When I opened my first investment account I was immediately drawn to the allure of technical analysis. The idea of being able to predict the future movement of the stock market simply by following a defined set of rules based on patterns in stock charts and indicators seemed too good to be true. The problem: it was too good to be true and I managed to wipe out my account in just a few short months. It became readily apparent to me that while technical analysis might be a useful tool for some investors, that the signals were just too unreliable for my taste. I wanted an investment strategy based on company fundamentals rather than price movement alone, and it was that realization that drove me towards a value investment bias in my portfolio. But what exactly is value investing, and just how does it compare to an approach based on technical analysis?
Technical Analysis in a Nutshell
The pure technical analyst pays virtually no attention at all to the fundamentals of the underlying company when making investment decisions. By fundamentals, I am referring to the financials, balance sheet, earnings, and future growth prospects of the company. Instead, technical analysis focuses purely on the pattern of price movement in the stock, as well as the volume. This is an interesting point. Some readers will be quick to point out that there are many hundreds of technical indicators available for the investor to use in addition to price and volume. Ok – let’s take a look.
SMA (Simple Moving Average)
Probably the most basic of the commonly used technical indicators, the simple moving average is quite simply (pun intended) the average of the recent closing prices over a specified number of periods. It’s most commonly expressed in the form SMA(50) or SMA(100), where the number in parenthesis is the number of periods from which the average is taken. Note that I use the term periods here instead of something more specific like days because as with nearly all technical indicators, the indicator doesn’t care about the timeframe. We could just as easily be talking about days, hours, minutes, or even years!
Typically the SMA is plotted on a chart along with stock price. A common buy signal is when the price crosses above it’s SMA, and a sell signal if it crosses below.
Seems like a reasonable idea, and it actually appears to be working in the example from Apple (APPL) above. I have a 50 day SMA plotted along with price over the course of 2012. Using SMA alone we would have sold at the beginning of May at about $580, bought back in at around $575 in June, and sold off again at $650 in early October. The problem is that any kind of investment approach based on averages, whether it be a simple moving average, exponential moving average (EMA), or even more complicated types, we need the stock price to trend to generate profit. More specifically, all we’re doing here is looking at price data in a different form.
Other Common Technical Indicators
The simple moving average is very basic. What about more complex technical indicators? Let’s look briefly at a few more:
- MACD (Moving Average Convergence/Divergence) – Uses price data to compute two moving averages, one of them being a fast exponential moving average (short period), and one with a longer period. The MACD looks at the divergence between the two averages and compares it to yet another EMA of itself called the signal line. When the signal line crosses above the MACD a buy signal is generated and vice versa for a sell. In other words, we’re plotting the difference of two averages, and comparing it to an average of itself. But again, there’s nothing magical about where these graphs come from. It can be traced solely back to the price data of the stock over time.
- RSI (Relative Strength Index) – Is part of the class of technical indicators called oscillators and ranges in value from 0 to 100. It is used to plot the strength or weakness in the momentum the stock has based on past performance, and looks at the rate of change of the price to calculate its value. Typically, RSI values higher than 80 indicate that the stock has become overextended (overbought) and is due for a correction. Conversely, an RSI value of less than 20 indicates that the stock has become oversold and may represent a good buying opportunity. Interesting concept, but again all we’re doing is looking at the price data to produce this indicator.
- Bollinger Bands – Consists of two bands, that are calculated and plotted based on how volatile the stock price has been over the past N periods (usually 20). The spacing between the bands is based on a multiple of the standard deviations of this volatility. So for example when the stock is quite volatile the bands expand apart, and when the stock is tame, the bands contract. Again, this is just another way (albeit an interesting one) to plot price data.
- VMA (Volume Moving Average) – Much like the SMA we discussed previously, an average can just as easily be taken of the volume data. Trends can be seen as to whether interest in a stock is increasing (volume increasing), or whether a particular day’s trading was significantly over or under the norm. Volume-based technical indicators utilize volume data, which is the only other information typically used by a technical analyst other than price.
