Article by: Ernest Lim
Recently, I heard two university students debating over the effectiveness of technical analysis (TA) and fundamental analysis (FA). Much debate has been on-going for many decades on the usefulness of FA and TA and whether one method triumphs over the other. I will give a brief description on both methods, respective advantages and disadvantages and how to combine them to use it as techno-fundamental analysis.
DESCRIPTION OF FA
FA is a study of evaluating the intrinsic value of a security via analysis of the economic, industry, company, financial and other qualitative and quantitative factors. The intrinsic value is then compared with the security’s current price to determine the position that one has to take.
Table 1 lists some of the advantages and disadvantages of FA.
| Advantages | Disadvantages |
|---|---|
| Identify sound stocks: FA enables the investor to identify sound companies with excellent management, strong financial position and in high growth industries. This significantly increases the returns that you can generate from the stock. | Time consuming: One has to familiarize himself with the country, industry, company in order to reach a conclusion in the stock analysis. Besides, different valuation models or relative valuation models apply to different industries. |
| Get rich through FA: Warren Buffett is a classic example who obtains his wealth (2nd richest man in the world) through FA. There are extremely few (if any) technicians who obtained tremendous wealth via TA. | Majority of the FA information comes from company: As most of the FA information comes from the company itself, it is typically biased, in favour of the company. |
| Develop thorough understanding of the company and industry: Through FA, the investor would be able to understand the company and the industry. This knowledge is important because the investor would know how to react to plunges in share price – i.e. he will have an idea whether the stock plunges because of impending bad news (e.g. unable to meet outstanding loan obligations) or mainly due to poor market sentiment. | Disregards momentum: Some companies considered as market darlings can continue to surge, despite their lack of profits or revenue. Some undervalued companies can remain undervalued for years before surging, thus momentum should not be disregarded. |
Table 1: Advantages and disadvantages of FA
DESCRIPTION OF TA
TA is the study of price patterns and trends in the financial markets so as to exploit those patterns. It was brought to the forefront with the advent of Dow Theory at the turn of century. Dow Theory subsequently laid the foundations for what was later to become modern TA. TA hinges on three core principles:
Market action discounts everything
Patterns exist
History repeats itself
Below are some of the general advantages and disadvantages of TA, summarized in Table 2.
| Advantages | Disadvantages |
|---|---|
| Ease of usage: For example, a head and shoulder pattern chart pattern has the same interpretation on a stock chart or currency chart or commodity chart. | Subjectivity: Given the same chart, one technical analyst may think that the stock is building a base, while another may think there is more downside. |
| Price incorporates all available information:Price shows the consensus of all the market participants to the latest information available. It should be more correct than wrong. | Crowd can be wrong: For example, during the dot com bubble, many people piled their life savings into the technology stocks, only to find themselves losing the bulk of their money. |
| Do not require in depth understanding of financial statements: TA does not require one to pore over the thick annual reports, quarterly reports. It also does not require the user to decide whether he should use discounted cash flow models or relative valuation models to value the stock. | Historical: Charts cannot be used to predict sudden positive or negative events. For example, if China suddenly put in a price ceiling on all abalone produced and sold in China, abalone companies such as Oceanus would definitely be affected. |
| History may not repeat itself: History does not always repeat itself. If it always does, the richest people will be historians! |
Table 2: Advantages and disadvantages of TA
TECHNO-FUNDAMENTAL ANALYSIS
In my opinion, both FA and TA have their advantages and disadvantages. Although they are founded on different basis, I would rather assimilate the strengths of both FA and TA into a techno-fundamental analysis. How do I do that?
I will use FA to identify which stocks to buy or short and TA to identify when and whether to do this. Assuming if FA warrants a buy on Sinotel, Midas and Broadway, TA can be employed to identify a good purchase price or an opportune time to buy. A good purchase price is usually on or a tick above a strong support. Opportune time can be identified like the confirmation of an inverse head and shoulder pattern where price makes an upside breakout above the neckline (signifying a price reversal) with volume confirmation.
Conversely, TA can also be used to identify which stocks to buy or short and FA can confirm whetherand when to do it. For example, assuming if TA generates buy signals on Sinotel and Celestial on 29 Apr 09, I would use FA to confirm whether there are near term price catalysts and sound fundamental reasons to buy. FA would be able to filter out Celestial as it has impending convertible bonds to finance in June 09 (where it is rather apparent that it has problems financing them). FA can also provide an idea on when to take a position in the stock. For example, through a FA of Midas, one would know that it is likely to announce contracts in the next three months. Thus, if this is coupled with a buy signal from TA, one will have favourable odds of making a positive return on Midas.
CONCLUSION
In a nutshell, investing is a game of probability. Only the insiders in the company know almost everything about the company. For us, who are outsiders, although we may have gathered extensive sources of information on the company, industry, country, we may still be wrong. Thus, it is wise to couple TA (price consensus of all market participants) with FA (specific knowledge of industry & company) to increase the probability of earning a positive return on your investments.
Next time, if you hear people debating over the usefulness of FA and TA, do go up to them and say “Techno-fundamental analysis, anybody?”
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