Broadly, there are two ways to approach the stock markets. There is the fundamental approach wherein you look at the inherent strengths of the company, evaluate its operating environment and then take a call on whether to buy or sell the stock. The other approach is a technical approach wherein you rely more on charts and patterns to take a view of markets. Let us understand these approaches a little better…
Fundamental Analysis approach…
Fundamental analysis involves the following steps and building blocks…
Fundamental analysis is based on the premise that the markets are not efficient and therefore it is possible to earn above market returns by identifying quality stocks and holding them long enough.
- Fundamental analysis approaches equities in two ways. Firstly, there is the top-down approach where you have to be first convinced about the macro-economy, then about the industry in which the company operates and then the company itself. Secondly, there is the bottom-up approach wherein you identify the stock first and use the macros and industry factors to ratify the choice.
- The most important decision in fundamental analysis is the projecting of future cash flows. These estimates are based on plant visits, reading of financial statements, talking to competition and through management discussions. The projections also consider non-financial factors like management quality, corporate governance, transparency etc.
- Once the projections are made, the next step is to arrive at a fair valuation of the stock. Normally, the fair value of the stock is arrived at by discounting the future cash flows using the cost of capital and then ratifying it with peer group P/E ratios and historic market price.
- The decision to buy or sell the stock is then taken based on whether the market price is below the fair value or above the fair value. Most analysts also give importance to a Margin of Safety so that they factor in estimation errors.
Technical Analysis Approach…
Technical analysis involves the following steps and building blocks…
- The technical analysis approach believes that stock prices move at random and hence there is no point in spending time trying to look at the valuation of the company. Since markets are random, technical analysis entirely focuses on identifying past patterns in the market.
- Technical analysis is based on the premise that since markets are random by nature, past patterns will tend to repeat themselves. Hence the best thing that market analysts can do is to identify and understand these patterns and extrapolate it to the future. That is the crux of technical analysis.
- Technical analysis, contrary to popular belief, can be used in the short term and also in the very long term. In fact, the Dow Theory uses charts to very effectively and successfully identify patterns and predict markets over a 30-40 year period.
- Technical analysis uses popular indicators like oscillators, Moving Average Convergence Divergence, Supports & Resistances, and Bollinger Bands etc. Over a period of time, this has emerged as a separate discipline of study.
- Technicals are popularly used by short-term traders as it helps them identify where to put stop loss, where to book profits, when to be convinced about a turnaround in a stock, how to trade momentum etc. From a trading perspective, technical analysis is quite effective as a decision support tool.
- Technical analysts are also popularly referred to as chartists since they extensively rely on chart patterns to take their trade decisions. Technical analysts follow a 4-step process viz. Identifying patterns, extrapolating patterns, separating the pattern from the noise and taking key trading decisions based on these charts.
Adopting an eclectic approach to stock market analysis…
It is hard to say which works better as both these approaches have their own merits and demerits. Fundamental analysis is a lot more logical and scientific whereas technical analysis is largely based on empirical evidence of past patterns. But the big advantage for investors is that technical approach is a lot more democratic. When it comes to fundamental analysis selected parties like institutions and insiders will have access to more information and hence the quality of analysis will depend on the quality of information available. Is there is a mid-way of using both the approaches?
The answer is there is a mid-way. For example, fundamental analysis is a great way of identifying future winners. But these winners can test your patience. Technical analysis can help you analyze when momentum is coming in favour of these stocks and help you time your entry and your exit better. Secondly, the combination of fundamental and technical analysis works very well for traders too. Essentially, traders rely on momentum and momentum is created by news flows. It could be the Fed meet, the ECB meet, OPEC decisions, RBI policy, banking policy etc. When you want to trade momentum you need to be on the right side of the news. Hence you also need to time your entry and exit to perfection. That is where technicals can be of great help to you.
It is an academic debate to purely look at fundamental and technical analysis as competing approaches to stock market analysis. In reality, they actually complement each other quite well. It is up to the analyst to leverage both these approaches to get best results!