What is Fundamental Analysis and does it work?

Fundamental Analysis is one of two processes commonly used to select a stock market investment or trade, the other is Technical Analysis (although throwing a dart at the Wall St Journal is also gaining popularity).  In this article I will briefly cover:

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What is Fundamental Analysis? (FA)

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FA is the process of assessing the factors that affect a company in order to identify the future prospects of its share price.  The majority of the necessary data to do this can be found in a company’s annual report.  This includes its financial statement, management details, business concept and competition.  Here are some of the most commonly used fundamental indicators for a company:

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Market Capitalization Book Value
Revenue Revenue Per Share
Quarterly Revenue Growth Earnings
Earnings Per Share Quarterly Earnings Growth
Debt Cash
Debt / Equity Ratio Assets / Liabilities (Current Ratio)
Return on Assets (ROA) Return on Equity (ROE)
Profit Margin Operating Margin
Price / Earnings Ratio (P/E Ratio) Price / Book Ratio
Price / Earnings To Growth (PEG) Price / Sales Ratio
Dividend Yield Dividend Payout Ratio

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In addition to this, fundamental analysis can involve assessing the factors affecting the general economy.  The aim is to identify whether the future is likely to bring expansion or contraction to the economy and how this will impact the different sectors and industries that you are thinking of investing in.  Some of the most commonly used fundamental indicators for the economy are:

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Interest Rates Consumer Price Index (CPI)
Earnings Growth Rates Gross Domestic Product (GDP)
Jobless Claims Report Job Growth (Nonfarm Payrolls)
Employee Situation Report Employee Cost Index (ECI)
Consumer Credit Report Personal Income and Outlays
Money Supply Consumer Confidence Index (CCI)
Producer Price Index (PPI) Purchasing Managers Index (PMI)
Non-Manufacturing Report Durable Goods Report
Retail Sales Report Factory Orders Report
Productivity Report Trade Balance Report
Industrial Production Institute for Supply Management (ISM)
Existing Home Sales Housing Starts
Business Outlook Survey Tea Leaves

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A Fundamental Analyst believes that the true value of a stock is based on its stability, earnings potential and ability to grow.  The price that a stock is currently selling for could be above or below its true value when taking into account for its future potential.  The fundamental analyst looks to profit by exploiting this mispricing and generally attempts to do so by utilizing one of two main schools of thought on the subject:

  • Growth Investing
  • Value Investing

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Criticisms of Fundamental Analysis

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There are two common arguments against fundamental analysis.  The first comes from those who follow the efficient market hypothesis and believe that stock prices already reflect all that is know.  As a result they believe it is impossible to outsmart the market and identify mispriced stocks using publicly available information.  This would be true if human emotions were not a factor in market fluctuations and group intelligence was allowed to take effect.

The second argument against fundamental analysis is simply a matter of practically.  The following is a quote from a fundamental analyst who I have a lot of respect for.  It is a prime example of the vague conclusions that even the best in the business often arrive at:

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How that will play out exactly, how long it will take and what the road map along the way might look like is difficult to say, due to the many permutations of how events might interact.” – Bill Flekenstein

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There are so many different variables with regard to how a stock or the economy is going to perform in the future: there are economic factors, environmental factors, completion, currency fluctuations, changes in technology, the possibility that the information you have is not true or accurate etc.  For this reason many people say that it is (almost) impossible to use fundamental analysis to forecast the impact of all these different factors and make money as a result.  This begs the question:

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Does fundamental analysis work?

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After doing much research into the subject I have come to the undeniable conclusion that fundamental analysis does work.  In fact most of the world’s top investors with a long track record of market beating performance were/are fundamental analysts.  Rather than try to quantify why it works I have put together a list of the Top 13 Fundamental Analysts of all time, along with a quick summary of each persons investing style:

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Top 12 Fundamental Analysts of all time

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Warren Buffett – The most famous and successful investor in the world, Buffett is a value investor who looks for exceptional companies at reasonable prices.

David Dreman – Looks for stocks that are battered with good price / earnings ratios, low price / book ratios and a higher than average dividend yield.

Philip Fisher – Was an advocate of investing for the long term in high quality, high growth companies.  He looked to the strength of the management and the characteristics of the business.

Benjamin Graham – One of the founders of value investing he looked for companies with strong balance sheets, little debt, above average profit margins and good cash flow.

Jesse L. Livermore – Thought that the main difference between successful and unsuccessful investors was the amount of effort that they put into studying the fundamentals of a company and the economy.

Peter Lynch – Only invests for the long term and undergoes a depth of due diligence into the fundamentals of a company before investing that few can match.

Bill Miller – A value investor but not in the typical sense.  Miller thinks that any company can be a value stock simply by trading below its intrinsic value.  He attributes his success to extensive fundamental analysis.

