Recently, there are some interesting discussions on Fundamental Analysis (FA) – e.g. see Moola’s excellent articles below together with the Sahamas discussions:
Definition of FA
If you are a new investor wishing to learn more about FA, I would encourage you to google “Fundamental Analysis” first. It should give you a reasonable idea of what is meant by Fundamental Analysis. The Investopedia can also be recommended (see http://www.investopedia.com/university/fundamentalanalysis/). Some of the main points are:
“Fundamental analysis is the cornerstone of investing (Seng: note: not trading). … some would say that you aren’t really investing if you aren’t performing fundamental analysis.
“The biggest part of fundamental analysis involves delving into the financial statements. Also known as quantitative analysis, this involves looking at revenue, expenses, assets, liabilities and all the other financial aspects of a company. Fundamental analysts look at this information to gain insight on a company's future performance.
“But there is more than just number crunching (Seng: and definitely more than just low P/E ratios) when it comes to analyzing a company. This is where qualitative analysis comes in - the breakdown of all the intangible, difficult-to-measure aspects of a company.
Seng: Note that in both quantitative and qualitative analysis above, there is no mention at all about the stock price nor the volume traded. I have also sometimes called FA as “BA” or Business Analysis, as the focus is mostly on the underlying business which is a different concept from the stock ticker.
To me, there is no doubt that the Grand Master of Fundamental Analysis should be Warren Buffett, who started from virtually nothing to become one of the world’s richest man purely through investing over a very long period of time.
Throughout his entire life, he reads a lot and reads extremely widely e.g. he prefers to spend the entire day reading various company Annual Reports than doing other things. Despite his humbleness, he is sharp, intelligent, witty, humorous, with excellent understanding of both the quantitative and qualitative aspects of the business that he follows (which he describes as staying within his own circle of competence). As a result, he knows or is able to calculate very quickly in his own mind the Intrinsic Value of the businesses that he evaluates. This allows him to determine the Margin of Safety quickly. In a typical year, the number of times that he invests is rarely more than a handful (except in the rare years when market crashes when he feels like the only single guy in a harem full of eligible women). But when Mr Market provides him with a very “fat pitch” (large Margin of Safety), he does not hesitate to invest big, especially when others around him are fearful. And after he invests, he would prefer to hold the stock “forever”, unless the business fundamentals deteriorate in future which occasionally happens. In other words, Fundamental Analysis dictates his clear preference for “invest and hold forever” approach.
However, in more recent decades, as Berkshire gets bigger, the size of the investment universe gets smaller. In most years, he and Charlie would sit on large piles of cash, waiting for the big elephants to show themselves up. As cash does not earn a particularly high returns, he and Charlie are compelled to participate in various shorter-term arbitrage / mispricing positions in order not to let the cash drag Berkshire’s overall returns. This has increased his investing activities, although Berkshire turnover is still extremely low relative to the average investor. However, his clear preference is to find a few large “elephants” as opposed to “catching a lot of mice” for Berkshire.
The General FA Strategy
By and large, Fundamental Investors prefer to take their time to identify superior investments. They are generally patient, and can wait for the market to provide a fat pitch (a "low" price, or a large gap between stock price and Intrinsic Value). Once they acquired their position, they don't generally like to let go that position by selling, even when superficially, the price appears to have gone up a lot but still well below Intrinsic Values.
Whilst a lot of work goes into the selection, once the selection is made, it is a generally more laid back approach requiring little activity, and does not usually require constant monitoring of the stock market. Buffett's incredible lifetime results (together with the results of the other students of Graham) speaks a lot about the practicality and viability of this approach.
Some Common FA Myths
It is not uncommon to encounter many myths about FA. For example, some FA practitioners hesitate to invest unless the “stock volume traded” increases. Strictly speaking, the latter is not FA. It should be obvious that OILCORP’s future business earnings will not depend on whether today’s volume traded is 5 million, 10 million, or has been growing from 1 million a week ago. In contrast, OILCORP’s stock price might go up as a result of increasing volume traded, but this is Technical Analysis than Fundamental Analysis.
Another common myth is for “FA practitioners” to buy because the stock will soon split. Strictly speaking, this is also not FA. It should be obvious that splitting a stock does not necessarily increase the Intrinsic Value of the underlying business. Yet, stock splits can result in the stock “appearing cheaper” to retail punters, and the stock price can and usually (but not always) goes up after the split. So, a stock split is not FA, but is more “perception” investing, as it is based on appearance of a cheaper price than true business substance.
Another common myth is that FA is focused on low P/E only. There are many variants to this myth. Some would not buy if the P/E is say double-digit, and would only focus on single digit P/Es. Some would not buy if the P/E is higher than the average company in that sector, or higher than the average stock market P/E. Others would simply look at P/E only, and ignores cashflows (the latter happens more frequently than you might think). In my personal opinion, rigid adherence to these absolutes are examples of "incomplete FA", as FA is more than just P/E, even though P/E is important. To the best of my knowledge, Buffett would never condone purchasing such stocks for Berkshire on such a simplistic basis.
There are of course other myths about FA, but that would be outside the scope of this article. It should also be noted that some FA practitioner in practice employs a variety of methods to arrive at they buy/sell decisions. For example, you will sometimes come across the term "Rational Investor" for someone who employs both FA and TA in their investment approach. (My blog name "Fusion Investor" is another similar term).
Does it matter?
At the end of the day, one might ask - does it matter to adopt a “rational/fusion approach” (which combines elements of incomplete FA, TA, psychological investing and other methods) as label it as “FA”, as long as the stock price goes up?
Besides the obvious mislabelling, there are other potential dangers to be aware of.
First, I believe that mislabelling is potentially misleading, and in my personal experience, tend to impede rather than promote learning. If the overriding goal of any new investor is to achieve a superior investment result over his / her own lifetime, then, this will not help. Since habits once formed are harder to change, it can lead the new investor away from the teachings of Graham and Buffett permanently.
Second, an incomplete FA method can give good (or bad) results initially, but over the long-term, may be less than optimal if there is no change. If one's objective is to achieve superior investment performance over a lifetime, then, this will make it harder.
Third, a poorly communicated basics or incomplete approach can promote unnecessarily longer dependency on the guru. To me, the best teachers are those that teach their students to become independent, if not to become better than them. Yet the market place has many gurus and followers with little hope of becoming better than their "guru". In this regard, Graham could not have been prouder of Buffett.
Some final words
My personal belief is that if someone truly wants to have a superior investment result for the rest of his life, he will not have a bad result by studying Graham and Buffett. The web and good bookstores are full of such resources on both Masters. Personally, I’ve read many written by and about both of these Masters and haven't yet encountered a really bad book on both of them. New investors can start with Janet Lowe’s introductory book "Value Investing Made Easy". More experienced investors may wish to consider Buffett’s biographies, other books written about Buffett and Graham, as well as Buffett's own writings in his annual Berkshire Chairman’s Letter.
Disclaimer: The above merely represents my own personal view on the subject matter. As usual, always use your own judgement and invest (buy, hold, sell) at your own risks.