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Why Fundamental Analysis Drives Higher Returns With Lower Risk

Posted on May 16th, 2018 by The DiscoverCI Team

So you’re looking for a stock analysis strategy that generates high returns with lower risk. You aren’t alone!

But how do you actually do it?

While there are no guarantees when it comes to investing in the stock market, there are steps that the most successful investors take before investing in a stock that have proven to return better results. 

Warren Buffett, one of the most successful investors in the world puts it like this:

“Risk comes from not knowing what you are doing” and  “Never invest in a business you cannot understand”

- Warren Buffet, aka “the Oracle of Omaha”

Quotes via SureDividend

While his advice may seem obvious, sometimes this message gets lost in all of the stock market noise.

More and more investors are buying stocks based on pure speculation, and on the misguided advice from “experts” without completing their own due-diligence. Not good!

One of the best ways to follow Buffett's advice and "know what you are doing" before investing in a stock is to include fundamental analysis in your investment strategy and research. In this article we will:

  • Refresh on the basics of fundamental analysis - what it is, and why it is important,
  • Cover the different types of fundamental analysis,
  • How to complete your analysis and understand the fundamentals of a company, and 
  • Discuss how to understand a business before you invest.

Fundamental Analysis Definition

Let’s start our journey to stock analysis enlightenment with answering a “simple” question - What is fundamental analysis?

Well, it turns out, that isn’t such a simple question after all.

The strong belief at the core of every great fundamental investor is that market prices do not accurately reflect all available information on a company, and that discrepancies exist between market pricing and the actual fair value of a stock.

If fair value is not equal to the current stock price a fundamental analyst will identify the discrepancy, indicating the stock is either over or undervalued, and the market price will ultimately gravitate towards the stock’s fair value.

In performing the analysis an investor looks at all of the macro and micro level details that impact the value of a company (i.e., the fundamentals of a company). This information is used to determine the value of the Company’s stock, which is evaluated in conjunction with other data points to make the most informed decision possible.

Objectives of Fundamental Analysis

Fundamental analysis attempts to identify which stocks have a market price below their intrinsic value, and thus, provide a high value investment.

Fundamental analysts have a better picture of the possible movements of both the stock market and individual stocks because as many elements of the market and company are investigated as possible.

Think of fundamental analysis as bargain shopping at a pawn shop, only the items in the pawn shop are stocks, and the pawn shop itself is the stock market. Not every item in the pawn shop would be priced at a discount compared to its value, and some items may be priced $1.00 below its market value, and others may be priced $10.00 below its market value.

The job of the bargain shopper is to analyze the different items (name brand, condition, resale market, etc…) and determine whether that product is priced at a discount compared to its market value. If the bargain shopper finds an item priced well below its market value, the resale value down the road could end up being a great return on their investment!

Obviously, there are a few differences between bargain shopping and analyzing stocks, but the principal remains similar. Buying assets at a discount provides a higher likelihood of making money when you sell that asset.

The Different Types of Fundamental Analysis

An effective analysis of a businesses includes the examination of the underlying factors that affect the well-being of the company, and thus the well-being of that company’s stock. The goal is to derive an independent value, which can be used to forecast future movements in the Company’s stock price, and ultimately lead to an edge over other investors.

The end result of effective stock analysis is better investment performance, and more money in your pocket.

The type of analysis performed depends on the underlying factors impacting a company’s performance. These factors are generally grouped into the larger categories of industry metrics, overall economy health, or factors specific to each individual company.

Industry analysis

An analysis of industry level factors may include, industry norms and expected overall industry performance, company growth rates compared to industry norms, and outside forces working for, or against, company growth within the industry.

For example, an insightful fundamental analyst may have predicted the decline in Barnes & Noble’s (ticker: BKS) stock price, if they effectively analyzed the downward pressure on the physical bookstore industry when BKS was trading at around $17.50 in July of 2015. BKS currently is trading at around $5 per share (May, 2018).

Analyzing the industry that BKS competed in during 2015 may have revealed positive indicators in certain areas, but understanding the impact of the growing electronic book industry, and the resulting impact on sales of physical books, could have foretold the coming drop in the Company’s stock price from 2015 to 2018.

Macroeconomic trends

Cashing in on macroeconomic trends is one of the best ways to look like an investing guru when the economy is trending upward.

It is also one of the quickest ways to lose your hard-earned cash when the winds of the macroeconomy change to a downward trajectory, and you’re left holding stocks and taking losses.

The best way to avoid being stuck with a good investment in a bad economy is to continually take the pulse of the macroeconomy, and apply your macroeconomic insights to your stock evaluation.

