"The Problems With Fundamental Analysis"
Neil A Costa
Fundamental analysis has been a well-known method of selecting stocks for many decades.
Fundamental analysis is a technique used to identify stocks that are 'undervalued' by the market, that is, they are selling at a price that is lower than the stock's intrinsic value at the time. Fundamental analysts assume that buyers will be attracted by the stock's 'cheap' price, and will collectively purchase the stock in sufficient numbers to cause its price to rise.
Fundamental analysis is also used to identify so-called 'growth' stocks - stocks that have the potential to increase in value over time due to increasing earnings. BHP was, for a long time, an excellent growth stock in Australia. IBM was a classic growth stock in the United States.
To determine whether a stock is undervalued, or is a growth stock, a fundamental analyst examines numerous company statistics and other factors such as the effectiveness of the management, in order to make an assessment of the intrinsic value of the company. The relative value of the company to others in its industry, and the prevailing economic conditions, are also considered.
- Liquidity patterns, such as current assets to current liabilities./li>
- Working capital management efficiency, such as an analysis of the value of stock held by the company, measured in days./li>
- Financial structures, such as the amount of gearing, balance sheet strength, and the company's debt structure./li>
- Profitability ratios, such as rate of return, return on assets, and the gearing of the company's earnings./li>
- Market performance ratios, such as dividends per share, dividend cover, dividend yield, earnings per share, discounted cash flow, the price-to-sales ratio and the price/earnings ratio./li>
- … and many others./li>
Fundamental analysts obtain the data they require from company reports, announcements, financial Internet sites and from company web sites.
The 'Value' Approach
The 'value' approach to fundamental analysis was first outlined by Benjamin Graham and David Dodd in their classic book Security Analysis, first published in 1934. This approach is popular with investors such as Warren Buffett who is one of the most successful long-term investors in the world today.
The Problems With Fundamental Analysis
Fundamental analysis, when used in isolation, has a number of serious drawbacks:
- There are an infinite number of factors that can affect the earnings of a company, and its stock price, over time. These can include economic, political and social factors, in addition to the various company statistics mentioned earlier./li>
- The data used can be at least six months out of date./li>
- Reported earnings can be dubious - due to creative accounting. For example, property valuations; value of mastheads; deferring the reporting of product development costs./li>
- It is difficult to give appropriate weightings to the factors./li>
- The results obtained from this analysis are only valid for a limited period of time after the analysis has been performed. Forecasts are often downgraded - hence the saying "if you are going to forecast, forecast often"./li>
- The rules change to suit the game. /li>
- In the early 1970s and 1980s price/earnings multiples of 80 or 90 were considered acceptable by some for 'blue chip' stocks in the United States. /li>
- In the 1980s in the United States some biotechnology stocks sold at '50 times sales'. The companies had no earnings and paid no dividend. The new yardstick to value these became 'products in the pipeline'. By the late 1980s most had lost three-quarters of their stock price!
- It assumes that the analyst is competent. In fact, the best analysts in stock brokers' offices end up on the sales desk or in portfolio management where the salaries are much higher.
- A fundamental analyst assumes that other fundamental analysts will form the same view about the company and buy the stock, thus restoring its value and returning the trader or investor a capital gain. In practice, an undervalued company's stock price can stay at approximately the same level (or decline) for years!
- It assumes that news travels instantly - but will everyone act on it instantly?
- It ignores the influence of random events such as oil spills, product defects being exposed, acts of God and so on.
- It assumes that there is no monopolistic power over markets.
- Even when fundamental analysis reveals an undervalued company, or a stock with high growth prospects, it does not tell us anything about the timing of the purchase of the stock. In other words, we may have discovered a grossly undervalued stock whose price has been falling for some time, and may well continue falling!
- Fundamental analysis sounds plausible - even scientific!
- Fundamental analysis has appeal, as traders and investors feel more secure knowing why a stock should rise.
Estimates of the future growth of company earning, and profits, play a key part in fundamental analysis. Unfortunately, growth estimates can be correct, but could have already been factored into the price of the stock. There is a reason for the Wall Street saying "buy on rumour; sell on fact".
(A Market Analyst II Chart of Keycorp.)
A classic example is the Australian stock Keycorp. On Friday 21 July 2000 I received an email advising that a stock, Keycorp had announced a $515 million alliance with Telstra, the huge telecommunications company. On Saturday 22 July 2000 financial newspapers ran banner headlines such as "515m Link for Keycorp". The day of the announcement, Friday 21 July 2000, was the day of the end of a move in Keycorp which saw its price rise from $7.50 to $16.00 in just one month.
IBM - When the well-known United States stock IBM was at $320, its intrinsic value was $173. One fundamental analyst projected its 16 percent (at the time) growth rate for 30 years. The price projected was half the United States' national income!
