Since the goal of stock trading, and trading here is used in the widest sense, meaning anytime one is looking to take a position with a stock with the expectation of future profit from the position, is to make a profit over time, all methods of analysis must be seen as a way to successfully predict these outcomes.
Fundamental analysis looks at the underlying conditions behind a stock, how the business is doing for instance, in an effort to predict this. Some people think that we do this because we’re looking to buy a business and therefore want to know what we’re buying, and in some sense that might be applicable, but publicly traded stocks are a different animal than privately held equities.
Fundamental analysis can be useful though, as the things that this measures can matter to various degrees in various situations, and in some, perhaps not at all, so it’s important to understand the limitations and the utility of this analysis.
It can be more helpful actually to understand what the limitations are first, before we go off and look to apply some of these techniques, so that’s where we’ll start.
Fundamental Analysis is To Some Degree Disconnected from the Market
There is a lot of confusion between the nature of privately held equity and publicly held equity, for instance owning a piece of a private company versus a public one. This is the source of much misunderstanding.
The applicability of fundamental analysis is a source of quite a bit of disagreement among those considered to be experts in the financial markets industry, versus those who choose to measure markets more from market activity itself.
There is no doubt though that if one is going to use fundamental analysis to guide their decisions, they properly understand how markets really work and how relevant this analysis may be.
The first thing we need to realize is that the price movement of stocks has its own market, independent of the underlying business, and this market will be influenced to some degree by the performance of the business behind the stock, as well as being guided by a number of other factors.
With a privately held company, the value of the company’s stock is going to be intimately connected to business performance. After all, that’s what you own, a piece of that business. So this is a case where fundamental analysis will completely guide the valuation of your stock.
Some people think that this is now publicly traded stocks work as well, or more often, feel that business fundamentals play a bigger role than they do in practice.
The “in practice” part of this is going to be dependent on investor behavior, and ultimately, it is dependent upon this completely, much like privately held stock is completely based upon the business itself.
The market will act upon changes in fundamentals, although often these are priced in before the news comes out, but this is future, not present fundamental news. It would actually be true to say that the market has already priced in current fundamentals, to the degree it wishes at the present time.
So we can’t really just look at fundamentals and say, well maybe people will study this more and realize that the company is worth more than the market is saying, the market is saying it’s worth that much right now and there’s no disputing it.
This is a point that not a lot of people properly understand. The present isn’t even relevant when it comes to business performance, it’s only the future that matters, and you won’t see the future laid out for you in nice ratios that you can dig up from the company’s books.
The Effect of the Market as a Whole
As we know quite well, stocks do not move in linear fashion with their business results. The main reason is that there’s more to it than this, there’s the microeconomic side of things, the business, and there’s also the macroeconomic side, the stock market as a whole, and the underlying macro factors that influence it.
If you’re just studying the micro side, which we tend to do with stocks, then you’re going to miss a big part of the equation. This isn’t quite as bad as it may first appear though, as the thinking is that over time, macro conditions will improve, and this will only serve to further enhance the value of stocks.
This does require a long-term view though, at a point where economic cycles run to the extent that the bottom of a future cycle is higher than the present, or when at least the median point of it is higher than where we are at now.
This does not mean that fundamental analysis is only relevant in the very long term, but this is where it is most relevant, and the reason is because this is where market swings can be ignored to some degree.
We can also look at the fundamentals of the economy as a whole, as the sharp analysts do. For instance, the brightest of them predicted the most recent recession, the breaking of the bubble, and adapted their trading decisions accordingly.
Stock prices are really a function of nothing else other than how much money is in the stock market as a whole, and then the percentage of that money that an individual stock is being valued at. So as the ocean rises and falls, this does tend to see the majority of boats, individual stocks, moving with the tide, or at least being significantly influenced by it.
So if we’re going to be doing fundamental analysis, we’re going to need to account for market fundamentals as well, if we want to be seeing the entire picture that is.
What Fundamental Analysis Can Tell Us
Deciding on a stock play is always about the future, not the present. Fundamental data primarily tells us about the present, a company’s return on equity, it’s price to earnings ratio, or whatever measure we’re looking at.
Once again, this is already priced into the stock, and what we need to do if we’re going to use fundamental analysis is to look at not where the business is now, but where it is headed.
It makes no sense to think that a stock is undervalued based upon whatever ratio or measure and say, well the market is inefficient, it will surely see the error of its ways and value my stock more correctly.
Now this might happen, perhaps a lot of people will hear or read a certain person or company touts it, saying things like this company is undervalued and so on, and this might cause increased demand for it, from the proclamation.
We can’t count on that though and it’s more reasonable to think that the stock is not undervalued, at least based upon its current situation. Saying a stock is undervalued actually only makes sense if all you are after is dividends.
However, it might increase in value in the future if its performance improves, at least relatively to other stocks, so a company doing better than another, growing more, might see this growth continue such that it becomes more desirable and will be valued higher.
That’s really what sound fundamental analysis is about, and we can even separate this from the macro stuff, where we can use macroeconomic fundamental analysis to tell us whether we should be in the market at all, and if so, we can look to fundamental analysis to guide us toward what stocks we should be in.
Looking at price movement history can be very useful, and this is based both on the business and people trading in predictable patterns. Both can have an influence on the price of a stock, and generally speaking, the shorter the time frame, the more relevant this price and volume analysis, technical analysis, is, and the longer the time frame, the more relevant the prospects of the business tends to be.
It’s All About Momentum
The main reason for this is that technical analysis is highly dependent upon the momentum of the trading itself, and short-term momentum is more reliable, where fundamental analysis is based upon longer term influences.
So we could say that fundamental analysis measures fundamental momentum, versus the price momentum of technical analysis, and the expectation with fundamental analysis is that fundamental performance now makes it more likely for it to continue, like price movement of certain types make this market action predictable.
Individual investors don’t really have the skill nor the wherewithal to do much of their own fundamental analysis, other than looking at a few simple ratios perhaps, and there are a lot of stocks to analyze. Investment firms hire teams of people and spend large amounts of money analyzing this data, although some of this information is made available to the public, and one can learn to interpret the higher-level views that these reports provide without a whole lot of time or trouble or expense.
It is always important though to keep your perspective when looking at technical data and projections, and perhaps most importantly, realizing that this needs to pertain to your desirable time frame.
If you’re looking to hold stocks for decades, projections about a company’s short-term earnings shouldn’t really interest you much, but their increasing their market share and their increasing their profit are things that may bode well for you if this can be expected to continue.
This is all about gaining and keeping perspective, and making sure that you are basing your decisions upon your plan and what matters to it.