Monday, August 04, 2014

Fundamental Analysis Vs Technical Analysis

I had the privilege to address a group of investor at Madras Stock Exchange last Saturday. A retired banker has emailed me the following question after the meeting.

“I hope you are following the Fundamental Analysis alone, if I am correct.   Why not it is  combined  with Technical Analysis?  Or otherwise from the back end are you following the Technical Analysis also?”

I am happy to publish ‘Fundamental Analysis Vs Technical Analysis’ chapter from the book ‘The Science of Stock Market Investment’ in an attempt to answer that question.

Fundamental Analysis

This branch of analysis emphasizes more on the financial statements of the company. Determining whether a stock is overvalued or undervalued based on a detailed study of current monetary position, estimate about the future and managerial ability is supposed to the main crux of fundamental analysis. On top of that, other socio-economic, political, ecological and level of competition are some other considerations in the process.

An effort is made here to scientifically establish the value of a company by studying various numbers and ratios derived from both the balance sheet and profit & loss account for many years in a row. Everything that we discussed in prior chapter(s) is fundamental analysis by definition. They are supposed to be suitable for medium term and long term investors. Goes without saying, it is equally bitter for short term investors and likewise speculators. They are better off following technical analysis.

Technical Analysis

Technical analysis disregards – prefix the term ‘totally’ if you want to spice it up -  anything related to the business operations and other genuine financial indicators. Then? It is an art of studying stock price trends with the help of charts. It is an art constructed by many otherwise great scholars by assiduously studying the price movements in thousands of companies for many years together. Its main principle is, ‘This is how the market has been so far and exactly how it will be in the future too’.

Anything that goes down will come up; that goes up will come down. That is the nucleus of this method. Technical analysts don’t confine their territory with price movement trend alone. They also examine trading volumes at various market prices. Tops and bottoms will be studied in details with the help of the charts. If there is a surge in volume at the top/peak, then we can assume that those people who bought at lower levels are using this high price to get out. Likewise, if we notice heavy volume at the bottoms, then some players are accumulating the stocks cheaply. Technical analysts have developed some conviction about these heavy volumes. These high volume stock-turnover is said to happen just before the peak in an upward journey and before the bottom in downwards journey.

Price will naturally drop when majority of the investors begin selling the stocks. After certain point, price would have come down so much that nobody else might prefer to sell the stocks any longer. This is referred as ‘oversold’ situation. As most of the prospective sellers got rid of their holdings, the probability of further decline is minimal. Even if people come forward to sell it will be easily absorbed by increasing number of buyers. Buying interest at this point supports the price from falling down further and hence is called ‘support level’.

Overbought’ is the opposite of oversold. When many investors and traders continue to buy the stocks, the price shoots up. Then at some stage buying interest dries up. Stock prices won’t move up unless new buyers show up. The supply of stocks exceeds the demand at this stage, which we rightly refer as ‘overbought’. This is also known as ‘resistance level’.

Which came first, the chicken or the egg?  This is an unending question. If you need to draw some parallel to this question in the stock market, you can ask, “Which one came first, fundamental analysis or technical analysis?” Whatever came into practice first that does not make significance to a true investor. What might really have greater significance is the answer to another question, “which analysis is to follow first?”, because the correlation between these two branches of analysis is a puzzle and hard to understand.
If we can call fundamental aspect as ‘causes’, the technical analysis can be said to reflect the ‘effects’. Factor such as sales, profit, future expectation etc. and the inherent uncertainty that we consider as inputs in the fundamental analysis are some of the ‘causes’. When the news, perception and understanding about these factors are available for the investment community they tend to buy or sell securities in huge number. This action changes the price of that particular company or the entire stock market. Prices thus changing are plotted in the chart and the trend is tracked. This is what we call as the ‘effect’.

We naturally expect the price to reflect the changes in fundamental attributes. Unfortunately this does not happen all the time. Though there won’t be any substantial difference in the operations of a company between this week and the week before this, stock price fluctuation in a week’s time is beyond anyone’s rational understanding. That is why we had to term the relation between the cause and effect as a kind of puzzle.

Technical crew don’t really bother to ask ‘why’ the share prices move in a particular direction. If you ask this question, then you are likely to receive discover real answers such as excellent profit, tough business environment, incompetent management etc. But technical analysis bluntly disregards them. Instead, it tries to focus more on the direction and velocity of price movement.  With the help of price charts/trends it subsequently attempts to answer questions such as how far will the movement last, at which point it will reverse the direction etc.

