There are two main types of investment research: fundamental and technical analysis. Investors would do well to be familiar with both approaches.
In fundamental analysis, stock is valued according to the financial data a company reports. These data are analyzed to predict the likely movement of that company’s stock price. At the Common Sense Investor, we tend to prefer fundamental analysis as a primary research method mainly because it gives you deep insight into the strength of a company and its prospects moving forward. Fundamental analysis tends to be the preferred choice of long term investors who can see beyond the temporary volatility of the markets. It is based on the belief that over the long term the stock market is rational, but over the short term it can be overly emotional and not properly reflect a company’s value.
Technical analysis, on the other hand, involves the study of market charts. Instead of looking at the actual reported data, the technical analyst examines the stock’s historical price movement. The underlying premise here is that there are clear and predictable patterns in the market that can be identified and exploited by the smart, active investor.
What’s interesting is that these two methods can paint very different pictures of the same business.
Fundamental analysis does not ignore market trends, but treats them as only one element in an overal analysis. A company’s financial results over the years, its operations efficiency, the reputations of its officers, and the markets in which they are competing are all elements of analysis. A fundamental analyst may look at dividends and stock value, how cash is managed, level of debt, market share, countries the business operates in, and the growth of revenues and earnings versus expenses.
This is all based on the idea that a company must be fundamentally sound in order to make money over the long run. Graham and Dodd in Security Analysis stated that the market is in no way a predictor of a company’s future performance. It is, instead, a voting machine rather than a weighing machine. Even if the true value of a company is not currently reflected in its market price, fundamental analysis works on the idea that it will eventually come out due to market forces.
Valuation techniques like the P/E ratio and return on equity are often used to determine the true value of a company by a fundamental analyst. But no fundamental analyst depends on these techniques to the exclusion of other data, such as general company financial health and growth or loss of market share.
Technical analysis, on the other hand, believes that there is value in the “voting” procedures of market valuation of stock. Many technical analysts think there is more art than science in technical analysis. A technical analyst is not so concerned with why a price is moving than the fact that it is moving in a particular direction or in a particular pattern. Profit can be made in any market if you position yourself to take advantage of the price trend. The simplest form of technical analysis is the idea that you should, with up trends, look for opportunities to buy; and with down trends, look for opportunities to sell.
The three primary beliefs in technical analysis is that first, price action in the market trumps all other things; second, that prices move in trends; and third, that history repeats itself. A pure technical analysis ignores the company itself to look at the pricing of the company and the pricing of similar companies historically to predict trends in market valuation.
The two types of valuation can be combined to make some effective market strategies. For instance, the difference between a stock’s actual value as determined by a fundamental analysis and its value on the market, which is what the technical analysis would reveal, is profit that the clever investor can count on making in the future. There are many other ways to combine the two approaches that may be more valuable than either alone.