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Robert Abbott
Robert Abbott
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Value Investing: What’s Behind Fundamental Analysis?

Key issues for value investors using fundamental analysis

January 15, 2020

In chapter four of his book, “Value Investing: A Comprehensive Beginner Investor’s Guide,” Blaine Robertson argued that fundamental analysis was the “lifeblood” of investing. I would be more specific, noting it is the essence of value investing, but of little consequence in other strategies, especially technical analysis (more on this later).

He also pointed out that fundamental analysis aims to figure out the value of a stock or other security by considering it in relation to underlying factors—and not to market prices. Indeed, prices in the stock market have little or no bearing on fundamental valuations.

More important for fundamental analysis are whether a company will be a good investment, if it is growing and by how much, and whether it is generating profits. In addition, fundamental analysis is very interested in each company’s debt situation.

Robertson looked behind the curtains of fundamental analysis and found several areas of interest:

The goals

  • Identifying a “fair value” for stocks, which will enable a prospective buyer to know if a company of interest is undervalued or overvalued. A value investor only wants to buy those that are undervalued.
  • Assessing a company’s financial strength, which Robertson said was a company’s ability to pay its debts. I would add that it will also involve a company’s potential to generate suitable returns and more.
  • Determining whether the company has a competitive edge, what Warren Buffett (Trades, Portfolio) called a “moat” or “economic moat.” Can this company handle the competition and still operate profitably?

The basics

  • What is this company’s worth? All investing is based on perceptions of value.
  • Sentiments affect perceptions, which helps explain how some stocks become overvalued or undervalued. I would add that the field of behavioral finance tries to address the gap between perceptions and quantified reality.
  • Stock prices are affected by industry trends. Robertson pointed out that all stocks should be assessed relative to the other companies in that industry.
  • Long-term investors gain the most from fundamental analysis, because stocks reach their peak of profitability in the long run.

Other securities

In this section, Robertson noted that while we normally think of stocks when discussing fundamental analysis, it also applies to other securities, such as bonds and derivatives. Whenever economic fundamentals are being analyzed, fundamental analysis is taking place.

In the case of bonds, investors look at economic issues such as yield and the creditworthiness of the issuer, whether government or corporation.

For stocks and other equities, investors check out revenues, earnings, profit margins and the like, information that comes primarily from a company’s financial statements. Robertson pointed to a couple of important ratios:

  • Liquidity ratio, which measures a company’s ability to convert its short-term assets to cash in order to satisfy short-term liabilities. In other words, could the company pay all its short-term bills if it had to?
  • Examples of profitability ratios include the operating profit margin, return on equity and so on.

In addition, stock investors will also want to check out a company on more qualitative terms, such as its reputation, its standing within its industry and the strength of its management.

Getting back to the quantitative, there is cash flow information from the cash flow statement. It will show a company’s liquidity at a specific point in time. I would add that investors should also look for “free cash flow,” which is what’s left after the company pays its bills and commits to capital expenditures. That is the real profit for investors. As noted, Robertson also recommended reviewing a company’s debt.

Finally, he suggested that investors check the company’s future prospects, presumably by doing discounted cash flow analysis.

Its importance

Fundamental analysis, according to Robertson, is about more than just the numbers. For example, it will help us understand how the system works by assessing the factors that influence the growth of companies.

At this point, the author turned his attention to technical analysis and its relationship with fundamental analysis. He wrote that technical analysts “merely” try to analyze stocks using statistics only. They believe future price activity can be determined by looking at the recent past. On the other hand, he wrote, fundamental analysts use information from a long period of time.

This, I believe, is a generalization that doesn’t necessarily fit the case. I have seen many technical analyses based on 10 years of historical charts and I have seen fundamental cases based on five years of history. One type of analysis is not automatically longer term than the other.

At the same time, he argued that fundamental analysis might be used to find stocks with strong fundamentals, and technical analysis could then be used to identify the best price to pay. Again, I would object since the essence of fundamental analysis is to find a stock selling for less than its intrinsic value. Charts are irrelevant to most value investors (but there are exceptions).

A follow-up paragraph made more sense. Here, Robertson argued fundamental analysis could be used to find undervalued stocks, and technical analysis might then be used to determine entry and exit points. This is most useful when market pricing is dynamic; for example, the price of a stock has been dropping steadily and a value investor wonders, “Should I buy now, or should I hold and wait for an even better price?” In that case, technical signals such as crossovers may be helpful.

He added that some investors believe the two types of analysis can be profitably combined or integrated, while others believe that fundamental and technical analyses are incompatible and only one or the other should be used.

Conclusion

The place and importance of fundamental analysis have been presented in chapter four of “Value Investing: A Comprehensive Beginner Investor’s Guide.” Author Robertson has made the case for putting fundamental analysis at the front and center of a value investor’s toolbox.

The chapter included sections on the goals, the basics and the importance of fundamental investing, as well as information on the application of fundamental analysis to stocks and bonds.

A final section dealt with technical analysis, a section which was arguably weak. The author might have made his case stronger by adding more context, more specifics and examples.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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