Academics and researchers have spent considerable time searching for the secret to making it rich on the sharemarket.
The trouble for investors is that – when every supposed ‘expert’ yells from the rooftops proclaiming the secret to successful stock investing – it’s almost impossible to separate the researched theory from the pure sales pitch.
For this reason, we decided to provide a broad overview the major theories of stock analysis recognised worldwide – everything from GARP, growth and income investing to technical analysis. The theories presented here have attracted plenty of supporters over the years – some amassing fortunes by carefully applying these ideas to find, buy and ultimately sell top-performing stocks. So which theory is the best?
The best theory is the one that you can use to the best effect – according to your individual needs. If you hate taking on risk, work full-time and dislike spending long-stretches at your computer then trading using technical analysis is not your game. Similarly, if you enjoy the process of analysing balance sheets, calculating financial ratios and generally keeping on top of major company events, then fundamental analysis is probably more your style.
There’s no point even attempting to follow the rules of a theory if it doesn’t suit your temperament, risk appetite, mindset and way of living. So with that in mind, we’ll launch into outlining the major theories below.
This is the school of investing best represented by billionaire stock guru, Warren Buffett, who amassed over $52 billion from applying this theory to purchase stocks largely in the US. Buffett is widely regarded as the most successful investor in history, which certainly gives this school of investing some credence. Cynics argue that Buffett’s advantage is his fame: in short, whichever stock Buffett buys has a pretty good chance of going up as investors jump on for the ride. Notwithstanding, few would argue that the sage of Oklahoma doesn’t know a thing or two about the stockmarket and how to be a successful stock picker.
Fundamental analysis regards buying a stock like buying a part ownership in a business, and similar factors are taken into consideration. How much the business is worth, or its value – derived by analysing such factors as revenue, profit, debt levels and other factors of the business such as competition, economic cycle and competitors – is always compared to the current share price. This gives the fundamental analyst a per-share figure; typical examples are the price/earnings ratio (P/E) and earnings per share (EPS). It’s only by using a per-share figure that the fundamental analyst can compare a company against its peers and the market.
Below we outline the major categories or schools of fundamental analysis. While there are always purists who religiously stick to just one category, there are other investors who successfully pick stocks by mixing and matching elements of different categories.
Value – The bargain hunter
A common mistake of investors is to look at the share price of a stock in isolation and decide whether a stock is expensive or cheap. For example, regarding a $3 share as cheaper than a $500 share. Just one word of warning: don’t say this at a party full of fundamental analysts. They’ll eat you for dinner.
Price on it’s own is irrelevant and useless for a fundamental analyst. The price of a stock must always be compared to the value of the company.
The tricky bit, of course, is working out the value of the company, called its intrinsic value, and not all fundamental analysts agree on how this should be calculated. Some will look to how much the company would be sold if liquidated (if all of its assets were sold tomorrow). Other approaches are to use the highly popular price/earnings (P/E) ratio, sales relative to the market capitalisation of the stock or even dividend yields.
Once a value investor has decided on a company’s intrinsic value, this value is compared to the current share price to discover whether the company is currently cheap or expensive.
When you think about it, it is not really different to any investing decision. When buying property, for instance, investors always try to get a bargain by aiming to buy the property less than it’s really worth. Value investing is no different.
Personality traits of the value investor
Value investors are comfortable buying shares in out-of-favour stocks. For this reason the value investor must think independently, and execute their buying and selling decisions with courage and conviction. If you have a penchant for following the pack – buying and selling stock because everyone else is – then value investing is not your style. Read on.
Growth – The action hunter
The growth style of fundamental analysis involves buying shares in a company you believe has the potential to significantly boost earnings and profits over the coming years. Spotting a bargain, which is the key concern of the value investor, comes second to finding a company that has the potential for explosive growth.
Therefore growth investors look to factors such as the growth rate of the company and industry it operates in. New markets such as biotech, technology, or up-and-coming mining stocks in a growth industry such as uranium, for instance, can make the average growth investor hot and bothered.
Since growth investors are more interested in the future value of the company, the current share price isn’t a major concern. In fact, in complete contrast to the value school of investing, the growth investor is actually content to pay more than the intrinsic value of the company to jump on board a dynamic company, whose explosive growth in revenue and earnings should fuel the share price over time.
