INTERESTING LINK

An interesting interview with Deepak Shenoy co-founder of MONEYOGA, where he discusses his motivation, investment philosophy and other views. A must read for all bloggers and investors.

FUNDAMENTAL VS. TECHNICAL ANALYSIS

The quandary facing an investor today is to decide what theory should he use in his process of stock selection. If he is taking professional advice, who should he turn to, fundamentalists or chartists?

Have you ever had the experience of completely researching a stock, looking into its ratios and the market potential of its products and then investing into it, only to find that after you have bought it, the stock simply stagnates or even goes down? In such cases do you have the conviction in your analysis to hold on to your stock through thick and thin, disregarding the market and the opinions of analysts to sell? If the answer is yes, then you have the most important attribute a fundamental analyst should have. Patience.

Then again who does not like an investment to appreciate right after one makes it? Technical analysis gives one an indication of the direction which a stock is poised to take and investment decisions are based solely on such indicators. Technical analysts do not give any weightage to the accounts of the company, its products or the quality of its management. The company might be bankrupt for all they care. Their decisions are based on what the charts tell them. However, should they go wrong they have stop losses to protect them. The argument for the chartists is 'cut your losses and let your profits run'.

So we come back to the original question. Which process does one choose? It all depends on your nature and your frame of mind towards investing. If you cannot take a loss, stay away from technical analysis. Because, if your analysis should go wrong, the chosen investment has no fundamentals to protect your downside. The stock could well crash to zero (or rather near zero). If you make a trade and your stop losses are triggered, it is imperative that you book losses and not revise your stop losses downward.

If you are a fundamental investor, it does not matter what the stock price does in the short run, as long as you have done your research. The key here is patience and the capacity to mentally bear any notional losses in the conviction that your choice is backed by solid homework and that the market has to recognize its potential in the long term. This form is only suited to long term investors. If the stock appreciates after your purchase, well and good. But your timeframe should essentially be a long one right from the outset. It is an investment sin to convert short term trades to long term investments after they have fallen.

Therefore a good approach to stock selection might be to first research a stock on its fundamentals and then use technicals to time your purchase. The negative being that a stock price may already have broken out by the time your fundamental analysis is done. A method I personally like and follow is to allocate a certain percentage of your portfolio (say 75 %) to stocks based on fundamentals and deploy the remaining funds to technical picks. I generally do not tinker much with the first group, but whenever I make a profit on my investments in the technical basket, I remove my profits from the markets and redeploy the principal in other picks.

BASICS OF TECHNICAL ANALYSIS

Technical Analysis is the science of predicting the movement of stock prices using chart patterns. These charts plot the stock prices against time. When a particular pattern is formed on the stock charts, it gives an indication to the technical analyst as to the direction in which the stock price is headed.

The rationale behind the science of forecasting stock price movements using technical analysis is that market movements are usually predicated by an activity in the stock by informed sources. It is often observed by investors that the price of particular stock goes up without any apparent reason and when the price is ruling quite high, a positive development is released by the company in the press.

No development of a significant nature, whether it is a takeover, a merger, a large order or a setback in earnings, takes place overnight. Technical analysts believe that well before any major news gets released in the market, the stock is accumulated or sold, depending on the nature of the news by informed circles. It may be fundamental analysts who have got wind of some developments through their research or it may be company insiders.

Any activity of this nature follows three phases viz.
Accumulation : Where large quantities of stock are bought without much influencing market prices.
Marking up : Where sharp upward price movements are seen due to sellers having sold out and buyers still buying.
Distribution : Where stock acquired at low prices are gradually sold out.
This is an example of bullish activity in a stock.
Bearish activity will similarly follow the phases of distribution, marking down and accumulation.

Such activity produces distinct patterns on stock charts. An experienced analyst can spot this pattern and use it to draw his conclusions as to the direction in which the stock should move.

Major patterns are classified into three categories as under:
1. Bullish patterns
Head and shoulders bottom
Double bottom
Rounding bottom
Triangular bottom
2. Bearish patterns
Head and shoulders
Double top
Rounding top
Triangular top
3. Continuation patterns
Flags
Pennants
Wedges

Volumes are an important consideration in the studying of patterns and no study can be considered complete unless due regard is given to significant changes in volumes.

Since chart patterns are far from infallible, the concept of stop loss is an important aspect of technical analysis. When the decision to buy or sell is made a stop loss is also incorporated into the calculations. This gives the investor protection against greater losses should his trade go wrong.

Resistances are determined to indicate to what levels a stock is likely to move up before it meets selling pressure and supports indicate to what level a stock can move down before it encounters buying demand.

Technical analysis therefore relies upon the human element in trading. Its price patterns capture the relative balance between buying and selling as well as directed action by insiders or groups of operators.

BASICS OF FUNDAMENTAL ANALYSIS

Investing based on fundamental analysis of stocks is considered by many to be the best form for the long term investor. There are two broad approaches in which fundamental analysis may be carried out.

Based on the present and future prospects

This approach consists of valuing a business based on various factors related to the products of a company, its markets, its competitors, its efficiency and service levels, its reputation in the minds of its customers.

An evaluation on the above parameters may be done by carrying out a market study of the company. One way to achieve this would be by talking to the company’ suppliers, customers, competitors, ex employees and dealers and distributors. Doing this would enable an investor to judge the strength of the company’ products in the market and its perception in the minds of its customers and competitors. An investor can thereby determine whether the company has strong customer loyalty for its brands, do its competitors have respect for its business acumen and does it treat its stakeholders fairly.

After a complete market study is carried out and the company has performed well on the initial checks, the management may be approached to discuss its future plans with regard to capacity expansion, launch of new products, fund raising plans etc.

Based on past performance

This approach consists of looking to the past to see how a business has performed so far, in order to give us a reasonable picture of how well it may be expected to do in future. This involves looking at published accounts and annual results of the company for the past 5 years and examining the following parameters:

a) Average rate at which the company is growing its sales.
b) Average rates at which the profits are growing.
c) Growth in per share earnings. This gives a clue as to whether the profits are keeping pace with dilutions in equity capital.
d) Market Capitalization (M Cap) of the company. (For more on this refer May 08 archives)
e) The dividend yield of the stock. (For more on this refer May 08 archives)
f) Price to Earnings (PE) ratio and Price Earnings to Growth (PEG) ratio.(I shall discuss this in depth in a future post)
g) The Net Profit Margins.
h) Return on Capital Employed (ROCE). This is the ratio of net profit to capital employed (Equity Capital + Reserves and surpluses)
i) Book value of each share. (Particularly applicable in case of Banking and Financials stocks)
j) Net Current Assets (NCA) of the company ( If the business is available at a M Cap near to its NCA, it may be further investigated as an attractive value buy)

After all these ratios are calculated they may be looked at in relation to the ratios of other companies in similar lines of business, to determine whether the company being investigated is undervalued or not. Ratios should never be used in isolation but as a benchmark against which other alternatives may be compared.

If both these approaches are combined, it cannot fail to reveal several undervalued stocks which may prove to be multi baggers once the market realizes their potential.

The above is only a brief summation of the principles underlying financial analysis and is intended to serve as an introduction to the subject. Investors are advised to further read up on the subject to broaden their understanding of the principles involved.