John Neff – Uses fundamental analysis to identify good companies, in good industries, with low price / earnings ratios.

William J. O’Neil – A growth investor who looks for stocks with the greatest potential for large price increases within a short period if purchase.

Thomas Rowe Price, Jr. – A pioneer of growth investing he focused on identifying companies with strong management in fields that were likely to see earnings and dividend growth that would outstrip inflation and the overall economy.

Sir John Templeton – Was a value contrarian investor and searched for neglected companies around the world with low prices and an exceptional long term outlook.

Ralph Wanger – Looks for strong small companies with entrepreneurial managers running businesses that are easy to understand and will benefit from a macroeconomic trend.

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Why I don’t use Fundamental Analysis

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We have established that fundamental analysis works and that most of the top investors of all time have used it to make their fortunes.  Why then do I not use it and why do I think fundamental analysis is not suitable for the average investor?

One thing that became clear while I was researching the really successful fundamental analysts is that most underwent a depth of analysis that was beyond the capabilities of the average investor.  They often meet with company management and got ‘inside’ a business before investing in it.  They had the resources to check that a company’s balance sheet was in-line with reality.  When asked how he became so successful in investing, Warren Buffett answered:

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We read hundreds and hundreds of annual reports every year.

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Personally I don’t have the intelligence or the motivation to go to such lengths before making an investment.  Reading annual reports and balance sheets all day long is not something that I can get excited about.  What about you?

However while observing the daily action of the market and looking for a way to draw a profit from it I came to a realization.  Yes, the fundamentals dictate what a stock price will be… eventually.  But over the short and medium term it isn’t the fundamentals that matter.  It is the markets interpretation of the fundamentals.  As a result I came to a new definition for what the market is:

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The stock market represents the collective human emotional interpretation of all that is known and its subsequent effect on the supply and demand of shares in publicly traded companies.

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So we are dealing with human emotion and its effect on supply and demand; not human logic!  Is it positive for the market when the Fed increases interest rates?  That depends on the markets interpretation of the reasons for such action at the time.  If a rate hike is expected and it doesn’t come then does that mean that the economy is too weak to handle higher rates or that inflation is under control and everything is great?

If the rate hike is expected and does come then does that mean that the economy is growing rapidly and just needs to be slowed down slightly or that inflation is a problem and the Fed is behind the curve? (Interest rates can be used to stimulate or slow the economy and to battle inflation.)  When the same news can be good one day and bad the next it is extremely difficult to assess the implications of the fundamentals.

In addition to this, even if you have an amazing ability to bring all of the fundamental information together to make sound investment decisions, you have to assume that the fundamentals you are working with are true.  Unfortunately Wall St has a long and growing history of lies, fraud and manipulation.

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Buying stocks with low P/E ratios can make sense only if the earnings – the “E” – are real.  The E was much worse than anyone thought… the banks themselves had no idea of how bad the E was – David Dreman, legendary fund manager laments purchases of financial companies made before the credit crunch.

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What are your thoughts?

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Do you think that Fundamental Analysis is a realistic path to stock market success for the average investor who works a 9-5?  Share your thoughts on Fundamental Analysis in the comments section below.

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Leave A Reply (7 comments so far)


  1. Shiv
    7 years ago

    I liked your explanation on Why I don’t use Fundamental Analysis? Nice article.


    • Derry Brown
      7 years ago

      Thanks Shiv, I am very glad that you enjoyed it!

      Cheers
      Derry


  2. Jarno
    6 years ago

    Fundamentals have been backtested in the book ‘what works on wall street’. And they do seem to have strong predictive power. Especially the price/sales ratio.


    • Derry Brown
      6 years ago

      Thanks Jarno. I find the biggest challenge with fundamentals is ensuring that they are true. But there is no doubt that they can and have been used successfully by the best in the business.


  3. Ritesh
    4 years ago

    I agree with efficient market hypothesis. But I think, the problem with the hypothesis is that it doesn’t give its due to human psychology of consistently behaving irrationally. e.g though majority of the persons know how thay walk and most of them walk straight but if they are put on a narrow platform high above the ground and asked to walk, most of them are going to panic and fall. So given uncommon situations most persons are going to make mistakes and someone like a ‘magician’ is going to make living out of it.


    • Derry Brown
      4 years ago

      Well said Ritesh. Thanks.


  4. Surinder Nibhanupudi
    4 years ago

    Agreed. Fundamental analysis takes knowledge and patience and most importantly the passion to do it after your 9 to 5 job. But you gotta admit that the success rates are better, the transaction is grounded on well-reasoned analysis and you can relax knowing that you’ve taken the right decision. Additionally, you will get guidance if you ask for it. I work a 9-7 job myself and it is hard to find a trustworthy adviser, but my experience with traders is worse!

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