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.
