If someone asks if you want to be rich or happy, you will probably say you want both. This shows that some things that are contrasted can actually be combined. The same logic applies to stock market fundamental and technical analysis.
For some people, you are either a long-time investor who focuses on fundamental analysis like Warren Buffett or a trader who concentrates on technical analysis like Robert Rhea, author of The Dow Theory.
The stock market fundamental and technical analysis discussion has often been couched in this either-or format for many years. However, many now recognisze that this can be a false dilemma and it’s possible to combine both as an investor or a trader.
“Using a combination of both could be the ultimate winning strategy,” according to The Ticker, an American newspaper.
In this article, we will consider stock market fundamental and technical analysis, how they differ, and how they can be combined to help traders and investors. We’ll cover:
- What is fundamental analysis?
- What is technical analysis?
- Fundamental analysis vs technical analysis: How they differ
- Stock market fundamental and technical analysis: How they can be combined
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1. What is fundamental analysis?
The best way to understand fundamental analysis is to reflect on one of Warren Buffett’s quotes: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Fundamental analysis is the art of identifying wonderful companies to invest in. Since a stock is a portion of ownership in a company, the long-term price of a stock will reflect the performance of the company whose ownership it represents.
From Warren Buffett’s stock holdings and statements made in various contexts, we can identify two key aspects of fundamental analysis: quantitative analysis and qualitative analysis.
The former involves combing through a company’s financial statements (balance sheet, cash flow statement, and income statement) to see how well it performs while the latter entails non-financial indicators of a company’s performance like its management and products (or services).
Quantitative analysis
Three types of financial ratios are used to summarisze a company’s financial health:
- Profitability ratios: These ratios highlight how well a company can generate profit from its operations. Profitability can be measured against the assets of the company /return on assets), its equity (return on equity), or its employed capital (return on capital employed).
- Liquidity ratios: These ratios consider how well a company can meet its short-term obligations (current liabilities) from its short-term assets (current assets).
- Leverage or solvency ratios: These ratios focus on how viable a company is in the long term. It does this by comparing its debt level with its assets and equity. If a company has too much debt relative to assets and equity, then its long-term viability is doubtful.
Warren Buffett considers these three ratios when conducting the quantitative analysis of a company.
His most popular metrics across the three categories are:
- Return on equity (ROE): As an investor, you want to know how well the company is using shareholders’ funds (equity). Return on equity is a good measure of this. It shows how much profit the company is making from the equity it holds. The formula is net profit divided by equity multiplied by 100.
A high (relative to competitors) and growing ROE is one of the marks of a wonderful company.
- Net profit margin: This is another profitability ratio. It is the net profit divided by revenue (multiplied by 100) and it measures how well a company can turn sales into profits. If this margin is low, it shows that too much of the company’s revenue is going to operational (selling, general, and administrative expenses) and non-operational (interest payment, tax) expenses.
A high and growing profit margin shows that a company is excellent at managing its expenses and turning revenue into profit.
- Current ratio: This is a liquidity ratio that shows how many times a company’s current assets (convertible to cash within a year) can cover its current liabilities (obligations that are due within a year).
It is calculated as current assets divided by current liabilities.
Buffett prefers a current ratio of at least 1.5.
- Debt-to-equity ratio: This is calculated as total debt divided by total equity and it indicates how leveraged (dependent on debt) a company is. A company with a high debt-to-equity ratio is using more debt than equity to finance its assets.
Buffett prefers companies with more equity than debt (given the impact of debt on long-term viability) and thus wants a debt-to-equity ratio below 0.5 or 50%.
- Economic moat: Buffett prefers companies that have durable and sustainable competitive advantages. That is, they have things they are especially good at that others cannot profitably replicate.
Though a huge part of the economic moat can be uncovered using qualitative analysis, there are some quantitative indicators as well. These include sustained high return on invested capital, sustained high gross margins, and high market share, according to Indexology Blog, a blog of S&P Global, a global financial corporation.
Quantitative Indicators of Economic Moat
Source: Indexology Blog
Qualitative analysis
Many indicators of good performance cannot be quantified. “An investment operation is one that can be justified on both qualitative and quantitative grounds,” according to Benjamin Graham, Buffett’s teacher and mentor.
Adding qualitative analysis can help you produce a sound investment strategy.
Some useful qualitative indicators include:
- Management: Buffett is big on the quality of a company’s management. Here, he is concerned about their passion for and understanding of the business, how well they manage the company, and how they treat shareholders.
He wants managers who serve the interest of shareholders (especially in capital allocation decisions) rather than seeking to exalt themselves.
- Economic moat: Some qualitative indicators of economic moat include having products or services that are unique. For him, this uniqueness will be reflected in the company’s capacity to increase prices without losing market share.
“If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. If you have to have a prayer session before raising the price by 10%, then you’ve got a bad business,” he said.