- Patterns – There are entire books written on how to interpret the various patterns that occur in plots of stock price. They often have descriptive names like cup and handle, double bottom, or shooting star. Buy or sell signals are generated based on the occurrence of these patterns, often in conjunction with (confirmation by) other technical indicators. Often the existence of a pattern is quite subjective, and knowing when to actually pull the trigger and act on a pattern is far from an exact science.
As we’ve seen above, pure technical analysts really only base their trading decisions on two pieces of information: Price & Volume. It’s just sliced and diced and presented in many interesting forms. I used to love this methodology. If one indicator wasn’t working properly, there’s always six more to either confirm or refute. And therein lies the problem – some indicators work some of the time for some situations. For every indicator saying buy there’s another one saying sell, and since all indicators boil down to just a different presentation of price and volume, there is no reliable means to determine which ones are correct except in hindsight.
Fundamental Analysis: Information Overload
Taken to the extreme, fundamental analysis is the polar opposite of technical analysis in that recent price action plays second fiddle to the underlying financials and growth prospects for the company. Price is still important, but the investor taking a fundamental approach to making purchasing decisions typically wants to compare what he/she thinks is the current value of the security to the current trading price. To arrive at this estimate, there’s a vast wealth of information available. The analysis can range from extremely complex, to extremely simple. A complex analysis might use a finely tuned model that takes everything into account ranging from projected dividend growth, present value of cash flows, and trends in the company’s debt. A simple analysis on the other hand might look at just a few pieces of information, say for example the ratio of the company’s PE to it’s earnings growth rate (actually called the PEG).
Let’s look at some of the most common types of information used in fundamental analysis, and see how it could potentially be used to influence an investor’s decisions:
- Earnings – Arguably one of the most important metrics in determining a company’s worth, earnings are an important factor in most fundamental analysis techniques. Earnings are most commonly expressed on a per share basis, and expressed as EPS (Earnings per Share). Investor’s are typically willing to pay more for a company that is expected to increase its earnings in the future – and that only makes sense.
- Debt – On the other end of the spectrum, debt comes into play, and more specifically how capable the company is to manage or pay off the debt it has incurred. Small amounts of debt relative to the earning potential of a company is actually quite healthy and serves to allow the company to grow at a faster rate than it would otherwise be able to achieve from its cash flow alone. Too much debt in relation to the company’s size however can become unmanageable and become extremely cumbersome or even impossible to pay off, leading to bankruptcy. There are several metrics used to quantify this: debt/equity ratio, current ratio, and quick ratio are some of the most common. Each of these attempts to quantify the company’s ability to handle it’s debt obligations.
- Return on Investment – Ultimately, we as investors buy ownership in companies because we believe that the management of the company will be able to provide a higher return on our money than we would be able to achieve on our own. This is a point that is often missed. There are three common metrics that are used to determine just how well management is doing with the money entrusted to them: Return on Capital (ROC), Return on Equity (ROE), and Return on Assets (ROA).
- Dividends – Eventually, the management of most profitable companies will determine that they can’t achieve an acceptable return on investment with the cash on hand. It is their duty to return this excess money to the company’s shareholders by means of dividends. Whether or not a particular company pays a regular dividend at all is one thing to consider during a fundamental analysis. Also key is how fast the dividends are growing, whether there have been any lapses in the payment of dividends, and also the payout ratio, which is the percentage of earnings that are paid out to investors instead of being retained to spur future growth.
- Management – The rise and fall of company’s are often directly attributed to their leadership. As such, management cannot be overlooked when analyzing a company based on fundamentals, more specifically management’s ability to grow the company, and their ability to recognize when they can’t achieve an acceptable level of growth, resulting in an increase in dividend payments.
- Products – A company’s products themselves play into a proper analysis, but tie into many of the other metrics discussed above. Is a new product coming that will command an increased market share? This will generate earnings, may require the company to take on additional debt to finance new tooling, and will rely on management’s competence for a successful execution.
The Case for Value
Based on the sheer amount of information available, there are any number of directions an investor can go in performing an analysis. Some investors seek to make decisions solely on growth, while others may take a buy and hold approach, choosing to purchase companies they believe in fundamentally, and never selling. I have grown to believe that a Value Investing approach makes the most sense for my investment goals and personality. But why?
