Fundamentalists Vs Technicians

Foreword from ShareInvestor

This article “Fundamentalists Vs Technicians” by Mindy Tan was first published in The Business Times on 09 May 2011 and is reproduced in this blog in its entirety.

MINDY TAN elaborates on these two camps which represent very diverse investment strategies

IF you ever take a walk down Wall Street and encounter a heated argument with terms like “tea leaf reading” or “voodoo” being thrown around, take heart. The witch hunt has not left Salem, it is merely the vocal arguments of the fundamentalists and the technicians.

There are, broadly speaking, two camps on Wall Street: the fundamental analysts (fundamentalists) who boast investors like Warren Buffett and Jim Rogers, and technical analysts (technicians) like traders Mike Swanson and Martin Schwartz.

These two camps represent very diverse investment strategies that is only in recent years starting to receive (barely lukewarm) acceptance in either camp.

Fundamental Analysis

The biggest part of fundamental analysis involves delving into the financial statements. This involves looking at revenue, expenses, assets, liabilities, and all other financial aspects of a company. Fundamentalists look at this information to gain insight into a company’s future performance.

Analysts also look at less tangible factors – the quality of the company’s board members and key executives, its brand-name recognition, proprietary technology etc.

The field of fundamental analysis is based on two main assumptions:

  • Share prices do not fully reflect a stock’s real/intrinsic value.
  • In the long run, the stock market will reflect the fundamentals.

Is that all there is to it?

Xi Dong, assistant professor of finance, Insead, says: “A fundamentally ‘good’ firm does not mean it is a good stock to invest in if the market already knows the firm is good. Research shows that good firms measured by fundamental variables do not necessarily outperform bad firms… The most difficult part for successful fundamental analysis is to find the hidden fundamental value of the stock that is temporarily not recognised by the rest of the market. This is very hard to achieve, especially repeatedly.”

Technical Analysis

Technical analysis is the study of financial market action. The technician looks at price charts and technical indicators derived from price changes.

The field of technical analysis is based on three assumptions:

  • Technicians believe that the company’s fundamentals, broader economic factors and market psychology are all priced into the stock, removing the need to consider these factors separately.
  • After a trend has been established, future price movement is unlikely to waver from the trend.
  • The concept that history tends to repeat itself is particularly prevalent in their analysis of price movement. The repetitive nature of price movements is attributed to market psychology (ie market participants tend to react in the same way to similar market stimuli over time).

Prof Dong adds: “There are a few stylised effects discovered by technical analysis that either robustly exist in history or may exist because of some rational/behavioural reasons. (For example), size is a phenomenon that small market cap firms outperform large market cap firms. Such effects are very strong and statistically robust. Some of them exist for a rational or a behavioural reason. For example, the reason for small cap outperforming large cap may come from the fact that investors overall are less willing to invest in small stocks possibly because they are riskier in terms of their future prospects. This preference causes a big firm to be valued higher than a small firm today (thus lowering holding-period return in the future) even when these two types of firms are expected to generate the same value in the future.”

Never The Twain Shall Meet?

Commonly referred to as the oil and water of investment strategies, there are some striking differences between the two forms of analysis.

Charts vs financial statements. At its most basic level, technicians approach securities from the charts since they hold the view that a company’s fundamentals are accounted for in the stock’s price.

A fundamentalist on the other hand starts with financial statements, to determine a company’s intrinsic value.

Time horizon. Fundamental analysis takes a long-term approach to analysing the market, often looking at data over a number of years. It can take a long time for a company’s value to be reflected in the market, so when a fundamentalist estimates intrinsic value, a gain is not realised until the stock’s market price rises to its “correct value”.

Technicians, on the other hand, work with relatively shorter time frames. A day-trader for instance, would break down charts in spans of minutes, while a swing-trader would probably utilise time frames of days and months. Remember, the overall goal of technical analysis is finding patterns, and these avail themselves regardless of time frames.

Trading vs investing. In general, technical analysis is used for a trade, whereas fundamental analysis is used to make an investment. In trading, the appreciation of capital is the objective; if dividends are paid out, this is an added advantage. In contrast, investing looks more towards income over time. Income producers – eg dividends – are thus the prime motivation.

Advice From Buffett

Eleven years ago, Warren Buffett issued a parable to investors, filled with advice that still rings true today.

“Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball. They know that overstaying the festivities – that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future – will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”

Now that you understand some of the fundamentals of equities trading, don’t be afraid to get your feet wet. Just remember the three golden rules:

  • Only invest money you can spare
  • Manage greed and expectations effectively
  • Always do your research