Personality traits of the growth investor
Growth investors are always on the lookout for the next Microsoft or Google and are happy to pay what may appear to some as a rip-off at the time to get on board. The growth investor must be patient as it can take some companies a long time to realise their full potential.
Growth investors are dreamers or idealists. They like new technology, new markets, and are comfortable with backing a smaller company provided it seems blessed with a bright future. If you’re someone who feels more at ease with the status quo – you prefer big bank stocks for example – then growth investing mightn’t be your style.
The best tennis players in the world don’t all sport the same style and investors, likewise, shouldn’t think that a specific style of investing wins every game. To be a successful investor you firstly have to choose a style of investing that suits you, and then it’s a matter of perfecting this style.
Last week we looked at the fundamental analysis schools of growth and value investing. Ask most fund managers around town what school they belong to and chances are it’s one or the other. Some analysts combine flavours of both schools, such as tracking down growth stocks (remember these are stocks with the potential to significantly boost future earnings) and then wait for a dip in the share price to buy cheaply, which is the hallmark of the value investing school. This approach is typical of the GARP school of investing (Growth At A Reasonable Price) – there’ll be more on this later.
Income – the desire for dividends
Some investors enjoy the comfort of receiving a dividend cheque in the mail, and are happy to buy shares in companies that guarantee (well, almost guarantee, as nothing is certain in investing) a regular income stream of dividends over the years.
The often-said phrase that you are better off buying shares in the big banks that pay healthy dividends than keeping your savings in a bank account fairly squarely sums up income investing.
A company that pays dividends – or a proportion of its profits to shareholders – must be fairly large and established since smaller companies reinvest most of their profits back into the business, and typically don’t have a cent to spare for shareholders.
But high-dividend paying companies are hardly chart-toppers, so don’t expect these companies to blow your socks off with share price rises. Rather, a steadily rising share price is a good result for a high-dividend paying stock.
The dividend yield (not the dividend) is the most important figure for the income investor. So don’t go around hunting for a stock that pays a $4 per share annual dividend but instead look to the dividend yield, which is the annual dividend per share (say $4) divided by the share price (let’s say $100), or 4%.
It’s hardly a stretch to see the benefits of investing in a stock paying a solid dividend yield. In short, an investor with $100,000 in a stock offering a 4 per cent dividend yield will pocket $4,000 a year in income, not to mention any franking credits to further boost gains.
A word of warning for income investors hunting for the perfect high-yielding stock: a company with a struggling share price can sport a high dividend yield (since share price is the denominator in our dividend yield calculation) so always ensure that the company is healthy, with good prospects for future share price gains. There’s no point buying a stock with a high dividend yield for one year that consequently lowers or stops paying dividends in the future, or worse still, has a plummeting share price. It’s always handy to check the company’s history in paying dividends as a guide to how reliable it’ll be in the future.
GARP – Growth at a reasonable price
If both value and growth-styles of investing have attributes that you like then GARP, or growth at a reasonable price, combines elements of both.
GARP investors seek out companies that have exhibited strong earnings growth in the past, with the prospects for continued earnings growth in the future. But they also like a bargain.
Similarly to the growth-style of investing, a GARP investor will often agree to buy a stock with a high price/earnings (P/E) ratio with the view that strong future earnings will boost the share price over time. However, unlike the bullish growth investor, the GARP style buys stocks with an eye to value. They don’t like to overpay. A company trading at 30 or 40 times earnings, for instance, would be too expensive for the typical GARP practitioner.
Since GARP investors are often more conservative then growth investors, they often perform worse during bull markets (take the past four years as an example), but relatively better during market corrections. However, in contrast to the true value investor, who bargain hunts during market bears – buying when everyone is selling – the GARP investor will typically do worse than the true value punter when the turnaround comes. In short, the performance of the GARP investor should almost sit in the middle of value and growth to generate more consistent returns over time.
Just one month before the scandalous US energy firm Enron was busted for accounting fraud in late 2001, of the 15 most highly influential company analysts in the US, 13 analysts recommended the stock as a “buy” or “strong buy”, while just two labelled it as a “hold” or “sell”.
