The last 12 months have seen a positive trajectory in the US stock markets, with S&P 500 currently standing at 2,353.7 points versus 2,082.4 on April 4, 2016. This depicts a return of just over 13% for those who entered the market on April 4 of the previous year. But what if someone entered on June 27, 2016 when the S&P 500 was trading at 2,000.5 points. This person would have surely generated an almost 18% return on investment. And what if, this person did not buy all the 500 stocks comprising the index, but rather invested only in the ones that were undervalued and were expected to beat the S&P 500. You get the point!
So how can you select these stocks and make a profit on that money lying idle in your savings account. The first step would be to transfer that into an investment trading account and then using analytical technics to start selecting undervalued stocks.
Stock Analysis Methodologies
Fundamental and Technical Analysis are the two main methodologies used for analyzing the current performance and forecasting the future growth trend of stocks.
Fundamental analysis, as the term suggests, focuses on a target company’s fundamentals to derive intrinsic value of a stock. This type of analysis encompasses studying everything from the overall economy and industry conditions to the financial condition and management of the target company to draw conclusion around the estimated value of its stock. In short, fundamental analysis begins with the analysis of the target company’s financial statements.
Technical analysis, on the other hand, is used to value stocks by looking at market trends and statistics generated by market activity. This technique is built on the premise that past events can be used to predict future trends, and starts with analysis of price charts. Rather than providing a single estimate of a stock's intrinsic value, technical draws charts to depict the target stock’s future trajectory, signaling a possible target price range.
Which Methodology is for Whom
When deciding on which method to use, the question should not be which analysis technique is better and when it should be used, it should rather be what is your investment time horizon and which type of investor are you.
The underlying assumption behind fundamental analysis is that the short-term market is wrong, and that the price of the stock will correct itself over the long run, matching the intrinsic value estimate derived from fundamentals. Hence, if you are a long-term value investor, fundamental analysis is for you.
On the contrary, if you are a day trader, or a person looking to capitalize on daily or weekly price fluctuations, then technical analysis would fit your bill.
Challenges and constraints
Since fundamental analysis relies on information such as the financials of a company, it is obvious that availability of reliable information on fundamentals is the first key to success. Fundamental analysis is relatively more time consuming – that is, it takes more time to arrive at an estimate of the stock’s intrinsic value – since data from over a number of years is used. Furthermore, the information used for the analysis is released over long periods of time – financials are released quarterly and earnings per share do not change on a daily basis like price and trading volume. This adds an additional constraint.
On the contrary, technical analysis can be used on a time-frame of weeks, days, or even minutes. But, this type of analysis is only useful when there are meaningful and identifiable patterns in the historical price trend of a company’s stock. According to a popular capital markets theory, known as the Efficient Market Hypothesis, all past price information of a stock is already included in its current market price. Hence, analyzing past price movements should provide no insight into the future price trend.
The optimal solution
The two approaches used together can provide strong insights. For example, a long-term investor could use fundamental analysis to estimate the intrinsic value of a stock. If the intrinsic value comes out to be higher than the current trading price, indicating that the stock is currently undervalued, technical analysis can then be utilized to figure out the best time to enter in this stock in order to further improve the return on investment.