- Economy-wide (macroeconomic) analysis: “Fundamental analysis frequently involves looking at gross domestic product, inflation, unemployment rates, industry or sector trends, and the company’s competition,” according to Investopedia, a financial education website.
Knowing the direction that the larger economy is going can help to understand which sectors or industries will shrink. This type of analysis can be done by looking at economic indicators or by studying how technology is changing.
When digital camera technology replaced film-based photography, Sony came to the forefront and Kodak died.
Investors who understood what was happening would have gone out of Kodak and invested in Sony instead.
Even when a technology trend will disrupt rather than kill off an industry, it is important to identify companies with the capacity to flow with the trend and those that will die off.
Such qualitative macroeconomic analysis is crucial for successful long-term investment.
Fundamental analysis and value investing
For Buffett and other value investors, fundamental analysis ends in determining the intrinsic value of a company.
The intrinsic value is what the company is worth. In the short term, the company’s market price will deviate from this value, but in the long term, there is a closer alignment.
Consequently, value investors want to buy wonderful companies when they are undervalued – their intrinsic value is higher than the market price – so they can make money when the market price is catching up with the higher intrinsic value.
However, intrinsic value is subjective and two smart fundamental analysts will arrive at different values. To reflect this subjectivity, Buffett only buys a wonderful company when its market price is substantially less than the intrinsic value he calculates. In his early days, he insisted on a 50% margin of safety but he has been more flexible about this.
There are many valuation methods for calculating intrinsic value but they all boil down to which items on the financial statement you use for the calculation.
Some of the popular options include dividend (an example is the dividend discount model), cash flow (a popular example is the discounted cash flow model), earnings (P/E ratio being an example), and book value (P/BV being an example), among others.
2. What is technical analysis?
Technical analysis uses past price and volume data to predict future price action. It does this by identifying patterns and trends in past price and volume movements.
In essence, technical analysis is based on the principle that price patterns repeat themselves (because they are based on market psychology). “Technical analysts believe past trading activity and a security’s price changes can be valuable indicators of the security’s future price movements,” according to Investopedia.
Thus, technical analysis can be used to make money from buying stocks whose prices are expected to increase or shorting (selling) stocks whose prices are expected to decrease.
The practice of technical analysis goes back to Dow Jones, the founder of the Wall Street Journal and the Dow Jones Industrial Average Index. Since the popularization of his Dow Theory, others like William Hamilton, Robert Rhea, Edson Gould, and John Magee have developed the field of technical analysis, according to Investopedia.
There are four main parts to technical analysis as it is being used today: chart patterns, moving averages, and technical indicators. Understanding these three is crucial for learning how to start trading stocks.
Chart patterns
Price trends can be summarized in the form of charts that show the ebb and flow of a stock and thus reflect market sentiment. Line charts and candlesticks are the most popular charts used by technical analysts.
When it comes to pattern identification, the latter is the most useful. As seen below, a candlestick contains four pieces of information: the opening price, closing price, highest price, and lowest price within a timeframe.
A candlestick chart shows various patterns. When a pattern has consistently resulted in price movement in a particular direction, technical analysts use it as a predictor of future price movement.
Some of the most popular candlestick patterns include bullish engulfing, bearish engulfing, morning star, evening star, hammer, and hanging hammer, among others.
Let’s use the first two to illustrate how chart patterns are used.
Below is the bullish engulfing chart pattern:
Source: Strike
When a green candle (bullish candle) engulfs a smaller red candle (bearish candle), some analysts see it as an indicator of an upward price movement, especially if it occurs at the end of a downward trend.
The bearish engulfing pattern, shown below, is the opposite of the bullish engulfing pattern.
Source: 1 Share Market
When this pattern occurs at the end of an upward trend, it might indicate a reversal to a downward trend.
Support and resistance levels
Support and resistance levels are foundational to technical analysis.
When buyers keep buying at a particular price or price range and will not allow prices to fall below that range, that constitutes a support level. On the other hand, if sellers will not allow prices to rise above a range, that constitutes a resistance level.
Both can be seen in the chart below:
Source: Optimus Futures
If a support or resistance level has been tested many times, it can be expected to hold in the future. Some analysts will trade within this support and resistance range – buying at support and selling at resistance or shorting at resistance and taking profit at support.
Others will see trading opportunities only when a support or resistance level has been broken (breakouts), taking it as an indicator of a new trend. For example, a broken support indicates a downward trend, and a broken resistance an upward trend.
Moving averages
Moving averages are mean (average) price movements over a given period.
Below is an example of a moving average:
Moving averages can be simple or exponential. Simple moving averages (SMAs) accord equal weight to all historical prices within the given period while exponential moving averages (EMAs) allot greater weight to more recent prices.
Upward or downward moving average lines can indicate an upward or downward trend. Some analysts also use moving average crossovers as a trading strategy. For example, if a shorter moving average (say 50 SMA) crosses a longer one (say 200 SMA) from below, it can be seen as an indicator of an