It’s understandable, therefore, that investors who lost money as Enron collapsed would question the validity of fundamental analysis, the dominant theory of stock analysis utilised by analysts and investors worldwide. Indeed, if selecting stocks based on fundamentals was so foolproof, then why didn’t the most highly skilled investment practitioners in the country see the telltale signs of a company on the verge of collapse?
Meet the critics of fundamental analysis, who say that fundamental analysis is so subjective and so often swayed by market noise and opinion that it’s not worth the bother. Such critics would argue that the company analysts who held “buy” recommendations on Enron were caught up in the company’s hype; its regular press releases to the market and the overall market perception of Enron as a dynamic and rapidly growing company. In effect, the analysts became wedded to the stock, unable to objectively analyse a company in crisis.
Over the past two weeks we’ve outlined the popular schools of fundamental analysis, including value, growth and GARP, or growth at a reasonable price. This week, we’ll spend some time on what many regard as the antithesis of fundamental analysis – called technical analysis.
Technical analysts are often called chartists because historical prices downloaded into a variety of charts are the primary sources of information for the technician. Most technical analysts don’t know, or care, about a company’s underlying business model. They just care about its price history, its volume and whether their indicators are telling them to buy or sell. In this way, the technician is saved from a company’s hype and its ability to baffle company analysts.
Since fundamental analysis – which analyses such things as a company’s financial statements, industry growth rates and its competitors – is based on publicly available information, the technical analyst argues that knowing the fundamentals of a company hardly offers one investor an advantage over others. In other words, since a company’s fundamentals is common knowledge (and therefore applied by investors to buy and sell the stock), the technician assumes that such information is already factored into a stock’s price. So rather than stressing over calculating the return on equity (ROE) of a stock, or coming up with the price/earnings ratio as a guide to valuation, the technician simply looks to the share price. According to the technical analyst, price changes over the short term hinge on the psychology of the market or forces of supply and demand. And all of this information is summed up in the chart.
Technical analysts believe that investors are fairly predictable. They regularly follow patterns of behaviour such as succumbing to emotions of greed and fear. If a company announces headline-grabbing news, for instance, investors gobble up its shares because other people are doing the same.
A November 2006 study by Brad M Barber and Terrance Odean at the University of California noted this tendency of investors to act in patterns, such as gravitating towards attention-grabbing stocks, including companies in the news, stocks experiencing abnormally high trading volume and stocks with extreme one-day returns. Since there are so many stocks to choose from investors limit their choices to companies that have recently caught their attention. (The study concluded that this behaviour does not generate superior returns, in fact, quite the opposite).
This tendency of investors to react to market stimuli in similar ways creates patterns of price behaviour. The technician aims to use this behaviour to chart the timing of their entry and exit into a stock.
As an example, let’s say that a large super fund started buying an enormous tranche of shares in a given stock over a period of a week. The aim of the technician is to spot activity that can lead to extreme price movements. The heightened volume and buying pressure of the super fund picking off orders should alert the technician to the activity. A clever technician would jump on for the ride.
As a quick aside, heavy trading volume during a share’s upward ascent is regarded as a bullish sign, while heavy trading volume accompanying a price fall smells of bearishness. This is applied equally to gauging sentiment in the overall market.
Technical analysis versus fundamental analysis
Technical analysis isn’t foolproof. And since there is no single system or technical analysis strategy it’s almost impossible to prove whether it actually works or not. Critics label it voodoo and poke fun at its fancy trade-speak – its triple bottom breakouts, ascending triangles and Fibonacci number patterns. They say that historical data will tell you what would have gone up yesterday but not what will go up today.
Who’s right? Well, some say that both approaches have their merits and the answer is to successfully combine the two. For instance, you might use technical analysis to detect trend changes, and fundamental analysis for an understanding of the longer-term value of a stock. Technical analysis could be used to time an entry and exit into a stock that you’ve already noted is fundamentally sound.
Anyone serious about share trading should probably have a basic understanding of both approaches – since some of the tools utilised could come in handy at some point. Indeed, a broader knowledge base can alwasy help in better interpreting the market forces at play.