demand function and not on being familiar with the ins and outs of the business, that is the instrument, being traded.

His concern is that the instrument should have movement and be liquid, and not concern himself with details of cash flow, profitablility, Net Asset Value, etc.,as all these matters are irrelevant from the trading point of view~ except ~ in circumstances in which the intrinsic value of the instrument is so damaged as to make it untradeable, such as it being suspended from its listing on an exchange, but that is a finer point and a different matter altogether.

Suspension does not at this stage enter the discussion. It is a separate issue.

Socrates,

Your comments are dead-on correct ... as noted in my response to Lion, i missed the reference to "trading" in his article.

When digging deep into the fundamentals, I do it for investing purposes. Thus, at least for now, it is best that I bow out of these discussions since I do not trade fundamentals in the manner described by Lion.

 

[SOCRATES]

Socrates,

Your comments are dead-on correct ... as noted in my response to Lion, i missed the reference to "trading" in his article.

When digging deep into the fundamentals, I do it for investing purposes. Thus, at least for now, it is best that I bow out of these discussions since I do not trade fundamentals in the manner described by Lion.

Hello QQQ Short, thank you for your reply. I hope you like this....

I have dug out this post of mine from a parallel thread entitled:~

Do you use fundamentals ?


I posted.....


The problem it seems to me to be that both groups muddle the differences that exist between trading, investing and speculation. Very often, the trader believes himself to be speculating, the speculator thinks he is trading, and the investor believes himself to be doing neither. Additionally, neither of them knows anything in depth about anything other than what they are doing themselves, leading to squabbles of the most amusing nature.


Kind Regards.

 

[LION63]

Tuffty,

I am not assuming that buying/selling stock cannot be based on more than one discipline. What I am saying is that when trading with short time horizons, it is unnecessary to analyse as much as an investor would. It will take too long for the information to filter through to the market in the form of results etc. As such, it would be a fruitless exercise.

Having said that, it depends on how long you hold the position for and what kind of returns you are seeking. May I hasten to add that extra information/knowledge never harmed anyone.

QQQShort,

There is no need to apologise for participating in a discussion, it is your right and nobody can fault you for that. I am not saying that one ratio or bit of information regarding a company's business or financial performance is sufficient to make a decision and then trade in the shares, it requires using a combination of all these valuation tools and in some cases more. PEGs and PE ratios on their own would take quite a while to yield any meaningful returns if any.

 

[LION63]

Socrates,

I agree that fundamental valuations of stocks do not account for the current technical position of the stock, that as you say is determined by supply and demand at any given time. In this respect you are spot on and that is not up for debate. What I am saying is that once one has arrived at perceived fair value for the stock of company X, it is now possible to ascertain if it is reasonably priced when compared with other stocks in its sector and in the prevailing market conditions.

You say that the technicals of supply and demand will determine price - agreed but sooner or later the market will ascribe the correct price to the shares. The fundamental trader aims to find that price first and act accordingly.

 

[SOCRATES]

OK, yes Lion, I am being called to supper, and this space is reserved for comment when I return, later.

Right, I am back. Your post above clarifies a lot. I am not averse to fundamental analysis as I have done a lot of it in the past when dealing particularly with the merit of one Blue Chip against another. But there is a difficulty.....and I am not sure you may have spotted it.

I am willing to expand on this.

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 dilemma is that the stock selected by fundamental analysis additionally, for it to "motor" has to fall within these parameters. These parameters are not assessable or detectable via fundamental analysis, but only via technical analysis. Now, imagine a situation in which a very good stock is chosen on the basis that it fulfils pre set fundamental criteria but does not fall within these parameters. It will not motor. This is why there are dozens of examples of stocks that remain undervalued even in a roaring bull market. There is nothing wrong with them but they do not attract professional interest.

The problem is that the public alone is not able to make them go up.They require a technical basis on which to move. The converse is also true. Stocks which are not so bright in comparison to others in fundamental terms can be seen to be marked up continously in bull phases whilst the better stocks in terms of intrinsic quality remain neglected, and that is the reason.

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.

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. This is because of the stigma attached to a failing stock in fundamental terms cannot be overriden with transparent excuses. The professionals trading in it will now most likely turn their attention to a stock that is healthy in which they can trade with confidence. In this respect Fundmentals are important, but, in any event, a stock that is not wanted for whatever reason, is going to be marked down, and in terms of technical analysis this cannot be hidden and is immediately obvious if you are skilled at reading the chart.

 

[ducati998]

SOCCY,

I have read the article and how discover you are an accountant. I did not know this. What I do know is that what you say about stock selection using fundamentals is not exactly complete, is it ?

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.

What you are really describing is a tactic for selecting stocks on the basis of " rights to an income".

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.

These two concepts are frequently muddled, and this is not the way to go about things, I respectfully submit.

And you have just muddled them.

Inspection and comparison of Price Earning Ratios, Dividend Yields, Cover, between one stock and another are just cursory preliminaries, because they are what one might call "limited yardsticks".

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

But these limited yardstick have their use, which is to ascertain quickly within a group of stocks in a sector in which they are grouped, which ones are currently in terms of "current market price" more expensive than the others.

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

Many fundamentalists are perplexed by the obvious disparity existing in P/E Ratios between very similar stocks within a given sector in a very competitve commercial scenario. Surely if these stocks are competing companies and provide similar services, with similar margins, in the same marketplaces, with a similar infrastructure in terms of effective management, adequate resources, size and so on, should not their P/E Ratios be similar ?

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.

But before turning our attention on that, let us continue with the idea of stock selection for investment purposes. Investment means buying something, paying for it and keeping it.

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

The health of the stock cannot accurately be assessed from the P/E Ratio. To do this properly, copies of the Balance Sheet, Profit and Loss Account, the Chairman's Statement, the Report of the Directors, the Report of the Actuaries, have to be acquired, for a recommended period of at least five years and examined carefully by applying principles of Investment Analysis in order to assess the past curent and potential future health of the enterprise and its ability to maintain growth and compete and remain profitable and continue to be able to pay out dividends commensurate with progress. This is not a P/E Ratio, this means taking the company apart, in the same way that a skilled mechanic will dismantle an engine and put it back together again.

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

Actually doing this excercise of (understatement) "reading a balance sheet" is a correct prerequisite to committing money to an investment in a stock. But there is no absolute guarantee that the stock is going to rise as a consequence of having a healthy corporate life and a sound set of figures regularly delivered and declared in its Annual Accounts.

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.

This is because the Fundamental Condition of a Stock is totally divorced from the Technical Condition of the Same Stock. Fundamentals deal with the health of the company, whereas Technicals deal with the price of the stock in the market.~ they are driven by different and separate forces.

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"

The first force is performance of the company itself in relation to its competitors and relevant to the general industry or sector in which it finds itself, and the second force, which is the force that drives the price, is Supply and Demand, or rather the fluctuating differences in intensity that exist between the two.

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

Yes, bear in mind that some member ventured the opinion that I have no understanding of fundamentals whatsoever. I do not know who the member is, because it appeared as a vote on my reputation score.

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

It seems to me you have both things muddled. I am not referring to intraday trading at all.

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

The technical position refers to the supply demand situation relevant to the stock. The price is driven by supply demand and not the merit of the dividend, or the earnings, or the cover, or the company or the directors themselves. They are two separate issues. This is the point I am making.

No, you are still totally confused.