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Evaluating Stocks: Fundamentals and Technical Analysis

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  • Evaluating Stocks: Fundamentals and Technical Analysis

    Certainly, a "complete" course on security analysis is well beyond the scope of this text. There are many excellent books devoted to the subject of how to analyze the value of securities - both from a fundamental as well as a technical standpoint. The goal here is simply to provide a basic understanding of the methods and theories behind each type of stock analysis.

    It should be pointed out early on that Fundamental Analysis and Technical Analysis of securities are two fairly radically different approaches to determining the correct [or fair] value of a company's stock. Let's start with a general overview of each method and then look into the specifics of each area. Again, for a more detailed examination of each type of analysis, we suggest you refer to our book list and/or the books specifically mentioned throughout this document.

    The definitive work on Fundamental Analysis is widely considered to be the classic book "Security Analysis" by Benjamin Graham and David Dodd. This book, which was first published in 1934, is considered by most on Wall Street to be the 'Bible' of security analysis.
    In fact, it was Benjamin Graham that Warren Buffett studied under when he first started in the stock market. Much of Berkshire Hathaway's success can likely be traced back to the information and ideas provided in the book Security Analysis and by the teachings of Benjamin Graham (although, it's widely acknowledged that Warren Buffett put his own spin on things over the years as well).

    Fundamental Analysis is just as it sounds. It is based on examining the fundamental pieces of a business and its operation. There are no exotic formulas used. You do not need to be a mathematician. Anyone with a simple calculator and some basic information about a business should be able to employ Fundamental Analysis quite effectively.
    The basic idea is if you put a dollar into the business (in the form of buying the stock) how much of a return can you expect. How much yield will you likely see and/or how much growth will you experience based on the operation, markets, competitors and costs of the business. Obviously, not all aspects of these fundamentals can be quantified. Areas such as "good will" or changes in the economy or the consumer can be difficult to nearly impossible to calculate. However, to a large degree Fundamental Analysis throws these items out as uncertainties and simply looks at the cold hard facts which you do have available to you. Things such as costs of goods sold, margins, tangible assets, expenses, etc.

    Armed with these basic and tangible numbers, one should rather easily be able to calculate the value and profitability of any business (given the numbers available and/or provided are accurate of course). Once a valuation is arrived at, the person performing the valuation can decide whether or not the market place (in this case the stock market) is applying what could be considered a fair market value to the stock. Certainly, when attempting to make a profit on Wall Street, it is advisable to search out stocks which are (or at least appear are) being improperly or undervalued by the market. For the Fundamental Analyst, once an undervalued security is found, it's simply a matter of buying the stock and waiting for the market to realize the "more accurate" value of the security (assuming of course he/she is correct in their assumptions).
    Find a cheap security, buy it and become rich. If only it were that simple. Or perhaps it is? Just ask Mr. Buffett.

    If the definitive work on Fundamental Analysis is provided by Graham and Dodd, then perhaps the definitive work on Technical Analysis is provided by Martin J. Pring in his book "Technical Analysis Explained". To quote this well regarded book on the definition of Technical Analysis:
    "The technical approach to investing is essentially a reflection of the idea that prices move in trends which are determined by the changing attitudes of investors toward a variety of economic, monetary, political, and psychological forces. The art of technical analysis -- for it is an art -- is to identify trend changes at an early stage and to maintain an investment posture until the weight of the evidence indicates that the trend has reversed."

    Technical Analysis is nothing new. It has been used in one form or another for as long as stocks have been traded. In fact, the star character in one of my all time favorite books ("How I made $2,000,000 dollars in the stock market" by Nicholas Darvas) used mainly Technical Analysis principles in his investing - whether he knew it or not. However, "Charting" also commonly called "Chart Reading", which Technical Analysis is also referred to as, has become much more popular and widely used in perhaps only the last 20 to 30 years on Wall Street. This may be largely due in part to its more wide spread teaching and acceptance in colleges in more recent years.
    If, based on my own experience and knowledge of this method of analyzing securities, I had to summarize all of Technical Analysis down into one central idea, I would put it like this:

    The corner stone of Technical Analysis is the concept that no single individual can ever hope to know as much about a security as the whole of Wall Street does at any given time. Because "Wall Street" is made up of everyone who is invested in - or may invest in - the stock market, their collective knowledge about any specific stock and/or the market is such that this mass of people and combined knowledge (i.e. Wall Street) can valuate securities nearly instantaneously and far more accurately than any single individual.

    As such, in the mind of the Technician, it follows that there must be no need to use something as "archaic" as Fundamental Analysis to value a stock, when everything known about the stock (and this includes the business fundamentals) is nearly instantly reflected in the stock's price. In this situation, it would make much more sense to use the recent and historical trends and movements of the stock price to deduce not only the current fair market value of the stock, but where the price "may move" in the future. This future price movement is largely extrapolated based on historical chart patterns and how the stock has faired recently in relation to support and resistance levels. Any Technical Analysis book worth its salt will quickly introduce you to chart patterns such as "double tops", "trend lines", etc. It is these patterns which are the core of Technical Analysis.

    However, the question of whether or not these patterns on charts can always accurately predict future price movements of a stock is (and probably always will be) up for debate between Fundamental and Technical Analysts. If there is one fundamental (again no pun intended) flaw to Technical Analysis, it is perhaps that over the years Technical Analysis has been [incorrectly] extrapolated to mean that the market will "always perfectly" evaluate a security based on all information known by the markets. Unfortunately, that is not "always" the case.
    This brings to mind a funny joke I once ran across in a book (I believe the book was by or about Warren Buffett) regarding how Technical Analysis has been elevated to levels beyond its true capabilities:

    A Technical Analyst and his friend were walking across the street. His friend noticed a $10 bill laying in the middle of the road and exclaimed, "Look, there is a $10 bill in the road". At which point the Technical Analyst said "If it were really a $10 bill, it wouldn't be laying in the road".
    This joke underscores the idea that Technical Analysis may not always evaluate the market without error. However, as long as you keep this point in mind, then Technical Analysis and chart reading can be a helpful tool in both investing and trading.

    Finally, we should point out that the term "Quantitative Analysis" on Wall Street simply refers to someone (also sometimes referred to as a "Quant") who employs a mix of both Fundamental and Technical Analysis in attempting to properly evaluate stocks.

    Good luck in the markets!

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