Trade Like a Pro – Part 5: The Role of Fundamentals

3 minute read

Part 5 excerpted from lesson 6.3 of the upcoming Trade Like a Pro ver.10 course.

Professionals know that before they can improve their trading they must improve their selection. Fundamental Analysis is the tool used to determine intrinsic value. Fundamental Analysis reveals in which market, industry, or security to invest. Without this knowledge, we dilute our performance in generic indexing or worse, random selection.

Why Fundamentals Matter?

The first book I read after I became a broker was Intellegent Investor by Benjamin Graham. The second was Security Analysis by Graham and Dodd, the book that was and still is the bible for all Fundamental Analysis. When I left for New York to continue my training both volumes were in my suitcase. As I mentioned in an earlier post, I applied what I learned to buy my early stocks after I returned from training. Identifying what to invest in was the first step.

But there seemed to be an underlying problem that nobody addressed. There were times when fundamentals didn’t matter or misled. First let us examine how Fundamentals work, so we can better understand when and why they don’t.

Professional Fundamental Analysis

Fundamental Analysis is the hallmark of institutional and endowment investing. Most institutional managers subscribe to hundreds of services and newsletters to filter ideas. The primary role of a junior analyst is to read dozens of reports daily to identify possible trade ideas.

Top Down/Bottom Up Fundamentals

The analysis progresses from either a top-down or a bottom-up approach.

“Eighty-percent of returns come from being in the right market and industry.” – Charles Dow – Wall Street Journal columns

This is the top-down approach and begins with a review of the macro and micro economic factors at play. Geo-political influences, recent events, and potential changes are some of the factors examined. Then the scope reduces to market, industry, sector and finally security. Reviews continue with financial factors like:

  • balance sheet assets and liabilities
  • earnings per share
  • price to book and price to earnings ratios
  • beta
  • company initiatives
  • consumer behaviour
  • competition

The bottom-up approach undergoes the same analysis in reverse order. Practitioners focus more attention on the security and less on the market. The bottom-up approach may identify opportunities missed by a top-down process. The bottom-up analysis is more susceptible to the problem we will discuss later.

The analysis compares the valuation of the security relative to peers and the market. The eventual goal is a projection of future value. In the end, either method works to identify an opportunity. This is the sole purpose of Fundamental Analysis. The problem is homework is not the examination. Writing the exam requires a different set of tools. Like many things in life, a man with a hammer sees everything as a nail. Fundamental Analysis is an excellent hammer and identifies what to buy. But it can not be the only tool in our tool box.

When Fundamentals Don’t Matter?

Fundamental Analysis tells us what is most likely to be of value now. Value investors are the best source for whether something is under or over-valued. Many of the best value investors are negative now on the economy. But value investors are the worst at timing. They start buying under-valued stocks or shorting over-valued stocks, too early.

The value investor’s fatal flaw:

”Stocks can remain under or over-valued for an extended time, before reversing.” – Jeremy Grantham

Value investors’ eventual profits must overcome being wrong-sided at the extremes. It’s at the extremes where Professionals separate themselves from the herd. The endowments and hedge funds outperform the Fundamental traders, avoiding the fatal flaw. The Fundamental approach forces clients and investors to tolerate long periods of underperformance before reward.

Because losses have a greater negative impact than profits have a positive benefit, the net result is greater frustration and lower performance. Holding requires more patience than clients and investors have. They bail too early, capturing the loss and missing the payoff. Those who persevere experience lower returns because they must overcome the earlier losses or underperformance. Professionals avoid the early losses by implementing the necessary next step.

Fundamental Analysis tells us what to buy. Once we know which market, industry, sector, or security is the best value, we have to place a trade. This requires a different analysis. Next week we will discuss the missing half of the process.

Next Week

Technicals: The Professional’s Edge

Starts February 1st

Canadian Securities Institute

Trade Like a Pro ver.11 course starts February 1st. Endorsed by CSI and Moody’s Analytics for all financial advisors.

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