I speak with dozens of investors and traders on a monthly basis. Most are looking for stock tips or just basic advice on how to improve their investing results.
Many of these investors are having a difficult time in the stock market. It’s tough to continually pick winning stocks that will provide outsized profits over the long run. It’s not just during the current volatility that many investors are struggling, it’s all the time regardless of the market itself.
The fact is that even during roaring bull markets like the tech boom, many investors lost money.
When I drill down into the reasons that these investors are struggling in the stock market, one primary reason emerges.
The vast majority of these unprofitable or barely breaking even investors have one trait in common.
This trait is that they only use technical analysis to choose stocks.
Make no mistake, technical analysis is a powerful tool in every investor’s arsenal. However, it is far from perfect and needs to be tempered with fundamental analysis.
You see, stock charts can be very deceiving because price can move without any underlying known cause. These false moves trap investors who rely strictly on technical analysis to make real-time decisions in the stock market.
It is these bull and bear traps that quickly take profits and eat into your account equity at a rapid pace.
Investors who combine fundamentals with technical will understand if a price move has supportive fundamental factors. If the fundamentals support a price move, then it makes sense to buy or short the stock depending on the situation. If the fundamentals do not support the price move, avoid the stock!
There are certainly exceptions to the above rule. Even when you combine technical analysis with fundamentals it’s not fool proof. No investor or trader can avoid the unknown happenings that move price despite solid fundamentals and technical. However, it definitely shifts the odds in your favor over a series of trades!
I further dug into this issue by wondering why struggling investors generally avoided fundamental analysis in favor of technical analysis. One reason is that technical analysis just seems easier and heavily pushed by brokers since it often results in overactive trading which pushes up the commission numbers.
However, the primary reason why investors avoid fundamental analysis is that they simply don’t understand it.
Many believe that it takes an MBA to read financial statements and fully understand fundamental analysis. While fundamental analysis can become complex, it does not have to be to use it in a profitable way.
Most of fundamental analysis is purely common sense and understanding what makes a successful company. The truth is that fundamental analysis is easier to learn than the basics of technical analysis if you go about it the right way.
In an effort to help solve this widespread problem, here is an easy to follow plan for the correct use of fundamental analysis.
First, let’s take a closer look at exactly what is fundamental analysis.
Fundamental analysis goal is to define a stock’s future value by reviewing the actual condition of the company itself, the economy, and consumer/business trends.
It uses information available from the company’s own accounting, projections and outside economic data to build a portrait of the future prospects of the company. This data is then scrutinized and compared to the past and to other firms in the same sector to determine the strength or weakness of the company.
On the other hand, technical analysis only studies the stock price itself in an attempt to forecast future price moves. Technical analysts believe that all the fundamental information of the company is already reflected in the share price. By understanding price patterns and trading volume, technical analysis preaches that investors can forecast the future direction of the stock price.
The secret to long-term success in the stock market is a top-down approach to stock picking. This approach combines both technical and fundamental analysis.
Starting with technical analysis to locate stocks that are making unusual moves then drilling into these stocks with fundamental analysis gain an overall understanding of the future potential . I start the process with technical screens to locate stocks exhibiting bullish or bearish behavior, then drilling into each company fundamentally to determine if the fundamental and technical picture support each other.
How To Use Fundamental Analysis
When it comes to fundamental analysis, many investors feel overwhelmed and don’t know where to begin. The most critical fundamental information is found in the company’s earnings report. It is where investors should begin their fundamental analysis of a company. Although, at first glance, an earnings report can seem overwhelming and difficult to understand, it’s actually a very simple document once you understand how it’s designed and what to look for.
Here’s How To Do It
Step 1. Review The Earnings Report
All U.S. earnings reports are designed the same way. Each one, without fail are built in the following manner.
Part 1. Financial Information
- Financial statements
- Management’s analysis of financial condition
- Market risk disclosures
- Controls and procedures
Part 2. Other Information
- Legal proceedings, risk factors
- Unregistered equity sales and use of proceeds
- Senior securities defaults
- Additional information
I know this seems like an overwhelming amount of information to digest. But it can be broken down into the following 3 steps.
Step 1. Begin with basic financial numbers
The basic critical numbers are revenue, net income, diluted earnings per share and earnings before interest and taxes (EBIT).
Compare these items with the previous quarter and year over year. Ask yourself is the company growing based on increasing numbers? Are the numbers stagnant or decreasing over time?
Step 2. Next look at the cash flow numbers
Cash is king with it comes to every business. Never neglect understanding a company’s cash flow. As yourself, where the cash is coming from? Is the company earning cash from operations or using cash to operate? Make sure the cash flow is positive. Remember, companies often show positive net income but negative cash flow. This is a red flag that all may not be as it seems with the company.
Step 3. Consider the risks
Once you have ascertained the company is in solid financial health, the next step is to ascertain the risks.
One of the primary risks today are lawsuits.
Legal proceedings are a critical risk factor. Although many companies have multiple small damage suits, pay particular attention to class action lawsuits. These can do tremendous damage to a company, win or lose, due to the high costs of defense.
The SEC requires companies to list their risk factors under Item 1A in the Other Information section of the earnings report.
Make sure there is nothing fishy here or downright frightening to the future of the company.
Many times very negative factors are couched in expertly chosen words designed to lessen the impact of the situation.
This means that a careful reading is critical for a complete understanding of the company’s situation.
While this is by no means a complete tutorial on fundamental analysis, it is a great start for novices in the discipline. By using the above factors investors can ascertain whether or not a stock market move has fundamental support.