Fundamental And Technical Analysis - How the Pro's Use Tools of the Game to Win Big

Stock investing is big business and no serious person goes into a big business without a well-thought out strategy for success. In the stock market, this is even more poignant because of the random movements and noise which could confuse and disorient the untutored. The market is driven by information, but much of what floats about is rumour. An undiscerning investor, not rooted in strategy and running about without a game plan, could get badly buffeted and end up a rolling stone. The pros operate in the market with an investment strategy. They also develop a stock evaluation and selection strategy on the strength of which they choose what to buy or sell. Though their operational strategy may not be firmly cast in iron, having a modus operandi provides focus and the sanity to target good results amidst the hoopla of the market.

Broad Strategy Options
In a broad sense, two stock investing strategy options are used predominantly by experienced market operators: fundamental analysis and technical analysis. While fully understanding and effectively applying them may require deeper scrutiny and some use experience, getting to know what experts do is the surest way for you to develop some bite and begin to produce brilliant investment results that will spur more interest. That's why we want to examine these methods of security analysis to help you decide, as an investor, your own approach to the market.

A Backgrounder
Let's paint a background to help put this in perspective. The stocks and other securities traded in the market are of individual companies (or governments). These entities operate within the macroeconomic system, which affects their operations one way or another. Given their internal strengths and weaknesses, they achieve varying levels of success in what they do, which reflects in the operational results they report. Influenced by these and other factors, various investors choose to buy or sell certain securities. Their decisions to buy or sell are the results of their expectations about the returns and prospects of the companies or just the market's pricing response to the securities. And that's the crux of the matter: how do you decide where to stand, relative to a particular stock?

Understanding Fundamental Analysis
Fundamental analysis is the security evaluation technique which relies largely on an analysis of the underlying forces that affect the performance of the economy, industry sectors, and the individual companies. It tries to determine the intrinsic value of a security by evaluating the financial condition and management of the company, its business model, competitiveness and other factors that define its future performance potential. Fundamental analysis assumes that the market could under-price a security in the short run, but will eventually realise this and re-price it to its appropriate level. If the intrinsic value (determined from the analysis) is significantly higher than the market price, it indicates there is room for profit. The opportunity lies in identifying such under-priced stocks and digging in to wait for the price correction. It is fundamental analysis that will reveal the strength and real value of the company, which may not be obvious to the market.

Fundamental analysis consequently relies much on the analysis of financial statements, particularly the profit and loss account, balance sheet and cash flow statements. It employs ratio and trend analysis, evaluating the critical parameters such as the revenue, expenditure, assets, liabilities, P/E ratio, EPS, etc. It is heavily quantitative, though the number-crunching is still reinforced with qualitative considerations. As the name suggests, this strategy seeks to base investing decisions on the fundamentals of the business, using its factual information. It probes for indications as to whether revenue is growing, whether margins are good and in what direction they are driving, how comfortable is the liquidity profile, the level of debt, and other factors that impinge on the expected performance of the business.

As would be expected, not all market operators buy the position of fundamental analysts. Part of their argument is that market prices already reflect these fundamentals of a company and should be more important.

Technical Analysis
The other major strategy, technical analysis, uses price and volume trends to evaluate the securities and reach investment (buy or sell) decisions. This is anchored principally on market momentum, driven by the sentiment of the operators and not so much to do with business fundamentals. A key contention of technical analysts is that the prices already reflect all the factors that fundamental analysis seeks to rely on. Instead, they are more interested in the momentum of market demand and supply, the underpinnings of future price trend. So, instead of analysing the securities to determine their 'true' value as fundamental analysts do, technicians focus on the market itself, reading its behaviour with a view to trending its future.

The key tool of technical analysis is charting - the plotting of prices and volumes of trades. Other tools support charting but all aim to read market activity. Further basis of this action is the belief that prices tend to develop a pattern or trend and this also tends to be cyclical. In effect, the historical pattern of price movements will repeat in the future (history repeats itself). By establishing the pattern for the market and individual securities, chartists, as they are called, determine where to position to make a kill.

Fundamental Vs Technical: Which to Use
It is obvious that there is no perfect tool, otherwise the whole world would have since gone for it. Each technique has its foundation and will serve your interest if it fits your investment mentality. With fundamental analysis, you have concerns about the accuracy of the 'intrinsic value' which forms the basis of your investment decision. You could be wrong, meaning that results you expect may never come. Even if you are right in your calculation about value, how do you determine how long it takes the market to see with you and respond to correct the price. Again, new financial information on companies (which you need) takes a while to become available and there are concerns over 'true and fair view' as heightened by experiences with companies like Enron and even Cadbury Nigeria. If your basis is faulty, the result is bound to be.

On the other hand, not everybody is in the market for daily trades. If you are in the market to invest and stay for some time, can you afford to follow and respond to prices everyday? That's the turf of traders. And if you are going to dig in and ignore short run price oscillations, is there any better way than to be sure of the intrinsic value of the security? After all, the dotcom bubble-burst of the USA market revealed clearly the danger of following price trends not backed by fundamental value of the business.

Ultimately, which technique you lean towards will depend on your investment psyche. Buy-and-hold investors are necessarily fundamentalists. 'Value investors' use fundamental analysis to pick value stocks (stocks believed to be undervalued). If you are uncomfortable with the seeming irrational exuberance of the market, the answer is to stick to the fundamentals. If you see yourself as an investor and not a trader, your tool is fundamental analysis. Traders, on the other hand, are largely chartists and technicians, concerned more with daily price movements and trends. If you're in the market for brief price speculations, get technical. That both techniques are in wide use and can each boast of highly successful adherents indicates that there is some value in either. And strictly, it's difficult to think of pro's who absolutely rely on only one technique.

What is most important for you as an investor is to realise that those who succeed in the market operate with a clear investment strategy and use tools of investment analysis. You can't become an expert overnight with these techniques. So you may make a choice: learn them and use them or enlist the services of market experts.

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