Is there a best method for stock-picking?
Most established fund management companies will proclaim that their fund managers use predominantly or even exclusively fundamental analysis when it comes to stock picking.
What we are commonly told by the asset management industry is that fund managers will be looking for stocks which are underpriced, and that this is determined best through examining balance sheets and income statements, and making comparisons with other stocks in the industry.
For various reasons, looking at technical indicators or charts is frowned upon in the same way as ‘market timing’ is frowned upon.
For institutions, there is certainly a strong incentive to justify their fees by distinguishing their process as fundamental investment, and entirely different from trading which is based on ‘pictures’.
However, looking only at fundamentals and ignoring technicals is not totally dissimilar to a doctor choosing to examine and question a patient, and refusing to look at the patient’s x-ray. In many ways they are just different sides of the same coin.
For individual investors, there are no constraints (apart from the size of a wallet!) on the investment process, and combining fundamentals and chart analysis can be very useful. In fact, the evidence is scant that either style is dependable, and they regularly go in and out of favour.
After all, market behaviour is often irrational for extended periods of time. Nevertheless, both fundamental and technical analysis do work well some of the time, and it is a good idea to gain at least a basic understanding of these 2 pillars of stock investment analysis.
There are various kinds of stock charts. These range from simple price trends and trading volumes using candle or line charts, to moving averages, Bollinger bands and a whole list of other indicators.
Traders who make use of technical analysis often develop very precise entry and exit points for their investments. Some chartists like to buy into rising momentum on a chart, while others like to take a contrarian stance and buy ‘bombed out’ stocks.
There are a few very well-known chart formations which seem to work a lot of the time, and these include the head and shoulders (before a stock price collapse), the double bottom and the double top.
Fundamental stock analysis
In contrast to chart analysis, fundamental analysis focuses on determining a value for a stock. This is accomplished by studying the balance sheet, cashflow statement and income statement of the company.
The process involves calculating various ratios, the most common of which are the price earnings ratio (PER) and the price to book ratio (PBR) and making forecasts for future growth. Fundamental analysis is generally more time-consuming than technical analysis, although that is no guarantee that fundamental analysis will result in picking the right stock!
Investing or trading – does it matter?
Although it is widely believed that technical analysis is used most often for trading over shorter time frames by day traders, in fact there are plenty of longer term investors who use charts to help determine whether to buy or sell.
Actually, neither methodology is superior. Rather, what matters is the final result – are you making money? So whether you are a trader who never considers fundamentals, a fundamental stock picker who never uses charts, or a fund manager who uses both fundamentals and charts, you are aiming to achieve the highest return possible with the least possible risk.
While the words ‘trader’ and ‘investor’ may have different connotations, semantics is far less important than stock performance.