Friday, May 25, 2012

Fundamental vs. Technical Analysis (a Primer).

Some would argue that both Technical Analysis and Fundamental Analysis attempt to predict the future price of a stock, and hence the best time to buy or sell the stock. They would say that these two techniques are complimentary investment tools.

Others argue that Fundamental Analysis is a thing of the past, and that modern computer power puts Technical Analysis in a place of supremacy.

Technical Analysis.

Technical Analysis is a form of prediction used by castle-in-the-air investors. Castle in the Air investing focuses on stocks that have momentum to carry them higher. It relies heavily on charts and psychology.

Practitioners of Technical Analysis are sometimes called "chartists" because of their slave-like devotion to charts to the exclusion of all else. Pure chartists believe that the market is 10% rational and 90% emotional or psychological.

Chartists try to out guess other investors without regard to underlying business of a stock holding. A cynic might say that the Chartist or Castle in the Air Investor is simply hoping to take advantage of the Greater Fool Theory.

Chartists believe that all knowable information is reflected in the stock chart (i.e. past price and current trend of the price). Chart shapes are of supreme importance to Technical Analysis, but a Head And Shoulders Pattern means the same thing regardless of the stock whose price chart makes the formation.

In Technical Analysis, trends might perpetuate themselves for 2 reasons:

  1. Mass psychology and crowd instinct - no one wants to miss out, so investors chase performance. This is often at the heart of stock market bubble.
  2. There may be uneven access to key information. Insiders learn of game changing information and buy shares. Insiders then tell friends who buy shares. Institutional money managers learn of the info and buy massive amounts of shares. Individual investors see price rise and pile on (see #1 above.)

Technical Analysis and Price Chasing Psychology.

Here's an example of how Technical Analysis attempts to explain momentum in terms of price chasing.

Stock xyz currently sells for $50 per share. The price then falls to $40. Next, the price rises again to $50 only to drop back down again as investors who bought at $50 sell their shares in the hopes of breaking even. This $50 point is then considered a level of resistance.

As $50 per share investors sell, other investors see the stock fall to $40. Investors who didn't buy xyz at $40 and see it rise to $50 feel like they missed out, so when the price drops to $40 they get on board and push the price up again. In this example, $40 is considered a support area.

It seems logical and makes common sense, but it doesn't explain every move in a stock price and it doesn't always predict where the price is headed next.

Where Technical Analysis goes wrong.

This kind of approach lends itself well to timing the market, day trading and speculation. Transaction fees and taxes often eat up any profits that may be found.

Fundamental Analysis.

Fundamental Analysis is sometimes called Firm Foundation Theory and it focuses on the underlying company rather than the stock price.

If Chartists believe the market to be 10% rational and 90% irrational, the Fundamental Analyst believes the market is 90% logical, 10% psychological.

Fundamental Analysis seeks to determine the true underlying value of the stock or company, usually called its intrinsic value.

There is perhaps no more prominent investor associated with type of investing than Warren Buffett.

Buffett epitomizes the fundamentalist approach. He tends to ignore the day-to-day "chatter" of the market and only buys a stock when he feels the price is at a discount to the company's intrinsic value.

Which is Better - Technical Analysis or Fundamental Analysis ?

This whole thing is rather like debating whether General Relativity is more accurate than Quantum Mechanics . Both represent different aspects, or slices of the universe - in the case of Technical Analysis and Fundamental Analysis the universe is the stock market.

In my experience and opinion, Technical Analysis can be helpful in explaining - and maybe even predicting - short term fluctuations of a stock price, but Fundamental Analysis proves to be the winner in the long term. Some of this is because the market tends to be more of an efficient market over time where stocks come to reflect the value of the underlying business, and some of it is because short term trading (associated more with Charting than Fundamental Analysis ) leads to higher fees and taxes that eat away at profits.

Monday, May 14, 2012

Apple Inc., Destined to Decline?

Is Apple Inc. destined to decline after the loss of it's iconic front man? Last year wrote A Tale of Two Apples , in which I pointed out that Apple Inc. did not fair too well in the mid to late 1980's after Jobs departed. I was openly musing what would be Apple's fate if Jobs once again departed, forced out this time by illness rather than corporate takeover.

It's still too soon to tell, but George Colony, CEO of research and analysis firm Forrester, is thinking what I'm thinking about Apple Inc..

Despite the numbers, Colony believes that:

"When Steve Jobs departed, he took three things with him: 1) singular charismatic leadership that bound the company together and elicited extraordinary performance from its people; 2) the ability to take big risks, and 3) an unparalleled ability to envision and design products."