Technical analysts wont recommend you to buy stock when the price moves down. Quite ironically, they would advise to sell them. Their school of thought goes like this. The price will continue to fall further. Till it goes down to the oversold position or support level, it is better to reduce stock exposure and stay away from investing fresh money.

Look at our INDIA NEXT stocks for instance. They are currently traded at Rs 90. Tomorrow it slips down to Rs 87. Technical analysts will wake up to the situation and shout, “It is very likely to go down till 80 if it breaches 87 mark. We recommend our subscribers to exit at this support level and then possibly re-enter at around 80”. This so called exit point (of 87 rupees) is termed as ‘stop loss’ point. The basic idea of ‘stop-loss’ philosophy is like amputation of a finger in order to save entire arm or leg from decay.  As you might have comes across desi movie dialogues that justify scarifying a family if such sacrifice would save entire village.

Well lets us consider the price dropping down to Rs 80 as per their prediction in technical analysis. If you ask them whether this is appropriate level to get in, they would suggest you to wait until they observe the signs of trend reversal. Same analysts who argued against investing at Rs 80 would urge you to buy heavily at Rs 84.

Proponents of technical analysis expect us to accept that technical analysis helps us to get into a stock just before the price picking up and sell at top before it start correcting.  They advocate to adapt this approach instead of keeping stocks idle through all the fluctuations. It sounds too good to be true. Prudent long term investors have no problem in disregarding the technical analysis not only because of their inability to understand the complex calculations, but also due to lack of evident to substantiate technical approach’s merits over fundamental analysis.

If you had bought INDIA NEXT restaurant stocks at Rs 90, you would have been convinced at that point of time that the price was lesser than the value  to qualify as a good bargain. If that is the case, what is the need to sell at 87 rupees? Isn’t it insane? Don’t you think it is speculation to sell the stock simply because somebody else will also sell to take the prices down, instead of sticking to the intrinsic value of the company? We cannot approve this approach as an act of investing. So, a hard core investor should realize that technical analysis is not for them but for speculators.

You recognize a company which has all the potential to move up to Rs 200 level in another five years from the current level of 100 bucks. In that case, how does temporary fluctuations of 80 and 70 affect us? To tell you the fact, this is the harvest time for long term investors. They should cultivate the habit of accumulating more to their portfolio for less price.

An attempt is made by some to assign fundamental analysis to value investors and technical analysis to growth investors. This false notion is to be erased from your brain system. Fundamental analysis is important for both of them. That is the foundation of investing. At the same time you may try to see what is going on in the technical world, rather than blindly ignoring it. Be it gambling or technical analysis, nothing hurts to get an exposure in them. But, don’t let that determine your approach.

Some advocates of technical analysts tend to argue, “This analysis does not stop with charts and graphs”. They claim to be investigating all the factors that affect the price and trend. Some of them even go to the extent of saying that they conduct surveys to gauge market enthusiasm and subsequently guess whether the future market trend would be bullish or bearish. How can that work?

For instance, let us assume that investors are at the peak of their bullish mood. They might have already put their money in the market and on top of that they would still expect it to move ahead. As majority of the investors have already entered the market and only expect it to climb further, new prospective investors will be less in number. So, this can reverse the trend and the market may turn bearish anytime. While their survey expresses over optimism, we cannot rule out the possibilities of the opposite occurring.

With the expansion of computer technology, the technical analysis is spreading like wild fire. It is very common in this new era to come across people who make tireless effort in spotting the direction and velocity of price movement by drawing numerous horizontal, vertical and inclined lines – linear and non-linear. Truly, if there are two things that have prospered with the advent of computers, they should be pornography and technical analysis than anything else.

If you are regular restaurant goer you might agree that the lunch at any Chinese restaurants does not complete without fortune cookies. Likewise, any talk about technical analysis will be incomplete without mentioning about ‘beta’. This number indicates the relative velocity of a stock’s movement with respect to the entire market. For example, SENSEX moves up 10 per cent. During the same time stock price of company X advances 15 per cent and Y 5 per cent. After sometime the market slumps 20 per cent. Companies X and Y decline 30 per cent and 10 per cent respectively. Company X is prone to higher fluctuations both on the upward direction as well on the downward direction. Y is dull stock.

Apart from the business risk of the companies, there is some element of market risk too. That is what beta value tries to capture. Technical analysts tend to asses market related risk of a company through  this beta number. Company X fluctuates1.5 times as the market. At the same time Y changes at half the market speed. This relative movement is known as Beta, which is 1.5 and 0.5 for X and Y respectively.

