Fundamental Analysis vs. Technicals When Trading and Investing
Fundamental Analysis vs. Technicals by Conner W. Mays
There are two “schools” of financial security analysis, Fundamental Analysis and Technical Analysis. The picture above proves that the two do not always recommend the same action, so how do you know what to do? Unfortunately, there is no exact rule here. However, if you understand the differences in the two, you can dig a little deeper and decide for yourself.
The most obvious link from a consumer to a company is the good or service the company produces and sells. For many, this is where fundamental analysis starts – if you don’t purchase a company’s products, why would you buy the company? Fundamental analysis focuses on a company’s actual and physical characteristics. How good are the products/services they provide? What is the competitive landscape? How has their management team performed in the past? How strong and sustainable is their financial performance and position? Are there macroeconomic issues that the company will face? Think of fundamentals as anything and everything that could directly impact a company’s current and/or future earning potential and financial stability.
** Some line item names have been altered for simplicity
** Data sourced from SEC EDGAR
Let’s talk about Apple. Above – you will find a high level view of Apple’s income statement. Stating at the top, we have $216B in Net Revenue and a Gross margin of $84B which is about 40%. The “Gross margin” is the portion of revenue left over after netting out the cost of the products they sell. This is the first level of profitability analysts look at. Generally, this is compared to a company’s historical margin and the industry average, this can tell an analyst how well a company is managing the costs of its supply chain relative to its peers and its own historical average.
Moving down the income statement we find “Operating expenses.” These are expenses necessary for Apple to continue operating as it does today. The “Operating income” line is watched very closely by investors because it represents the profitability of Apple’s “business-as-usual” operations. These earnings are considered to be the most repeatable and consistent (AKA EBITDA or “Earnings-Before-Interest-Taxes-Depreciation-Amortization.)
Financials can reveal much more about a company’s strategy than most people realize. For example, Apple’s Research & Development expense is about 17% of its EBITDA and around 40% of total operating expense in 2016, this information can be used to compare Apple to its competitors to analyze the relative size of their investment in Research & Development and thus; their commitment to producing innovative products vs. their competitors’. This technique is helpful when comparing companies of different sizes and is referred to as Common Size Analysis.
In reality, financial statements are examined at an extremely granular level, we won’t go into the deeper levels of analysis for today, but we will in later discussions – stay tuned.
We have all seen the pictures of trading platforms with multiple colored lines crossing and moving in wild directions, they can be very intimidating if you have never been exposed to them before. These lines and other similar graphics are referred to as “Technical Indicators” or “Technicals.” Technicals come in all shapes, sizes and colors, but they all have the same goal; to help a trader identify the price levels they would like to trade at, however, they all have different ways of arriving at those price levels. Technical analysis is the study of past relationships between price and volume movements in an attempt to forecast where a stock’s price is headed in the future. Technicals are useful when analyzing a stock’s current value relative to its past performance but they should never be the sole reason execute a trade. Past performance does not guarantee future performance but it can help give you an idea if the stock’s current price is high or low relative to historical levels.
How are Fundamental & Technical analysis used together?
Let’s take a look at Netflix (NASDAQ: NFLX) looking at the chart below, you can see that Netflix suddenly dropped after they reported quarterly earnings in April 2016. This was due to the company missing consensus forecast on a key metric.
From a technical point-of-view, Netflix’s price movement and trading volumes sent a number of signals that strongly suggested selling the stock was the right thing to do, as a result, the share price fell by approximately 22%. However, if you looked at Netflix’s overall business model, and the firm’s economics, they hadn’t changed (aka the fundamentals story was the same.) Investors and traders who recognized this, and put on a long position (purchased the stock), have enjoyed a return of approximately nearly 64% in a matter of months. If you think about it – situations like this are supported by Benjamin Graham’s quote I mentioned in my last article. In the short term, the market voted it didn’t like Netflix (technicals.) However, over a little longer time period, Netflix’s value (fundamentals) outweighed those votes and the stock has not only recovered the initial drop, it has soared to all-time-highs.
The Netflix scenario is one of many examples of a market over reaction, they are not easy to identify and they are very risky but, they can be very profitable when properly identified. Understanding the differences in technical and fundamental analysis, and how the two complement and contrast one another is a very useful skill. As I have stated before, and as I will continue to preach, a single data point is never enough to make you trade, be patient and persistent, the gains will come, there are no shortcuts.
Disclosure: I am long Netflix, Inc. (NASDAQ: NFLX) and Apple, Inc. (NASDAQ: AAPL) I will not add/subtract from said position(s) in the next 72 hours. I wrote this article myself, it reflects my own personal opinions and beliefs. Readers should not consider any statements made herein about specific companies and/or financial markets as a whole to be actionable investment advice.