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Fundamental Analysis

A complete course on stock analysis is well beyond the scope of this commentary. However our goal in this commentary is to provide a basic understanding of the methods and theories behind stock analysis.  There are many excellent books devoted to the subject of how to analyze the value of stocks both from a fundamental and technical standpoint. 

Fundamental analysis and technical analysis are two fairly radically different approaches to investing and trading.  Normally investors use fundamental analysis and traders use technical analysis. 

The definitive work on fundamental analysis is widely considered to be the classic book Security Analysis by Benjamin Graham and David Dodd. First published in 1934 this book is considered by most on Wall Street to be the bible of stock analysis. In fact it was Benjamin Graham that Warren Buffet studied under when he first started in the stock market. Much of Berkshire Hathaway's success can be traced back to the information and ideas provided in the book Security Analysis and by the teachings of Benjamin Graham. 

Fundamental analysis is just as it sounds. It is based on examining the fundamental pieces of a business and its operation. There are no exotic formulas used. You do not need to be a mathematician. Anyone with a simple calculator and some basic information about a business should be able to employ fundamental analysis effectively. 

The Basic Idea
The basic idea of fundamental analysis is to invest in a company's stock with the expectation that the stock in undervalued at the time of purchase. How much return can you expect on your investment How much growth will the company experience based on the operation markets competitors and costs of the business These are questions you will need answered. 

Obviously not all aspects of these fundamentals can be quantified. Areas such as good will or changes in the economy or consumer spending can be difficult to nearly impossible to calculate. However to a large degree fundamental analysis throws these items out as uncertainties and simply looks at the cold hard facts which are available. This would include costs of goods sold margins tangible assets expenses etc. 

Armed with these basic and tangible numbers one should rather easily be able to calculate the value and profitability of any business given the numbers available and/or provided by the company are accurate.  The problem with fundamental analysis is that it assumes the company is honest and telling the real story and not falsifying the numbers (eg. WorldCom or Enron).  Once a valuation is arrived at you can decide whether or not the stock market is applying fair market value to the stock. 

The True Value
Certainly when attempting to make a profit in a stock it is advisable to search out stocks which are or at least appear to be improperly valued by the market. For the fundamental investor once an undervalued stock is found it is simply a matter of buying the stock and waiting for the market to realize the true value of the stock assuming of course they are correct in their assumptions.  Find a cheap security buy it and hold it until you become wealthy. If only it were that simple. Or perhaps it is Just ask Mr. Buffet. 

We at STHQ are partial to technical analysis because we are traders and not investors.  Fundamental analysis does have its purpose but there are a lot of flaws with it.  As mentioned above investors are at the mercy of the company and must trust them to tell the truth.  Even if everything is fine with the company's books there is no guarantee that a stock will not remain undervalued for a number of years yielding very little return on investment.  Fundamental analysis can be good and should be used in any long term investments.  Long term investing is where fundamental analysis is most valuable.  It is of little value to the short term trader.

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