Focussed investing: allocating capital by concentrating on businesses with outstanding economic characteristics and run by first-rate manager.
The central theme uniting Buffett's investing is that the principles of fundamental business analysis, first formulated by his teachers Ben Graham and David Dodd, should guide investment practice. Linked to that theme are investment pricniples that define the proper role of corporate managers as the stewards of invested capital, and the proper role of shareholders as the suppliers and owners of capital.
Buffett and Berkshire Vice Chairman Charlie Munger have built Berkshire Hathaway into a $70-plus billion enterprise by investing in business with excellent economic characteristics and run by outstanding managers. While they prefer negotiated acquisitions of 100% of such a business at a fair price, they take a "double-barreled approach" of buying on the open market less than 100% of such businesses when they can do so at a pro-rata price well below what it would take to buy 100%.
The double-barreled approach pays off handsomely. The value of marketable securities in Berkshire's portfolio, on a per share basis, increased from $4 in 1965 to nearly $50,000 in 2000, about a 25% annual increase. Per share operating earnings increased in the same period from just over $4 to around $500, an annual increase of about 18%. According to Buffett, these results follow not from any master plan but from focussed investing - allocating capital by concentrating on businesses with outstanding economic characteristics and run by first-rate manager.
Learning from Buffett
Buffett views Berkshire as a partnership among him, Munger and other shareholders, and virtually all his $20-plus billion net worth is in Berkshire stock. His economic goal is long-term - to maximize Berkshire's per share intrinsic value by owning all or part of a diversified group of businesses that generate cash and above-average returns. In achieving this goal, Buffett foregoes expansion for the sake of expansion and foregoes divestment of businesses so long as they generate some cash and have good management.
Berkshire retains and reinvests earnings when doing so delivers at least proportional increases in per share market value over time. It uses debt sparingly and sells equity only when it receives as much in value as it gives. Buffett penetrates acounting conventions, especially those that obscure real economic earnings.
It is true that investors should focus on fundamentals, be patient, and exercise good judgment based on common sense. Many people speculate on what Berkshire and Buffett are doing or plan to do. Their speculation is sometimes right and sometimes wrong, but always foolish. People would be far better off not attempting to ferret out what specific investments are being made at Berkshire, but thinking about how to make sound investment selections based on Berkshire's teaching. That means they should think about Buffett's writings and learn from them, rather than try to emulate Berkshire's porfolio.
Buffett modestly confesses that most of the ideas were taught to him by Ben Graham. He considers himself the conduit through which Graham's ideas have proven their value. Buffett recognizes the risk of popularizing his business and investment philosophy. But he notes that he benefited enormously from Graham's intellectual generosity and believes it is appropriate that he pass the wisdom on, even if that means creating investment competitors.
-----
Buffett has applied the traditional principles as CEO of Berkshire Hathaway, a company with roots in a group of textile operations begun in the early 1800s. Buffett took the helm of Berkshire in 1964, when its book value per share was $19.46 and its intrinsic value per share far lower. Today (2002), its book value per share is around $40,000 and its intrinsic vlaue far higher. The growth rate in book value per share during that period is about 24% compounded annually.
Berkshire is now a holding company engaged in a variety of businesses, not including textiles. Berkshire's most important business is insurance, carried on through various companies including its 100% owned subsidiary, GEICO Corporation, the sixth largest auto insurer in the United States, and General Re Corporation, one of the four largest reinsurers in the world. Berkshire publishes The Buffalo News and owns other businesses that manufacture or distribute products ranging from carpeting, briks, paint, encyclopedias, home furnishings, and cleaning systems, to chocolate candies, ice cream, jewelry, footwear, uniforms, and air compressors, as well as businesses that provide training to operators of aircrafts and ships worldwide, fractional ownership interests in general aviation aircraft, and electric and gas power generation. Berkshire also wons substantial equity interests in major corporations, including American Express, Coca-Cola, Gillette, The Washington Post, and Wells Fargo.
Showing posts with label fundamental analysis. Show all posts
Showing posts with label fundamental analysis. Show all posts
Thursday 13 August 2009
Friday 26 June 2009
Some thoughts on Analysing Stocks
Ideally, a stock you plan to purchase should have all of the following charateristics:
- A rising trend of earnings, dividends, and book value per share.
- A balance sheet with less debt than other companies in its particular industry.
- A P/E ratio no higher than average.
- A dividend yield that suits your particular needs.
- A below-average dividend pay-out ratio.
- A history of earnings and dividends not pockmarked by erratic ups and downs.
- Companies whose ROE is 15 or better.
- A ratio of price to cash flow (P/CF) that is not too high when compared to other stocks in the same industry.
Keep It Simple and Safe.
Thursday 12 February 2009
The Death of Fundamental Analysis
The Death of Fundamental Analysis
By Shannon Zimmerman
February 11, 2009 Comments (0)
If Ben Graham or some other proud, dearly departed purveyor of brick-by-brick, fundamental analysis were to emerge from the great beyond and dial up, say, this chart of the market's action over the last year, you could hardly blame the venerable value hound for scratching his head and saying, "Hey there, youngster! What's with this Facebook thing I keep hearing so much about?"
Irrationality is painful -- and painfully boring. And when you have a passion for investing (as opposed to speculation), your capacity for patience is sometimes trumped by an impulse to throw up your hands and make other time-occupying arrangements while the market finds its proverbial bottom, comes to its senses, and revives an apparently moribund interest in corporate fundamentals as opposed to, say, big macroeconomic attacks.
Just don't do it
Still, as great investors like Graham have always known and taught, the time to go stock shopping is when you can buy quality on the cheap. Which is precisely where we seem to be, if the chart I linked to above is any indication.
The chart's big-picture story is of a market gripped by fear and panic. A closer look, however, reveals that that particular dynamic was accompanied by a proverbial flight not to quality (as represented by the large-cap-dominated S&P 500's anemic red line) but rather to the seemingly riskier little fish that comprise the Russell 2000 (represented in royal blue).
Virtually everything has tanked over the last year, of course. But in relative terms, small caps have trumped the big boys. That's surprising enough in the aggregate, but it's positively shocking when you dig into particular names.
Consider, for example, the following grade-A lineup -- rock-solid companies with financial strength, ample free cash flow, and long-haul track records of overachievement -- and how they've fared relative to both the S&P 500 and the Russell 2000 for the past 12 months.
Company
+/- S&P 500
+/- Russell 2000
Applied Materials (Nasdaq: AMAT)
-9.6
-11.1
Schlumberger (NYSE: SLB)
-10.4
-11.9
Berkshire Hathaway (NYSE: BRK-B)
-1.1
-2.5
UnitedHealth (NYSE: UNH)
-3.8
-5.3
Texas Instruments (NYSE: TXN)
-9.1
-10.6
eBay (Nasdaq: EBAY)
-14.9
-16.4
Honeywell (NYSE: HON)
-6.7
-8.6
That's a hit list of companies that, in my view, strike the right profile for folks in search of a clutch of companies to use as the centerpiece of their portfolios. That's particularly true for Fools who may be closing in on retirement and wondering how they're going to glue their nest eggs back together before their permanent tee time comes around. The upside potential of these titans relative to their downside risk -- at least in terms of these companies' currently attractive valuation profiles -- seems Goldilocks perfect.
My, what big market caps you have
Still, it certainly pays to mix it up when designing your portfolio, diversifying across the market's valuation spectrum and its cap ranges as well. Indeed, if the recent history charted by my Fool colleague Ilan Moscovitz holds true, small caps may have more room to run when the economy finally turns the corner.
The good news, of course, is that investing is not an either/or proposition -- and that fundamental analysis isn't dead. Once you've settled on the asset-allocation breakdown that works for you -- i.e., the right ratios of stocks to bonds, large caps to small, international to domestic -- your best bet is to fill in that personalized pie chart with vehicles that sport attributes similar to those I called out above in connection with our magnificent seven: companies that are firing on all fundamental cylinders as evidenced by robust financial health -- and wealthy long-term shareholders.
We're working hard
At the Fool's Ready-Made Millionaire, we've designed a five-star portfolio that matches the profile sketched above -- a lineup comprising a power trio of world-class mutual funds, an undervalued ETF, and four individual stocks that we think will whip up on the market over the next three to five years and beyond. The Fool itself has invested a million bucks of its own capital in our Ready-Made selections, and starting next Tuesday, you'll be able to as well.
That's the day we'll reopen Ready-Made Millionaire to new members, who'll be able to emulate our set-and-forget lineup at prices that, thanks to the market's irrational despair, are even more attractive that when we invested last July. Click here to be notified when our doors swing wide again -- and to snag our special 11-Minute Millionaire special report as an immediate download now.
Hope to see you Tuesday!
Shannon Zimmerman runs point on the Fool's Ready-Made Millionaire and doesn't own any of the companies mentioned. The Motley Fool owns shares of Berkshire Hathaway and UnitedHealth. Berkshire, UnitedHealth, and eBay are Motley Fool Stock Advisor and Motley Fool Inside Value recommendations. You can check out the Fool's strict disclosure policy.
http://www.fool.com/investing/general/2009/02/11/the-death-of-fundamental-analysis.aspx
By Shannon Zimmerman
February 11, 2009 Comments (0)
If Ben Graham or some other proud, dearly departed purveyor of brick-by-brick, fundamental analysis were to emerge from the great beyond and dial up, say, this chart of the market's action over the last year, you could hardly blame the venerable value hound for scratching his head and saying, "Hey there, youngster! What's with this Facebook thing I keep hearing so much about?"
Irrationality is painful -- and painfully boring. And when you have a passion for investing (as opposed to speculation), your capacity for patience is sometimes trumped by an impulse to throw up your hands and make other time-occupying arrangements while the market finds its proverbial bottom, comes to its senses, and revives an apparently moribund interest in corporate fundamentals as opposed to, say, big macroeconomic attacks.
Just don't do it
Still, as great investors like Graham have always known and taught, the time to go stock shopping is when you can buy quality on the cheap. Which is precisely where we seem to be, if the chart I linked to above is any indication.
The chart's big-picture story is of a market gripped by fear and panic. A closer look, however, reveals that that particular dynamic was accompanied by a proverbial flight not to quality (as represented by the large-cap-dominated S&P 500's anemic red line) but rather to the seemingly riskier little fish that comprise the Russell 2000 (represented in royal blue).
Virtually everything has tanked over the last year, of course. But in relative terms, small caps have trumped the big boys. That's surprising enough in the aggregate, but it's positively shocking when you dig into particular names.
Consider, for example, the following grade-A lineup -- rock-solid companies with financial strength, ample free cash flow, and long-haul track records of overachievement -- and how they've fared relative to both the S&P 500 and the Russell 2000 for the past 12 months.
Company
+/- S&P 500
+/- Russell 2000
Applied Materials (Nasdaq: AMAT)
-9.6
-11.1
Schlumberger (NYSE: SLB)
-10.4
-11.9
Berkshire Hathaway (NYSE: BRK-B)
-1.1
-2.5
UnitedHealth (NYSE: UNH)
-3.8
-5.3
Texas Instruments (NYSE: TXN)
-9.1
-10.6
eBay (Nasdaq: EBAY)
-14.9
-16.4
Honeywell (NYSE: HON)
-6.7
-8.6
That's a hit list of companies that, in my view, strike the right profile for folks in search of a clutch of companies to use as the centerpiece of their portfolios. That's particularly true for Fools who may be closing in on retirement and wondering how they're going to glue their nest eggs back together before their permanent tee time comes around. The upside potential of these titans relative to their downside risk -- at least in terms of these companies' currently attractive valuation profiles -- seems Goldilocks perfect.
My, what big market caps you have
Still, it certainly pays to mix it up when designing your portfolio, diversifying across the market's valuation spectrum and its cap ranges as well. Indeed, if the recent history charted by my Fool colleague Ilan Moscovitz holds true, small caps may have more room to run when the economy finally turns the corner.
The good news, of course, is that investing is not an either/or proposition -- and that fundamental analysis isn't dead. Once you've settled on the asset-allocation breakdown that works for you -- i.e., the right ratios of stocks to bonds, large caps to small, international to domestic -- your best bet is to fill in that personalized pie chart with vehicles that sport attributes similar to those I called out above in connection with our magnificent seven: companies that are firing on all fundamental cylinders as evidenced by robust financial health -- and wealthy long-term shareholders.
We're working hard
At the Fool's Ready-Made Millionaire, we've designed a five-star portfolio that matches the profile sketched above -- a lineup comprising a power trio of world-class mutual funds, an undervalued ETF, and four individual stocks that we think will whip up on the market over the next three to five years and beyond. The Fool itself has invested a million bucks of its own capital in our Ready-Made selections, and starting next Tuesday, you'll be able to as well.
That's the day we'll reopen Ready-Made Millionaire to new members, who'll be able to emulate our set-and-forget lineup at prices that, thanks to the market's irrational despair, are even more attractive that when we invested last July. Click here to be notified when our doors swing wide again -- and to snag our special 11-Minute Millionaire special report as an immediate download now.
Hope to see you Tuesday!
Shannon Zimmerman runs point on the Fool's Ready-Made Millionaire and doesn't own any of the companies mentioned. The Motley Fool owns shares of Berkshire Hathaway and UnitedHealth. Berkshire, UnitedHealth, and eBay are Motley Fool Stock Advisor and Motley Fool Inside Value recommendations. You can check out the Fool's strict disclosure policy.
http://www.fool.com/investing/general/2009/02/11/the-death-of-fundamental-analysis.aspx
Saturday 29 November 2008
Stock-Picking Strategies: Fundamental Analysis
Stock-Picking Strategies: Fundamental Analysis
Ever hear someone say that a company has "strong fundamentals"? The phrase is so overused that it's become somewhat of a cliché. Any analyst can refer to a company's fundamentals without actually saying anything meaningful. So here we define exactly what fundamentals are, how and why they are analyzed, and why fundamental analysis is often a great starting point to picking good companies.
The Theory
Doing basic fundamental valuation is quite straightforward; all it takes is a little time and energy. The goal of analyzing a company's fundamentals is to find a stock's intrinsic value, a fancy term for what you believe a stock is really worth - as opposed to the value at which it is being traded in the marketplace. If the intrinsic value is more than the current share price, your analysis is showing that the stock is worth more than its price and that it makes sense to buy the stock.
Although there are many different methods of finding the intrinsic value, the premise behind all the strategies is the same: a company is worth the sum of its discounted cash flows. In plain English, this means that a company is worth all of its future profits added together. And these future profits must be discounted to account for the time value of money, that is, the force by which the $1 you receive in a year's time is worth less than $1 you receive today. (For further reading, see Understanding the Time Value of Money).
The idea behind intrinsic value equaling future profits makes sense if you think about how a business provides value for its owner(s). If you have a small business, its worth is the money you can take from the company year after year (not the growth of the stock). And you can take something out of the company only if you have something left over after you pay for supplies and salaries, reinvest in new equipment, and so on. A business is all about profits, plain old revenue minus expenses - the basis of intrinsic value.
Greater Fool Theory
One of the assumptions of the discounted cash flow theory is that people are rational, that nobody would buy a business for more than its future discounted cash flows. Since a stock represents ownership in a company, this assumption applies to the stock market. But why, then, do stocks exhibit such volatile movements? It doesn't make sense for a stock's price to fluctuate so much when the intrinsic value isn't changing by the minute. The fact is that many people do not view stocks as a representation of discounted cash flows, but as trading vehicles. Who cares what the cash flows are if you can sell the stock to somebody else for more than what you paid for it? Cynics of this approach have labeled it the greater fool theory, since the profit on a trade is not determined by a company's value, but about speculating whether you can sell to some other investor (the fool). On the other hand, a trader would say that investors relying solely on fundamentals are leaving themselves at the mercy of the market instead of observing its trends and tendencies. This debate demonstrates the general difference between a technical and fundamental investor. A follower of technical analysis is guided not by value, but by the trends in the market often represented in charts. So, which is better: fundamental or technical? The answer is neither. As we mentioned in the introduction, every strategy has its own merits. In general, fundamental is thought of as a long-term strategy, while technical is used more for short-term strategies. (We'll talk more about technical analysis and how it works in a later section.)
Putting Theory into Practice
The idea of discounting cash flows seems okay in theory, but implementing it in real life is difficult. One of the most obvious challenges is determining how far into the future we should forecast cash flows. It's hard enough to predict next year's profits, so how can we predict the course of the next 10 years? What if a company goes out of business? What if a company survives for hundreds of years? All of these uncertainties and possibilities explain why there are many different models devised for discounting cash flows, but none completely escapes the complications posed by the uncertainty of the future.
Let's look at a sample of a model used to value a company. Because this is a generalized example, don't worry if some details aren't clear. The purpose is to demonstrate the bridging between theory and application. Take a look at how valuation based on fundamentals would look:
The problem with projecting far into the future is that we have to account for the different rates at which a company will grow as it enters different phases. To get around this problem, this model has two parts:
(1) determining the sum of the discounted future cash flows from each of the next five years (years one to five), and
(2) determining 'residual value', which is the sum of the future cash flows from the years starting six years from now.
In this particular example, the company is assumed to grow at 15% a year for the first five years and then 5% every year after that (year six and beyond). First, we add together all the first five yearly cash flows - each of which are discounted to year zero, the present - in order to determine the present value (PV). So once the present value of the company for the first five years is calculated, we must, in the second stage of the model, determine the value of the cash flows coming from the sixth year and all the following years, when the company's growth rate is assumed to be 5%. The cash flows from all these years are discounted back to year five and added together, then discounted to year zero, and finally combined with the PV of the cash flows from years one to five (which we calculated in the first part of the model). And voilĂ ! We have an estimate (given our assumptions) of the intrinsic value of the company. An estimate that is higher than the current market capitalization indicates that it may be a good buy. Below, we have gone through each component of the model with specific notes:
So far, we've been very general on what a cash flow comprises, and unfortunately, there is no easy way to measure it. The only natural cash flow from a public company to its shareholders is a dividend, and the dividend discount model (DDM) values a company based on its future dividends (see Digging Into The DDM.). However, a company doesn't pay out all of its profits in dividends, and many profitable companies don't pay dividends at all.
What happens in these situations? Other valuation options include analyzing net income, free cash flow, EBITDA and a series of other financial measures. There are advantages and disadvantages to using any of these metrics to get a glimpse into a company's intrinsic value. The point is that what represents cash flow depends on the situation. Regardless of what model is used, the theory behind all of them is the same.
Reference:
http://www.investopedia.com/university/stockpicking/stockpicking1.asp?partner=WBW
Next: Stock-Picking Strategies: Qualitative Analysis
Ever hear someone say that a company has "strong fundamentals"? The phrase is so overused that it's become somewhat of a cliché. Any analyst can refer to a company's fundamentals without actually saying anything meaningful. So here we define exactly what fundamentals are, how and why they are analyzed, and why fundamental analysis is often a great starting point to picking good companies.
The Theory
Doing basic fundamental valuation is quite straightforward; all it takes is a little time and energy. The goal of analyzing a company's fundamentals is to find a stock's intrinsic value, a fancy term for what you believe a stock is really worth - as opposed to the value at which it is being traded in the marketplace. If the intrinsic value is more than the current share price, your analysis is showing that the stock is worth more than its price and that it makes sense to buy the stock.
Although there are many different methods of finding the intrinsic value, the premise behind all the strategies is the same: a company is worth the sum of its discounted cash flows. In plain English, this means that a company is worth all of its future profits added together. And these future profits must be discounted to account for the time value of money, that is, the force by which the $1 you receive in a year's time is worth less than $1 you receive today. (For further reading, see Understanding the Time Value of Money).
The idea behind intrinsic value equaling future profits makes sense if you think about how a business provides value for its owner(s). If you have a small business, its worth is the money you can take from the company year after year (not the growth of the stock). And you can take something out of the company only if you have something left over after you pay for supplies and salaries, reinvest in new equipment, and so on. A business is all about profits, plain old revenue minus expenses - the basis of intrinsic value.
Greater Fool Theory
One of the assumptions of the discounted cash flow theory is that people are rational, that nobody would buy a business for more than its future discounted cash flows. Since a stock represents ownership in a company, this assumption applies to the stock market. But why, then, do stocks exhibit such volatile movements? It doesn't make sense for a stock's price to fluctuate so much when the intrinsic value isn't changing by the minute. The fact is that many people do not view stocks as a representation of discounted cash flows, but as trading vehicles. Who cares what the cash flows are if you can sell the stock to somebody else for more than what you paid for it? Cynics of this approach have labeled it the greater fool theory, since the profit on a trade is not determined by a company's value, but about speculating whether you can sell to some other investor (the fool). On the other hand, a trader would say that investors relying solely on fundamentals are leaving themselves at the mercy of the market instead of observing its trends and tendencies. This debate demonstrates the general difference between a technical and fundamental investor. A follower of technical analysis is guided not by value, but by the trends in the market often represented in charts. So, which is better: fundamental or technical? The answer is neither. As we mentioned in the introduction, every strategy has its own merits. In general, fundamental is thought of as a long-term strategy, while technical is used more for short-term strategies. (We'll talk more about technical analysis and how it works in a later section.)
Putting Theory into Practice
The idea of discounting cash flows seems okay in theory, but implementing it in real life is difficult. One of the most obvious challenges is determining how far into the future we should forecast cash flows. It's hard enough to predict next year's profits, so how can we predict the course of the next 10 years? What if a company goes out of business? What if a company survives for hundreds of years? All of these uncertainties and possibilities explain why there are many different models devised for discounting cash flows, but none completely escapes the complications posed by the uncertainty of the future.
Let's look at a sample of a model used to value a company. Because this is a generalized example, don't worry if some details aren't clear. The purpose is to demonstrate the bridging between theory and application. Take a look at how valuation based on fundamentals would look:
The problem with projecting far into the future is that we have to account for the different rates at which a company will grow as it enters different phases. To get around this problem, this model has two parts:
(1) determining the sum of the discounted future cash flows from each of the next five years (years one to five), and
(2) determining 'residual value', which is the sum of the future cash flows from the years starting six years from now.
In this particular example, the company is assumed to grow at 15% a year for the first five years and then 5% every year after that (year six and beyond). First, we add together all the first five yearly cash flows - each of which are discounted to year zero, the present - in order to determine the present value (PV). So once the present value of the company for the first five years is calculated, we must, in the second stage of the model, determine the value of the cash flows coming from the sixth year and all the following years, when the company's growth rate is assumed to be 5%. The cash flows from all these years are discounted back to year five and added together, then discounted to year zero, and finally combined with the PV of the cash flows from years one to five (which we calculated in the first part of the model). And voilĂ ! We have an estimate (given our assumptions) of the intrinsic value of the company. An estimate that is higher than the current market capitalization indicates that it may be a good buy. Below, we have gone through each component of the model with specific notes:
- Prior-year cash flow - The theoretical amount, or total profits, that the shareholders could take from the company the previous year.
- Growth rate - The rate at which owner's earnings are expected to grow for the next five years.
- Cash flow - The theoretical amount that shareholders would get if all the company's earnings, or profits, were distributed to them.
- Discount factor - The number that brings the future cash flows back to year zero. In other words, the factor used to determine the cash flows' present value (PV).
- Discount per year - The cash flow multiplied by the discount factor.
- Cash flow in year five - The amount the company could distribute to shareholders in year five.
- Growth rate - The growth rate from year six into perpetuity.
- Cash flow in year six - The amount available in year six to distribute to shareholders.
- Capitalization Rate - The discount rate (the denominator) in the formula for a constantly growing perpetuity.
- Value at the end of year five - The value of the company in five years.
- Discount factor at the end of year five - The discount factor that converts the value of the firm in year five into the present value.
- PV of residual value - The present value of the firm in year five.
So far, we've been very general on what a cash flow comprises, and unfortunately, there is no easy way to measure it. The only natural cash flow from a public company to its shareholders is a dividend, and the dividend discount model (DDM) values a company based on its future dividends (see Digging Into The DDM.). However, a company doesn't pay out all of its profits in dividends, and many profitable companies don't pay dividends at all.
What happens in these situations? Other valuation options include analyzing net income, free cash flow, EBITDA and a series of other financial measures. There are advantages and disadvantages to using any of these metrics to get a glimpse into a company's intrinsic value. The point is that what represents cash flow depends on the situation. Regardless of what model is used, the theory behind all of them is the same.
Reference:
http://www.investopedia.com/university/stockpicking/stockpicking1.asp?partner=WBW
Next: Stock-Picking Strategies: Qualitative Analysis
Greater Fool Theory
Greater Fool Theory
One of the assumptions of the discounted cash flow theory is that people are rational, that nobody would buy a business for more than its future discounted cash flows. Since a stock represents ownership in a company, this assumption applies to the stock market. But why, then, do stocks exhibit such volatile movements? It doesn't make sense for a stock's price to fluctuate so much when the intrinsic value isn't changing by the minute.
The fact is that many people do not view stocks as a representation of discounted cash flows, but as trading vehicles. Who cares what the cash flows are if you can sell the stock to somebody else for more than what you paid for it? Cynics of this approach have labeled it the greater fool theory, since the profit on a trade is not determined by a company's value, but about speculating whether you can sell to some other investor (the fool). On the other hand, a trader would say that investors relying solely on fundamentals are leaving themselves at the mercy of the market instead of observing its trends and tendencies.
This debate demonstrates the general difference between a technical and fundamental investor. A follower of technical analysis is guided not by value, but by the trends in the market often represented in charts. So, which is better: fundamental or technical? The answer is neither. Every strategy has its own merits.
In general, fundamental is thought of as a long-term strategy, while technical is used more for short-term strategies.
One of the assumptions of the discounted cash flow theory is that people are rational, that nobody would buy a business for more than its future discounted cash flows. Since a stock represents ownership in a company, this assumption applies to the stock market. But why, then, do stocks exhibit such volatile movements? It doesn't make sense for a stock's price to fluctuate so much when the intrinsic value isn't changing by the minute.
The fact is that many people do not view stocks as a representation of discounted cash flows, but as trading vehicles. Who cares what the cash flows are if you can sell the stock to somebody else for more than what you paid for it? Cynics of this approach have labeled it the greater fool theory, since the profit on a trade is not determined by a company's value, but about speculating whether you can sell to some other investor (the fool). On the other hand, a trader would say that investors relying solely on fundamentals are leaving themselves at the mercy of the market instead of observing its trends and tendencies.
This debate demonstrates the general difference between a technical and fundamental investor. A follower of technical analysis is guided not by value, but by the trends in the market often represented in charts. So, which is better: fundamental or technical? The answer is neither. Every strategy has its own merits.
In general, fundamental is thought of as a long-term strategy, while technical is used more for short-term strategies.
Thursday 23 October 2008
Fundamental analysis useful in bear market
Question: When should we use fundamental analysis?
Fundamental analysis is a good tool to engage at all times. It is particularly useful during a bear phase of the stock market.
When prices have fallen sharply to an unrealistic level, you could reap a handsome profit in future by using fundamental analysis to guide you in buying shares.
Fundamental analysis is a good tool to engage at all times. It is particularly useful during a bear phase of the stock market.
When prices have fallen sharply to an unrealistic level, you could reap a handsome profit in future by using fundamental analysis to guide you in buying shares.
- First, ascertain whether stock market is in a bull or bear phase.
- If it is a Big Bear, then use Fundamental Analysis.
Ref: Making Mistakes in the Stock Market by Wong Yee
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