Companies tagged with high beta (a value greater than 1) are considered to be risky and those with low (less than 1) are regarded as low risky. This is only in terms of market risk that has nothing to do with the business of the company under study. There is another category of stocks that move at the same rate as the market. There stocks with 1.0 beta value are known as unity stocks.

Our money invested in the stock market is susceptible to fluctuate due to general market movement. This is an accepted fact and even for a seasoned long term investor it will be foolish to deny this fact. At the same time, there is no need to be overly swayed by market forces and beta value. Over a long term the performance of a company’s stock would be purely based its business expansion and it will almost be detached from the overall market performance. Neither the index nor the beta will have any relevance with a particular company’s feat and fate.

Beta number indicates its past relative movement only and it is not a forecast for the future. Moreover it is not a constant number. It is based on the relative movement of a given company with the index for any period ranging a minute to centuries. In other words, beta value for one week may be different from one month, which will be very different from one year value. So when you ever think of using beta value in your investment decisions, please ask yourself whether you would be able to accurately predict future market movements and also individual company’s beta value for your exact investment horizon. Indulging in such an exercise is a waste of time.

Hence, we ought to detach the company from the general stock market and instead focus on its own business prospects. An investor should not imagine himself to be a market analyst, but as a business analyst. Fundamental analysis is the most important ingredient of business analysis. Our high school mathematics will sufficiently support this analysis. EPS, PE and other common aspects can be computed with basic multiplication & division and it does not require calculus and chemical formulae. It is unwarranted for an investor to adapt complicated technical analysis.

A friend of mine argued, “Fundamental analysis might suggest you what companies to buy. To decide when to buy you have to bank on technical analysis as there is no other alternate to rely on”. Before accepting or denying his statement, we’ll go through another point that confuses an investor more than anything in this world. It is the question of deciding when to sell an investment. My friend suggested technical analysis helped to answer that riddle as well.

Final wealth of a person is more dependent on when and at what price he chooses to sell – or how long he holds his portfolio together without selling - than when he buys. Believe me, this statement is no exaggeration.

Buying at low price and selling at high price is trading. On the contrary, buying when the price is lesser than its value and selling if (at all) it crosses that value is regarded as investment. A trader might sell the stock at Rs 200 which he bought at Rs 100. You might think it’s a profitable transaction. But if the value was Rs 150 when the price was Rs 100 and increased to Rs 300 whilst the price move to Rs 200, there is no justifiable reason to sell the stock.

“Well, then when should I sell?” - you might ask. The answer is very simple. For what reason did you buy the stocks? If that reason undergoes a change, then you can think about exiting from your investment. If you had bought due to low prices, then sell it off when prices move up. If you had bought thinking that the market has undervalued a particular stock, then you should get rid of that when it becomes overvalued. If you had bought by having high confidence on the management, then you might get out when that confidence fades out. If you had bought the stocks just for the sake of parking your idle cash, then you should sell when the need for money arises. If you buy aiming for high growth, then you should sell when that company’s growth prospects go down. Of course, you can sell if off when your girlfriend ditches you if you had made that investment to impress her.

My colleague’s wife was expecting a baby. He was very excited and was equally curious to know whether it would be a girl or boy. Revealing baby’s gender from the scan is banned in India and he was on the lookout for other avenues. It was like festival time at our office as everyone of us volunteered to discover a mechanism. We could finally spot an ancient Chinese gender predicting table from internet. Based on mother’s age at the time of conceiving and the month of the year, we were able to get baby’s gender. His wife conceived in her 26th age in an October month. The result  led us to the conclusion that he was going be blessed with a baby girl. He also yearned for a girl child.

Few months later, his wife gave birth to a baby boy. Table ditched him. Then a big debate took place. We tried to contemplate how that table might have been constructed. Ancient Chinese statisticians might have gathered birth dates of children born across years throughout their country and formed an easy to follow common table.

This Chinese gender prediction table and our technical analysis are not too different. Both of them rely in past data and expect the future to repeat. Nothing more to add.

Another friend of mine works in Singapore. He talked about this mythology table with his Chinese colleague and told his it was useless. Guess what response he got? Chinese friend reprimanded him in nose-spoken English. If we comment about the worthlessness of technical analysis, we are thrashed by suite wearing elite professionals’ eloquent English on the business channels.

1 comment:

SHV said...

enjoyed reading