Certainly, a "complete" course on security analysis is well beyond the
scope of this text. There are many excellent books devoted to the subject
of how to analyze the value of securities - both from a fundamental as
well as a technical standpoint. Our goal here is simply to provide a
basic understanding of the methods and theories behind each type of stock
analysis.
We should point out early on that Fundamental Analysis and Technical
Analysis of securities are two fairly radically different approaches to
determining the correct [or fair] value of a company's stock. Let's start
with a general overview of each method and then look into the specifics of
each area. Again, for a more detailed examination of each type of
analysis, we suggest you refer to our book list and/or the books
specifically mentioned throughout this document.
FUNDAMENTAL ANALYSIS:
The definitive work on Fundamental Analysis is widely considered to be the
classic book "Security Analysis" by Benjamin Graham and David Dodd. This
book, which was first published in 1934, is considered by most on Wall
Street to be the 'Bible' of security analysis.
In fact, it was Benjamin Graham that Warren Buffett studied under when he
first started in the stock market. Much of Berkshire Hathaway's success
can likely be traced back to the information and ideas provided in the
book Security Analysis and by the teachings of Benjamin Graham (although,
it's widely acknowledged that Warren Buffett put his own spin on things
over the years as well).
Fundamental Analysis is just as it sounds. It is based on examining the
fundamental pieces of a business and its operation. There are no exotic
formulas used. You do not need to be a mathematician. Anyone with a
simple calculator and some basic information about a business should be
able to employ Fundamental Analysis quite effectively.
The basic idea is if you put a dollar into the business (in the form of
buying the stock) how much of a return can you expect. How much yield
will you likely see and/or how much growth will you experience based on
the operation, markets, competitors and costs of the business.
Obviously, not all aspects of these fundamentals can be quantified.
Areas such as "good will" or changes in the economy or the consumer can be
difficult to nearly impossible to calculate. However, to a large degree
Fundamental Analysis throws these items out as uncertainties and simply
looks at the cold hard facts which you do have available to you. Things
such as costs of goods sold, margins, tangible assets, expenses, etc.
Armed with these basic and tangible numbers, one should rather easily be
able to calculate the value and profitability of any business (given the
numbers available and/or provided are accurate of course). Once a
valuation is arrived at, the person performing the valuation can decide
whether or not the market place (in this case the stock market) is
applying what could be considered a fair market value to the stock.
Certainly, when attempting to make a profit on Wall Street, it is
advisable to search out stocks which are (or at least appear are) being
improperly or undervalued by the market. For the Fundamental Analyst,
once an undervalued security is found, it's simply a matter of buying the
stock and waiting for the market to realize the "more accurate" value of
the security (assuming of course he/she is correct in their assumptions).
Find a cheap security, buy it and become rich. If only it were that
simple. Or perhaps it is? Just ask Mr. Buffett.
TECHNICAL ANALYSIS:
If the definitive work on Fundamental Analysis is provided by Graham and
Dodd, then perhaps the definitive work on Technical Analysis is provided
by Martin J. Pring in his book "Technical Analysis Explained". To quote
this well regarded book on the definition of Technical Analysis:
"The technical approach to investing is essentially a reflection of the
idea that prices move in trends which are determined by the changing
attitudes of investors toward a variety of economic, monetary, political,
and psychological forces. The art of technical analysis -- for it is an
art -- is to identify trend changes at an early stage and to maintain an
investment posture until the weight of the evidence indicates that the
trend has reversed."
Technical Analysis is nothing new. It has been used in one form or
another for as long as stocks have been traded. In fact, the star
character in one of my all time favorite books ("How I made $2,000,000
dollars in the stock market" by Nicholas Darvas) used mainly Technical
Analysis principles in his investing - whether he knew it or not.
However, "Charting" also commonly called "Chart Reading" - which Technical
Analysis is also referred to as - has become much more popular and
widely used in perhaps only the last 20 to 30 years on Wall Street. This
may be largely due in part to its more wide spread teaching and acceptance in
Colleges in more recent years.
If, based on my own experience and knowledge of this method of analyzing
securities, I had to summarize all of Technical Analysis down into one
central idea, I would put it like this:
The corner stone of Technical Analysis is the concept that no single
individual can ever hope to know as much about a security as the whole of
Wall Street does at any given time. Because "Wall Street" is made up of
everyone who is invested in - or may invest in - the stock market, their
collective knowledge about any specific stock and/or the market is such
that this mass of people and combined knowledge (i.e. Wall Street) can
valuate securities nearly instantaneously and far more accurately than any
single individual.
As such, in the mind of the Technician, it follows that there must be no
need to use something as "archaic" as Fundamental Analysis to value a
stock, when everything known about the stock (and this includes the
business fundamentals) is nearly instantly reflected in the stock's price.
In this situation, it would make much more sense to use the recent and
historical trends and movements of the stock price to deduce not only the
current fair market value of the stock, but where the price "may move" in
the future. This future price movement is largely extrapolated based on
historical chart patterns and how the stock has faired recently in
relation to support and resistance levels. Any Technical Analysis book
worth its salt will quickly introduce you to chart patterns such as
"double tops", "trend lines", etc. It is these patterns which are the
core of Technical Analysis.
However, the question of whether or not these patterns on charts can
always accurately predict future price movements of a stock is (and
probably always will be) up for debate between Fundamental and Technical
Analysts. If there is one fundamental (again no pun intended) flaw to
Technical Analysis, it is perhaps that over the years Technical Analysis
has been [incorrectly] extrapolated to mean that the market will "always
perfectly" evaluate a security based on all information known by the
markets. Unfortunately, that is not "always" the case.
This brings to mind a funny joke I once ran across in a book (I believe
the book was by or about Warren Buffett) regarding how Technical Analysis
has been elevated to levels beyond its true capabilities:
A Technical Analyst and his friend were walking across the street.
His friend noticed a $10 bill laying in the middle of the road and
exclaimed, "Look, there is a $10 bill in the road". At which point the
Technical Analyst said "If it were really a $10 bill, it wouldn't be
laying in the road".
This joke underscores the idea that Technical Analysis may not always
evaluate the market without error. However, as long as you keep this
point in mind, then Technical Analysis and chart reading can be a helpful
tool in both investing and trading.
Finally, we should point out that the term "Quantitative Analysis" on Wall
Street simply refers to someone (also sometimes referred to as a "Quant")
who employs a mix of both Fundamental and Technical Analysis in attempting
to properly evaluate stocks.
