Fundamental analysis applies the firm-foundation theory to the selection of individual stocks.
Technical Analysis
Study past price movements and trading volume of trading to to predict when to buy/sell a stock. Based on the castle-in-the-air view of stock pricing.
What Can Charts Tell You?
Principles of Technical Analysis
All information about earnings, dividends, and the future performance of a company is automatically reflected in the company’s past market prices.
Prices tend to move in trends, e.g. a stock that is rising tends to keep on rising.
It’s all about reading the charts, forget the underlying company:
- Connect the tops and bottoms of the days' trades.
- See a head-and-shoulders formation? The market has topped out.
- Beware of the bear trap. It’s the exception that tests the rule.
The Rationale for the Charting Method
- Mass psychology makes trends perpetuate themselves.
- Unequal access to fundamental information about a company.
- Investors often underreact initially to new information.
Resistance Area: if a stock bought at $50 stayed there and then dipped to $40, people will be anxious to the sell when it hits $50 again, making it hard to cross $50. $50 is the resistance area.
Support Levels: stock was trading at $10; investors didn’t buy; stock rises; stock comes back to $10. Investors will jump at the new chance. $10 is a support level.
Why Might Charting Fail to Work?
- Buying/selling after trend makes the chartist often miss the boat.
- As more and more people use it, the value of any technique depreciates.
- Profit-maximizing behavior. If some know that the price will go to $40 tomorrow, they’ll buy today until the price hits $40.
Fundamental Analysis
Strives to be relatively immune to the crowd. Makes a sharp distinction between a stock’s current price and its true value.
Determinants for Calculating the “True Value”
Determinant 1: Expected Growth Rate
Compound growth is under-appreciated. The rule of 72: \( \frac{72}{interest_rate} = time_to_double_investment \)
Example of reconciling to market prices: if 5% growth stocks sell at 13 P/E, reject a 5% growth stock trading at 20 P/E
But it gets harder for companies to keep growing at the same rate…
Determinant 2: Expected Dividend Payout
Other things equal, pay more the larger the proportion of earnings paid in dividends or buybacks.
I don’t know, what about companies that re-invest into research and the business?
Determinant 3: Degree of Risk
The bigger the swings in stock prices (relative to market) & annual returns, the greater the risk.
Other things equal, pay more, the less risky the company’s stock.
Determinant 4: Market Interest Rates
High interest rates offer a stable profitable alternative to the stock market.
Caveats
Future expectations cannot be presently proven.
Optimism and pessimism make it hard to be objective.
Precise figures cannot be calculated from undetermined data.
There an unfounded assumptions, e.g. Why a growth period of 10 years?
Perception of growth rates are not always comparable between time periods.
Before the dotcom boom, high-growth stocks traded at a modest premium over P/E multiples of common stocks. Not so in the late 90s and early 00s.
Why Might Fundamental Analysis Fail to Work?
Maybe the information will be worthless: good and bad info cancels out, transaction fees acting on the information, mistranslations of facts into earnings estimates.
All the information available to the analyst may already be reflected.
The market might correct its “mistake” by revaluing all stocks downward, rather than raising the price for your target stock.
Using Fundamental and Technical Analysis Together
Buy only companies that are expected to have above-average earnings growth for 5+ years.
Never pay more for a stock than its firm foundation of value.
Buy stocks whose anticipated growth stories make investors build castles in the air.
Everything is Priced In™️