To believe in something, it has to make sense, and I have been able to rationalize the philosophy of value investing to the point that it does. Value Investing uses fundamental analysis to seek out stocks that are currently trading at a price less than what their intrinsic value is.
As value investors we use fundamental analysis methods to seek out and buy those companies that are currently trading at a price less than what their intrinsic value is. We hold those companies until such time as they are no longer good value, at which point we sell for a profit.
There’s obviously a lot more to it than that, but this summarizes the essence of what we’re trying to achieve. And it makes sense:
- It follows the old stock market adage of buy low, sell high.
- It takes a lot of the fear and emotion out of investing because the company is being bought for less than what it’s worth (this can be a difficult concept to grasp and will be explored further in another post).
- It is based on real numbers that actually mean something. We are basing our calculations on fundamental metrics like earnings and sales instead of blindly looking at price without considering what’s driving it.
A Value Investing Example
Value investing is probably most easily explained by example. I am not going to go into detailed calculations here, but will show you the essence of what I am talking about. Let’s look at a company called Bio-reference Laboratories (BRLI) over the period of 2011-2012. BRLI is a company that provides medical laboratory testing services for individuals and physicians in the northeastern United States, and is a company that I follow quite closely.
Throughout 2011, let’s say that we as value investors determined that BRLI was a company we would be interested in holding for the long term, and that we would be interested in buying it, so long as we were getting it for a bargain. But that’s the question – what do we consider to be a bargain?
A bargain is defined as the purchase price being less than what we calculate the company’s actual value to be, based on fundamental principles. BRLI has been growing steadily for the past 20 years. The company has zero debt. Management is solid, and they are expanding both their services and geographical coverage. Let’s say we had an excel spreadsheet (hint: we do!) that we could use to quantify all of this data and have it tell us what the stock price should be, based on that data. Our spreadsheet might tell us that BRLI has an intrinsic value of $18 / share.
The tricky thing to note here is that stock price does not usually equal stock value. Stock prices typically fluctuate wildly all the time, based on millions of various factors: you have technical investors buying when price crosses above the moving average; buy and hold investors are buying on a bi-weekly basis when their paychecks come in; institutional investors (ie. mutual funds) might be selling so that they can redistribute funds elsewhere in their portfolio; uncertainty about the economy may cause people to either buy or sell based on their views of how things will turn out. In short, the stock market is pretty unpredictable. But by having already defined what we believe to be the true value of the stock, our life is made easy. We’re getting a bargain if we buy at less than $18 / share!
July, 2011 through the end of that year saw many buying opportunities for BRLI. Let’s assume that we have $60,000 we wanted to invest in this company and see how one scenario might have played out. In mid-July of ’11 we had the opportunity to buy right at $18 but, as we’ll see in other tutorials we also need a margin of safety on our entry so we wouldn’t have bought then. Our first real opportunity comes on Oct. 3, 2011 where we could have entered at around $17/share. Let’s assume that we invest 25% of our allocated capital, or $15,000 and manage to buy about 850 shares at $17 each. Things are looking great until early November until the stock drops significantly to a low of around $12 / share about a month later. During a drop like this it’s important to evaluate whether any of the fundamentals of the company have changed. If not – that is to say that we are still confident in our valuation of $18 / share, then we are able to buy more shares. Let’s say we invested another $15,000 on the way down at around $15, another $15,000 right at the bottom at $12, and put our last $15,000 in on the way back up at $16.50. Let’s see what our position looks like:
- Initial $15,000 @ $17/share: 850 shares
- 2nd $15,000 @ $15/share: 1000 shares
- 3rd $15,000 @ $12/share: 1250 shares
- Final $15,000 @ 16.50/share: 900 shares
We now own a total of 4000 shares and our average price is $14.82 / share. By April, 2012 BRLI was trading circa $24/share and by October it had reached just of $32/share. If we were to sell anywhere in this range, we would have achieved a profit of between $37,000 and $68,000 or a gain of 61% and 113% respectively.
This is the power of value investing at work. By defining an estimated intrinsic value, it takes a lot of the guesswork out of when to buy. And when you do buy, you can be confident you’re buying low (or at least lower than you would be otherwise). This helps to ensure that you will not only maximize profit on winning investments, but also serves to minimize losses on losing trades.