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Selecting stocks: Which is better, fundamental analysis or technical analysis?

10 Sep 2012 - {{hitsCtrl.values.hits}}

When you are making an attempt to analyze securities and make investment decisions, the strategies you use will most likely find themselves in two very broad categories: Fundamental analysis or technical analysis. Fundamental analysis and technical analysis are the two main schools of thought in the financial markets. These terms refer to two different stock-picking methodologies used for researching and forecasting the future growth trends of stocks.
Technical analysis looks at the price movement of a security and uses this data to predict its future price movements. Fundamental analysis, on the other hand, looks at economic factors, known as fundamentals.

When talking about stocks, fundamental analysis is a technique that attempts to determine a security’s value by focusing on underlying factors that affect a company’s actual business and its future prospects. Fundamental analysis involves analyzing the characteristics of a company in order to estimate its value. In the core of fundamental analysis lies collecting of all possible information about a public company.

On a broader scope, you can perform fundamental analysis on industries or the economy as a whole. The term simply refers to the analysis of the economic well-being of a financial entity as opposed to only its price movements.

Fundamental analysis serves to answer questions such as:

Is it actually making a profit?
Is the company’s revenue growing?
Is it in a strong-enough position to beat out its competitors in the future?
Is it able to repay its debts?

Of course, these are very involved questions and there are literally hundreds of others you might have about a company. It all really boils down to one question: Is the company’s stock a good investment? Think of fundamental analysis as a toolbox to help you answer this question.
Despite all the fancy and exotic tools it employs, technical analysis really just studies supply and demand in a market in an attempt to determine what direction or trend, will continue in the future. In other words, technical analysis attempts to understand the emotions in the market by studying the market itself, as opposed to its components. If you understand the benefits and limitations of technical analysis, it can give you a new set of tools or skills that will enable you to be a better trader or investor.

The differences
Like any investment strategy or philosophy, both have their advocates and adversaries.

Charts vs. financial statements
At the most basic level, a technical analyst approaches a security from the charts, while a fundamental analyst starts with the financial statements.
By looking at the balance sheet, cash flow statement and income statement, a fundamental analyst tries to determine a company’s value. In financial terms, an analyst attempts to measure a company’s intrinsic value. In this approach, investment decisions are fairly easy to make - if the price of a stock trades below its intrinsic value, it’s a good investment.

Although this is an oversimplification (fundamental analysis goes beyond just the financial statements). The most common data used in fundamental research and analysis would be revenues, expenses, profits, earnings per share, assets, liabilities, book value, dividends, cash flow and projected earnings growth rates. Key ratios would include price/earnings ratio (P/E), dividend yield, dividend payout ratio, return on equity, price to sale and price to book value.

T

echnical traders, on the other hand, believe there is no reason to analyze a company’s fundamentals because these are all accounted for in the stock’s price. Technicians believe that all the information they need about a stock can be found in its charts.

Charts can be used as a timing tool, even by traders who formulate their trading decision on the basis of other information (e.g. fundamentals).
Charts provide a concise price history-an essential item of information for any trader.
Charts can provide the trader with a good sense of the market’s volatility- an important consideration in assess risk.
Charts reflect market behaviour that is subject to certain repetitive patterns. Given sufficient experience, some traders will uncover an innate ability to use charts successfully as a method of anticipating price moves.

Time horizon
Fundamental analysis takes a relatively long-term approach to analyzing the market compared to technical analysis. While technical analysis can be used on a timeframe of weeks, days or even minutes, fundamental analysis often looks at data over a number of years.

The different timeframes that these two approaches use is a result of the nature of the investing style to which they each adhere. It can take a long time for a company’s value to be reflected in the market, so when a fundamental analyst estimates intrinsic value, a gain is not realized until the stock’s market price rises to its ‘correct’ value. This type of investing is called value investing and assumes that the short-term market is wrong but that the price of a particular stock will correct itself over the long run. This ‘long run’ can represent a timeframe of as long as several years, in some cases.
Furthermore, the numbers that a fundamentalist analyzes are only released over long periods of time. Financial statements are filed quarterly and changes in earnings per share don’t emerge on a daily basis like price and volume information. Also remember that fundamentals are the actual characteristics of a business. New management can’t implement sweeping changes overnight and it takes time to create new products, marketing campaigns, supply chains, etc. Part of the reason that fundamental analysts use a long-term timeframe, therefore, is because the data they use to analyze a stock is generated much more slowly than the price and volume data used by technical analysts.

Trading vs. investing
Not only is technical analysis more short term in nature than fundamental analysis, but the goals of a purchase (or sale) of a stock are usually different for each approach. In general, technical analysis is used for a trade, whereas fundamental analysis is used to make an investment. Investors buy assets they believe can increase in value, while traders buy assets they believe they can sell to somebody else at a greater price. The line between a trade and an investment can be blurry, but it does characterize a difference between the two schools.

If you use fundamental analysis to decide where to invest your money, there are many different metrics you can use. While fundamental analysis is much more qualitative and involves more subjectivity, charts are the main tool of technicians:

Although technical analysis and fundamental analysis are seen by many as polar opposites - the oil and water of investing - many market participants have experienced great success by combining the two. For example, some fundamental analysts use technical analysis techniques to figure out the best time to enter into an undervalued security. Oftentimes, this situation occurs when the security is severely oversold. By timing entry into a security, the gains on the investment can be greatly improved.

Alternatively, some technical traders might look at fundamentals to add strength to a technical signal. For example, if a sell signal is given through technical patterns and indicators, a technical trader might look to reaffirm his or her decision by looking at some key fundamental data. Oftentimes, having both the fundamentals and technicals on your side can provide the best-case scenario for a trade.

While mixing some of the components of technical and fundamental analysis is not well received by the most devoted groups in each school, there are certainly benefits to at least understanding both schools of thought.

In the world of stock analysis, fundamental and technical analyses are on completely opposite sides of the spectrum. Earnings, expenses, assets and liabilities are all important characteristics to fundamental analysts, whereas technical analysts could not care less about these numbers. Which strategy works best is always debated. Both fundamental and technical analyses are important and depending on the trading style one or another could be applied. The best may be the rational analysis, i.e. fundamental + technical analysis.

“Price is what you pay. Value is what you get” - Warren Buffett
(Source: Investopedia)

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Selecting stocks: Which is better, fundamental analysis or technical analysis?

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