If stock-picking wasn't hard enough an activity by itself, the plethora of buy-sell calls on all stock-related things complicates matters. There are various approaches to zero in on a stock which has the potential to deliver good returns.
Consider Wonderland, a country whose economy is growing at a healthy clip. On its stock markets, Alice, a company which makes and sells clothes through a chain of shops across Wonderland, has had a bad run as it struggled to grow profits.
Fundamentals and technical
Now, there's one expert telling you that Alice is good candidate to buy as it reversed its downtrend, bouncing back after hitting its key long-term support zone. Then there's this other analyst who also rates it a ‘buy', but bases recommendation on Alice's low valuations and a prospective jump in earnings after it sold some land to pay off its huge debt.
Both analysts have rated the stock a buy but have cited very different reasons for doing so. The first reasoning is termed technical analysis. The second approach is called fundamental analysis. The eternal question, then, is which of these methods is to be used. The answer involves first understanding what these two methods are.
Studying the financials
Let's continue the example. Given that Wonderland's economy is growing at a good pace, its people are likely to have growing disposable incomes and will therefore spend more. A retailer can benefit by capturing a part of this burgeoning consumption. Narrowing down to Alice, having paid off its high debt, saving in interest costs could result in higher profitability. A range of factors, therefore, affects Alice's revenues and profits.
Fundamental analysis involves estimating future earnings and the value (price) of a share by picking apart current and historical financial statements, assessing management, industry and other factors which have a bearing on the operations.
To wit, you have to answer key questions about the company. How have revenues and profits been growing? Is such growth sustainable? What is the market or demand for its products or services? Does it have an edge over competitors? Is it able to meet debt obligations? Does it have enough money to fund expansion? Does it have a competent management?
These are company-specific factors. You also have to broaden your view to understand the prospects of the industry the company is in. What is propelling the fortunes of that industry? What could be the dampeners? Is there potential in overseas markets or, conversely, do imports threaten the domestic market? What about competitive pressures?
Then go one step beyond and consider macro influences such as the state of the economy, government policies, exchange rates and so on. Fundamentalists arrive at an ideal stock price or intrinsic value by analysing the company, industry and the economy. Based on this, a stock is at its fair value, undervalued or overvalued.
If fundamental analysts pore over balance sheets, cash flow statements and profit & loss accounts, technical analysts study stock graphs. Technical analysis uses past market action in terms of price and volumes to predict how prices will move in the future. History repeats itself, so to speak.
Charting price and volume movement of a stock through a graph throws up different patterns. Analysts use these patterns to judge how a stock is trending, if it is on the verge of reversing from its current trend, what price it is likely to hit and so on.
To identify such trends, there are a variety of tools and indicators used together to judge whether prices are moving higher or lower. Candlesticks, patterns in charts such as head-and-shoulders, flags, pennants, price and volume indicators such as relative strength index, moving averages and so on are used to forecast prices and narrow down to stocks which will deliver.
Developing understanding
No matter which approach you choose, stock selection is an exercise both tricky and tedious. Dissecting financial statements takes a good deal of effort, requiring the application of tools such as ratio analysis, valuation methods, combing through annual reports, all company and industry-related news you can get your hands on and combining all this with your judgement to arrive at a decision. There is, however, a lot of guidance on analysing financial statements available online or in books. For instance, look through our ‘May We Help You?' columns to develop understanding on how to get started in stock markets.
Technical analysis too involves a lot of studying to understand the entire range of tools involved and then a good deal of experimentation before you can rely on your own judgement. Identifying the correct trend in time is certainly no mean feat. The stock exchange Web sites offer a few tools for you to test waters.
A combination works
Having understood the difference between the approaches, which one do you use? The key is to blend the two approaches. The degree of importance you bestow on an approach depends on your investment period and how frequently you want to churn portfolios. A profusion of long-term bets in your portfolio specifically requires more attention on fundamentals.
Fundamental analysis ensures that your picks have a firm grounding while helping you keep your wits and not be entirely swung by market irrationality in sectors or stocks. Technical analysis helps pin down that elusive ‘timing' by forecasting price movement. In a nutshell, while fundamental analysis tells you which stock to buy, technical analysis tells you when to buy it.