Edwards and Magee, authors of the classic book Technical Analysis of Stock Trends, suggest that we need not concern ourselves with the infinite number of factors that can affect a market, by stating:
Of course the statistics, which the fundamentalists study, play a part in the supply-demand equation - that is freely admitted. But there are many other factors affecting it. The market price reflects not only the differing value opinions of many orthodox security appraisers but also all the hopes and fears and guesses and moods, rational and irrational, of hundreds of potential buyers and sellers, as well as their needs and their resources - in total, factors which defy analysis and for which no statistics are obtainable, but which are nevertheless all synthesized, weighed and finally expressed in the one precise figure at which a buyer and a seller get together and make a deal…
(Technical Analysis of Stock Trends, page 5.)
So You Want to Use Fundamental Analysis as a Trading and Investment Tool?
If you conclude that it is worth conducting thorough, accurate fundamental analysis on stocks, you should also consider the following:
- Will you analyse more than 1,200 stocks in Australia alone? Do you have all of the latest information required? Do you have the time - it can take many hours to perform a thorough analysis on a single stock? Do you have the skill?
- Will you rely on your broker's fundamental analysis - given that the best analysts get into sales or funds management, and given that a recommendation from your broker could be simply a stock that your broker's company is pushing.
- Will you put your money in an actively managed fund? In America, this will give you, on average, a return of three percentage points less than an index fund (a fund which holds the stocks in the S&P 500 Index, a process which requires no analytical skill whatsoever!
Supply and demand fundamentals do influence the market over time, but as traders, it is more important that we track the market participants' beliefs about these supply and demand fundamentals, and we do this through the analysis of charts.
Is Fundamental Analysis for Everyone?
Burton G. Malkiel, author of A Random Walk Down Wall Street, one of the most respected financial publications, noted that between 1 July 1988 and 30 June 1998, the average United States managed fund underperformed the S&P 500 by more than 3% per year.
He concluded that:
Financial forecasting appears to be a science that makes astrology look respectable.
Basically, the security analyst must be a prophet without the benefit of divine inspiration.
Peter Lynch and Warren Buffett are two of the most successful investors in the world. Peter Lynch, just after retiring from running the very successful Magellan Fund, together with Warren Buffett, admitted that most investors would be better off in an index fund than an actively managed fund.
Benjamin Graham is widely regarded as the father of fundamental analysis. Shortly before his death in 1976 he stated that fundamental analysis could no longer be counted on to produce superior investment returns:
I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities… This was a rewarding activity, say, 40 years ago… but the situation has changed…
There are many different factors that can cause a stock's price to rise or fall - sometimes quite dramatically. These include interests rates, economic data, commodity prices, exchange rates, what is happening in other markets, company news and rumours, dividend payments, the activities of futures and options traders, the activity of funds and the impact of government policies. It is almost impossible to try and identify, and give an appropriate weighting to such variables, in any meaningful manner. Even if you are successful, your analysis will be out-of-date after just one day. For this reason technical analysts focus on the stock price itself, which is all that really counts. Trying to second-guess why a stock rises is a frustrating exercise that is of no value.
Technical analysis uses price, volume, market sentiment and cycles to predict future price movements. It is not concerned with the financial position of a company. Technical analysis assumes that the chart reflects all known information that could affect the price of a company. As a consequence, there is no need for technical analysts to concern themselves with economic or political issues, or even with market fundamentals.
The Critics of Technical Analysis
Many critics of technical analysis:
- Know very little, if anything, about it.
- Cite outdated studies…
- For example, some like to make the point that a double top can form by plotting the outcomes of tossing a coin. It can - so?
- That chart patterns do not work.
- Cite ridiculous, unproven techniques used by some lunatics and suggest that these techniques are part of technical analysis.
- Cite studies where one technical indicator is used in isolation - yet the technique would not be used in that manner by a competent technical analyst or trader.
- Fail, conveniently, to take into account studies in favour of technical analysis…
Economists used to dismiss as mere snake-oil salesmen technical analysts who use simple patterns in past data to predict share prices. Now, some think that stock charts can reveal valuable information.
[The Economist, August 19th, 2000]
Buying a stock based on the fact that a stock is fundamentally undervalued, alone, is the trading and investment equivalent of driving at high speed on the wrong side of a major highway, heading into the oncoming traffic and screaming "I'll be fine, I'll be fine - I am driving a safe car"!
One way to get the best of the fundamental and technical analysis worlds is to use a hybrid approach. Fundamental analysis can be used to identify 'value' stocks, for example, however the decision to buy them is only made when an appropriate technical signal is given. Of course, you have to somehow conduct, or obtain, accurate and current fundamental analyses of a wide range of stocks.
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