Technical Versus Fundamental Analysis What’s the difference?!?!….
This is true in business and this is true in life: “Buy low, Sell High”. Technical & Fundamental Analysis are two sides of the same coin. The underlying objective of these two different styles of investing is: “Buy low, Sell High”!
However, the methodology that governs these two techniques are as different as night & day.
Let me explained…
Technical Analysis encompasses the systematic understanding of human psychology perfectly described in the “Castle in the air theory”
Investors who adopted the “Castle in the air theory” are also known as speculators or momentum investors. The philosophy of “Castle in the air theory” deems that the intrinsic value of the stock and its main business operation is irrelevant; The price that you pay doesn’t have to correspond with the actual value of the stock, you could be overpaying by 2 times so long as you can find a buyer who is willing to bid at a higher price than what you paid for. To put it simply the foundation of this framework is “ Mass psychology”.
Technical investors study the movement of price and volume of a particular stock through charts. By accurately interpreting the movement of the stocks, it would tell the investors what other players have been doing in the past and what is the likely position of the current players.
1st principle: The Market prices are a reflection of the quantitative economic value of the company. I.E: dividends or P/E ratio.
2nd principle: A different variant with regards to “Newton’s laws of motion”. The second principles describe stocks in uniform motions tends to remain at that state. This second principle is what I personally believe is how “bubbles” form; Players in the market bootstraps the value of the stocks hyping up the market until it eventually pops, resulting in a sharp plunge.
To build upon the early statement, when companies fail to hit wall-street analysis benchmark, typically what we would see in the market [in extreme cases] players shorting the stocks causing the prices of the stocks to be significantly unvalued.
Now I am not going to get into the topic of how to accurately predicts stock movements, instead, I am going to share with you how the rationale behind reading charts.
There are tons of Investors(Day-Traders), who might smoke the rationale with overly-complex ideology on “Why charting works?” But I am going to simplify the most probable reasons for you.
- Herd Mentality
This is engraved in the nature of our DNA. We Homo-Sapiens are social beings and tends to mimic/conform to each other behavior. All, this behavior was essential for survival for our primitive ancestors.
As investors, we are also Homo-sapiens vulnerable to mass psychology, we tend to jump on the bandwagon [irrationally I might add]. When we see a favorable stock rising up & up, fearing the chance of missing out; Vice versa we notice a stock going downhill, instinctively we want to cut our losses. This is why bullish/bearish trends perpetuate themselves.
2. Speculative Information
Insider trading! Although illegal, it still happens. Let me explain this through a simple timeline.
An “Insider” who allegedly know favorable news about a company would mostly act on it, buying shares while the price is still low.
They would next tell their, circle of friends, who will act next, thereby increasing the price.
Next, mediocre hedge funds managers/brokers would be aware of the news and began to add the stocks to their portfolio. Resulting in a further increment of the stock prices.
Finally, the common people, by the time we hear about this news from Bloomberg or wall street journal, the prices are already inflated, well above what the stock is actually worth!
3. It can’t possibly get any lower?!
[This rationale is more apparent in blue-chip stocks.]
When stocks fall well below their average historical prices, speculative investors who failed to purchase the stock at that “Low price” tend to suffer a loss of aversion bias if the stocks rise up. IF the stocks fell back down, the speculative investors would jump at the chances, pretty much guarantee the prices would not fall below a certain price point.
A word of caution
The inherent flaw of using technical analysis, Investors can only act(buy) after the price trends have been established, & sell after the trend breaks. Ideally, Many speculative investors try to predict when would the trends breaks and sell even before the bearish streak starts. However, more often than not, sharp reversals in the market occur quite suddenly, causing massive losses for speculative investors who fail to act quickly.
“in the short run, the market is like a voting machine–tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine–assessing the substance of a company.”
– Benjamin Graham
Intrinsic value is the applied principle of Fundamental analysis. The primary concern for investors who employ the Fundamental analysis is to estimate the company future growth[i.e future earnings/income streams & dividends] and converted it to the present value.
There are 3 keys aspects that investors may wish to consider when estimating the firm-foundation value of a stock.
The expected growth rate investors often emphasized the importance of growth rate But what do we really understand about it?
We understand higher “growth rate” would lead to higher payout in the future. However, the everyday man does not stop to think why?
Well the magic link between high growth rate & high payout is known as “compound interest”
Compound interest is what makes 1+1=3 possible!
Suppose you invested $100 in an ETF that promises 5% annual return.
Percentage growth (With reference to year 1)
Given if N= 10 years the invested amount would be $163 equivalent to a 63% growth in 10 years. Which is 13%! This return is better than what you would get from simple interest. [This may not look much but trust me it adds up]
Here is a little tip for you guys to apply:
“The rule of 72: is a method to determine the amount of time investment would take to double, given a fixed annual interest rate. To use the rule of 72, divide 72 by the annual rate of return.”
“The rule of 70: is used to determine the number of years it takes for a variable to double by dividing the number 70 by the variable’s growth rate. The rule of 70 is generally used to determine how long it would take for an investment to double given the annual rate of return.”
In our current subject on compound interest, we should apply the rule of 72 to estimate the amount of time it would take to double our investment. With this note, the first fundamental rule for evaluating securities.
“A Rational investor should be willing to pay a higher price for a share the larger the growth rate of dividends and earning”
What Burton G.MALKIEL is talking about is the P/E ratio. What he suggests is that the P/E ratio is the more accurate reflection of the value of a stock rather than it’s a price.
company ABC is valued at $5 per share with an earning of $0.50 per share.
Company 123 is valued at $40 per share with an earning of $4 per share.
Both companies would have a P/E multiple of 10. Thus, both stocks should be valued equally, in this respect.
If you are interested to read more about P/E RATIO click here.
The expected dividend payout.
Dividends payout is arguably may be viewed by investors as one of the most important factors that can directly affect the price of a stock. Why?
Well, because it directly ties in with investors interests! For investors looking for dividends payout, I would suggest investing in REITs. This is because contrary to popular belief, investing in securities with high dividends payout might not be a wise investment If their future growth prospect is unfavorable. Secondly, it is common practices for companies who are in their growing phrase to pay little to zero dividends to their investors, as capital is used to instead finance growth or buying back stocks A.K.A Growth Stocks. If dividends still play a major part in your investment philosophy, you should look for companies with stable and consistent growth.
Risk is inevitable, there is no such thing as risk-free. The guys at wall-streets & Bankers tend to Leverage on calculated risk. As greater risk means greater reward. That’s why you are able to observe big companies hiring hundreds of employees and channeling plenty of resources to a “Risk management Department”.
For the everyday man without such vast resources, it usually would be wiser to invest in the “Blue chip stocks” that have to stand through the test time. The DrawBack here is that Blue-chip stocks usually can command a higher P/E multiple. Resulting in lesser returns.
After basic guidelines that directly correlates the company intrinsic value & its market value. We have to bear-in-mind that this is not the end all be all with regards to the firm-foundation analysis. There are 3 cautionary tales for investors who might employ this investing philosophy
Caveat 1: Expectations about the future cannot be proven in the present.
Caveat 2: The more assumption in your evaluation, the less precise your calculations is!
Caveat 3: Don’t overpay for the promise of growth.