IT PAYS TO USE FUNDAMENTAL ANALYSIS
BY: RASHID MUDALA
At times the market calls into question virtually every portion of your stock portfolio. You wonder, did I make the right decisions when I bought these stocks? To answer yourself in any rational fashion, you need to be able to judge whether circumstances, not just psychology, have changed for your holdings.
In times like these, strong fundamental analysis becomes key to your conviction.
Two weeks ago you might have looked at your portfolio and said, "This is the same bunch of stocks I owned happily a month ago. How did the world get so ugly so fast?" It's a good question, because chances are that your companies had not changed much. It was investor psychology that had. You could try to chase that psychology by day trading. Or you could opt out of the daily grind altogether, on the theory that you know your companies' prospects as well or better than anyone. In the long run you'll be vindicated. Psychology dissipates, fundamentals endure.
To understand the difference between pure fundamental analysis and its day-trading cousin, technical analysis, think of the market as an open-air bazaar with stocks as items for sale. A technical analyst would wade into the shopping frenzy with eyes seeking the crowd. He would ignore the goods for sale altogether. When the trader notices a group gathering in front of the booth peddling, say, cookware, he'd scramble over to buy as much inventory as possible, betting that the ensuing demand would push prices higher. The trader doesn't even care what a cast iron skillet is as long as some "greater fool" at the back of the line is willing to buy it for more than the trader paid.
The fundamentalist, on the other hand, takes a more sedate approach. The fundamentalist's eyes would be solely on the products before him. He would dismiss the other shoppers as an emotional herd of fools who couldn't tell a good deal if one slapped them in the face. Once the crowd dissipated from the cookware booth, he might casually wander over to examine the wares. First the fundamentalist might try to assess the value of the metal contained in a particular skillet if melted down and sold as scrap in order to establish a base price for the object. In the stock market this might be something like figuring out the book value or liquidation price of a company. Next, the fundamentalist would probably take a close look at the quality of the workmanship to see if it's going to hold up over time or crack on its first use, just like a stock analyst checks a company's balance sheet for financial soundness. Then, he might try to get a handle of the productive capabilities of the skillet in terms of meals cooked or people fed in a manner akin to forecasting future earnings from a company's income statement.
Finally, the fundamentalist would combine all of the data on the asset to come up with an "intrinsic value," or a value contained in the object itself independent of the market price. If the market price were below the intrinsic value, the fundamentalist would buy it. If above, the fundamentalist would either sell the skillet he already owned or wait for a better deal. Fundamental analysis is a lot more work, but therein lies its appeal. Crowd psychology can be a powerful yet fickle force in the markets. As a technician, you've got to stay constantly alert or risk getting trampled under feet when the herd reverses direction, as it normally does.
Diving in up to your elbows in the guts of some company to diagnose its prospects, on the other hand, takes the kind of surgical skill and diligence that many traders would just as soon bypass on their way to the rush of more instant gratification. As a fundamentalist, however, when you finally do buy a stock that represents a good value, you largely insulate yourself from the day-to-day whimsy of human impulse in favor of longer-term results.
The intrinsic value approach to the markets is based on a couple of big assumptions. The first is that the intrinsic value of an asset can differ from its market price. Purists of the "efficient market hypothesis" find this concept ridiculous. They feel that market price is the only reflection of true value for an asset and reflects all information available about its future prospects at any point in time. Detractors say the efficiency theory might hold in an ideal laboratory setting. But go out in the real world and things get a little sticky. Information flows get delayed, altered or incompletely disseminated. And more importantly, human beings act on their personal, at times illogical, perceptions about the world around them.
Assuming you accept the notion of intrinsic value, the second big assumption of fundamental analysis is that, even though things get out of whack from time to time, the market price of an asset will gravitate towards its true value eventually. Again, probably a safe bet considering the long upward march of quality stocks in general despite regular setbacks and periods of irrational exuberance. The key strategy for the fundamentalist is to buy when prices are at or below this intrinsic value and sell when they get overpriced.
Figuring out the fair value of a company is the tough part. There are no magic formulas, and a complete understanding of the entire process could take an entire career to develop (and for some analysts, it seems that two lifetimes wouldn't be enough). For the beginning investor not inclined to do fundamental research, it pays to rely heavily on professional sources and research reports from a broker to get a good fundamental picture of a given company.
This article is published for general investment advice and it must be noted that the price of
equities and the income derived from them can rise as well as fall. Neither First Mutual Limited nor the author shall be held liable for any losses as a result of the investment advice
contained in this article. It is important that specific investment advice is sought as each
investor’s investment will be dependent on their circumstances.
Contact:
Rashid Mudala: 091 276 226
Shepherd Shambira :091 252 639
First Mutual Limited Head Office: (263) (04)886000/34
Bulawayo: (263)(09)880651/5
Mutare: (263)(020)60818
Fax: (263) (04) 886043