Company Health

At the core of fundamental analysis you have the specific data relevant to each company you are analyzing.

Fundamental analysts employ various methods to analyze company metrics, including review of reported financial statements, analysis of key financial ratios, evaluating management team performance, identifying competitive advantages, and much more.

Financial data that is typically included in the fundamentals analyzed are revenues, earnings, return on equity, profit margins, and other metrics to determine a company’s underlying value and potential for future growth.

Great fundamental analysts are able to identify the key factors impacting a company’s valuation, and evaluate these to project future fluctuations in stock price.

Putting it All Together

Effectively evaluating fundamental data requires an investor to weight each of the above factors differently depending on the stock being analyzed. Not all company valuations can be calculated from the same data.

For some company’s, industry performance is driving significant increases or decreases in stock price, while other companies are less influenced by industry trends.

The factors you consider in your analysis, and the weighting you put on each factor in your decision making can be subjective.

Identifying the critical factors used in your analysis can differentiate you from other fundamental investors.

How to Do Fundamental Analysis

The factors discussed above are incorporated into the analysis of almost all fundamental investors. The method of analyzing these factors can be further broken-down into two approaches.

Bottom Up Analysis

At its core, a bottom up analysis focuses on individual securities rather than macroeconomic data, overall movements in the stock market or the prospects of a particular industry.

The bottom up approach is used under the assumption that individual companies can do well even in an industry, or overall market, that is not performing very well. This would be the opposite of the other analysis approach, called top down analysis.

Making the bottom up investing strategy work requires a thorough review and understanding of the company being analyzed. An investor needs to be extremely confident in their analysis of a company in order to invest, regardless of other macroeconomic factors.

A bottom up investing strategy generally lends itself better to realizing returns over the long-term. There may be wild fluctuations in the short term as the company’s stock price fluctuates with outside market factors, but over the long-term the expectation of a bottom up investor is that strong companies will outperform their peers in the market.

Top Down Analysis

In contrast to a bottom up analysis, a top down investment approach focuses on how macroeconomic factors and industry specific trends impact stock prices.

A top down investor considers the north star of stock investing to be the expected overall performance of specific industries and sectors, or the market as a whole. A top down investment strategy may work best if you believe when a sector is performing well, chances are, the stocks within that sector will also perform well.

It’s important to remember that a top down analysis does not disregard company specific factors, but rather, places a higher weighting on macroeconomic factors impacting that company.

Whether you’re using the bottom up, or top down approach, all of the relevant factors impacting a company’s valuation should be considered. The different approaches tend to weight each factor differently, which dictates the starting point of the analysis.

Why Fundamental Analysis?

Fundamental analysis is used by some of the most successful investors in the world, including probably the most famous investor, Warren Buffet.

The general consensus among investors is that analyzing the fundamentals of a business provides a few key strengths.

Long-term investing

Analyzing a company's fundamental data is good for long-term investments based on very long-term trends. The ability to identify and predict long-term economic, demographic, technological or consumer trends can benefit patient investors who pick the right industry groups or companies.

By making investment decisions based on the intrinsic value of a company, and armed with the belief that over the long-run, the Company’s market value will move towards this intrinsic value, a fundamental investor is able to withstand temporary fluctuations in a company’s stock price.

Spotting value

Fundamental analysis allows for investors to react confidently after determining a company’s intrinsic value.

If analyzing a company's fundamentals, and calculating an intrinsic value reveals that a company’s fair value is more than its current market value, an investor can act on the identified discrepancy in price, and sleep easy with the belief that the market value will move towards the Company’s fair value over time.

Lowering risk

Fundamental investors believe that analyzing a company’s fundamentals, and investing in companies with stock prices below their fair value limits their downside risk.

No investment strategy is free from some sort of speculation; however, analyzing a company's fundamentals attempts to identify the true value of a company, and requires less speculation than other investment analysis methods.

There are many factors that impact the movement of a company’s stock price, and no investor is capable of analyzing every one before buying a stock.

Calculating a company's intrinsic value and analyzing the fundamentals works to eliminate short-term bias, and focus on what fundamental investors believe to be main factor driving a company’s stock price - Intrinsic Value.

Using Fundamental Analysis

Just like Warren Buffet, you too can use fundamental analysis in your investing strategy to better understand a company, lower your risk, and grow your investment returns.

The secret to effectively analyzing stocks is to develop your process and routine of evaluating the underlying fundamentals, and identifying great companies that are undervalued.

So go forth, and begin your quest for market dominance, double digit returns, and more money in your pocket.

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