(Forrester: Without Jobs "Apple Will Coast, And Then Decelerate" - Forbes)

Colony thinks that without Jobs at the helm, Apple is cruising towards some rocky road ahead. His prediction is that Apple has enough of a product pipeline to coast for another 12-24 months, but will begin to decline and lose its reputation as an innovator and its market share with it.

In Colony's eyes, Apple is destined to be another Sony, Polaroid, Disney - and even the 1985 incarnation of Apple itself.

“Apple will coast, and then decelerate.”

Apple Inc., by the numbers.

The numbers for Apple Inc. tell a brighter story. 35.1 million iPhones, 11.8 million iPads, 7.7 million iPods and 4 million Macs all sold in Q1 of this year.

Apple's financial's look great too: $110+ billion in cash and no debt. Apple is aggressively expending into new markets, like China.

But where's the innovation? After years of new product lines, changing and challenging the definition of Geek Chic we're seeing little more than the next generation of products that previously changed the way humans related to technology.

And as for China, that endeavor may prove to be more of A New Threat to Apple's Empire? than a new market.

Apple is still a very good company, but with the loss of Steve Jobs, it could be argued that it now a very overpriced company if not one destined for decline.

Monday, May 7, 2012

4 Determinants Of Stock Value Estimation.

There are many factors that affect the price of a company's stock. It's one of the reasons why investing is so difficult, and why so many people miss their target when deciding when to buy a stock. Without some understanding of what drives stock prices, it's easy to buy high and sell low.

Here are four fundamental drivers (or determinants) of stock price, and what they should mean to you!

1. Expected growth rate

Why it's an important determinant:

Earnings don't grow at the same rate forever. Even if a company maintains successful management policies, it becomes harder to sustain high growth rates as the business grows and matures.

For example, a company earning $1 million only needs to grow its earnings $100,000 to achieve 10% growth rate. A company earning $10 million needs to increase its earnings by $1 million to achieve the same rate.

High growth rates don't hold over the long term.

What this should mean to you:

Generally speaking, you should be prepared to pay a higher price per share for a company with larger earnings and dividends. To put it another way, the longer the extraordinarily high earnings are expected to last, the higher the price will be. This is why higher growth stocks typically sell at high Price-Earnings Ratios.

2. Expected dividend payout.

Why it's an important determinant:

The higher the dividend payout, the greater the value of the stock. This is because the dividends are a predictable source of income to the investor, which makes it easier to determine the investor's return (theoretically). However, high dividend rates sometime mean danger. (see caveats below)

What this should mean to you:
A rational investor should be willing to pay a larger price per share, for good companies with higher dividend payout.

3. Degree of risk.

Why it's an important determinant:

There is always risk in investing. The higher the perceived risk of a stock, the lower the stock price, generally speaking. Risk is notoriously difficult to determine, which is why so many gurus outside of Wall street recommend index funds.

What this should mean to you:
A risk averse investor should be willing to pay a higher price for shares of companies perceived as less risky. The returns are perceived as more stable, and "safer", and so often sell at a premium.

4. Level of market interest rates.

Why it's an important determinant:

The stock market is only one place for people to put their money. At times, like early 1980's, bonds and other investments pay a higher return than what can be earned in the stock market. Higher interest rates, generally mean lower stock prices. Higher inflation though can lead to higher prices of stocks that are viewed as having the ability to increase earnings in step with inflation, while those who cannot will likely be left behind.

Also, as we've seen over the past 4 years, low interest rates typically lead to higher stock prices, since there are few alternatives to growing your money when banks and bonds pay close to 0%.

The exception to this is Junk bonds, but they are sometimes considered more like stocks than their "Investment Grade" counterparts are.

What this should mean to you:

A rational investor should be willing to pay a higher price for a share, the lower the interest rates. You can also expect prices of current holdings to rise as interest rates fall, and fall as rates rise. Follow the Federal Reserve and get a feel for interest rate expectations from the meeting minutes.

Caveats: The above assumes all other things are equal. The problem is that "other things" are often not equal.

For example, if considering whether to buy stock A or B, the stock with the higher dividend rate will be worth more - provided both A and B are of equal risk, earnings growth, debt level, etc...

It's easy to find stocks paying double digit dividends, when their price has been slashed and they're hemorrhaging cash. This may seem counter-intuitive. After all, wouldn't a company want to hold on to its earnings and turn the ship around? Not if management is only concerned with the stock price and they believe that offering a high dividend yield will attract income hungry investors.

Also, the future is unknowable, so things like projected earnings growth are only guesses. Some may be better guesses than others, but they are inherently guesses. Invest accordingly, and look for a Margin of Safety where possible.

If you liked this post, you may also like A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing.