Fundamental and technical analysis are two distinct investment methods used by investors to derive investment decisions. Both methods share the same objective, but the data and tools that they use to determine an investment decision are entirely opposed to each other. Technical analysis uses exclusively charts, while fundamental analysis relies on company reports and financial data. Let’s examine the two investment methods in more detail below;
Fundamental analysis uses real data to derive a stock’s intrinsic value. This type of investment method analyzes financial data, which is “fundamental” to the future performance of the company and its share price. So an investor who relies on fundamental analysis would be largely basing their investment decisions on several factors. For example, any competitive advantage a company might have compared to its rivals, such as patented technology giving its product a unique selling point. Moreover, a company might be able to take advantage of economies of scale, thereby undercutting its rivals, yet still maintaining the highest profit margin in its sector.
Another factor that fundamental analysts examine when determining a share’s intrinsic value, includes a company’s earnings growth. Is the business expanding in a profitable way by keeping its costs under control? Revenue growth is also an important factor when determining the viability of a business. If the business is under competitive strain it would show up in its revenue figures, since price is a factor of revenue, thus a fall in price due to competitive pressure would result in a fall in revenue, given no change to sales in a certain period. The company’s market share is also a crucial data for the fundamental analysis when determining the intrinsic value of the stock. The more dominant a company is in its market, the more likely it would be to drive rivals out and manipulate prices to maximize its revenue.
A company’s financial reserve is another factor fundamental analyst like to peruse over when deriving their investment decisions. In a period of economic downturn turn, when credit is tight, the availability of financial reserves could mean the difference between the company’s survival and failure.
Product pipe line, the likelihood of future products/services being launched on the market, is also considered by the fundamental analyst. For a company to remain a market leader, or aspire to dominate its market, product innovation and development are essential; this is particularly the case in the tech sector, pharmaceutical sector and frankly any business environment that could benefit from research and development.
Fundamental analysts also like to eye up the company’s management team, bearing in mind that a company is made up of people and guided by its management. Management track record and their experience are often used to gauge the future performance of the company.
For the fundamental analysts the Holy Grail lies in the company’s annual/interim reports and financial statements with the aim of finding value stock that the market has mispriced. So when the stock is underpriced they buy, alternatively when the stock is overpriced they do the reverse and sell.
The technical analyst, on the other hand, is a different type of animal. Indeed, a technical analyst doesn’t look at the financial statements of the companies they may wish to invest in, let alone know who runs them. The technical analyst bases their investment decisions on a distinct investigation method by studying historic charts, patterns and trends of publicly quoted companies. This type of analysis employs the use of charts, bar charts, candle stick charts, and trading volume to determine the future trajectory of share prices. Such things as a company’s revenue, market share, product pipeline and financial statements are literally of no concern to the technical analyst. It’s almost as if the technical analyst is entirely oblivious and unconcerned about the entity’s activities. The technical analysis is completely focused on the historic and potential future price movements of the instrument they wish to invest in. They believe that future price movement of a particular financial instrument can be determined by analyzing its price charts. Trend lines can be plotted to determine their trajectory and entry (buy) and exit (sell) points. Technical analysis, as a method of investigation assumes that we are creatures of habit that we behave in a certain predictable way when the price of an instrument breaks through a predetermined threshold point. So the technical analyst type of investor buys when an instrument’s price falls to its price support level, conversely they sell when the price breaches its price resistance level.
They say if you want to master a game you need to watch meticulously the top players in action. So what do the gods of the investment world do? Apparently, there is no ambiguity when you ask Warren Buffett, Peter Lynch and Benjamin Graham, whether they base their investment decisions on fundamental or technical analysis. "I realized technical analysis didn't work when I turned the charts upside down and didn't get a different answer," famously replied Buffett when asked what he thought of technical analysis as an investment method.
Meanwhile, Peter Lynch, another billionaire investor who was involved in Fidelity Investments, returning an average of 29 percent between the years 1977-1990, said "Charts are great for predicting the past." Benjamin Graham, famously said, "In the short term the market is a voting machine, but in the long run it is a weighing machine."
So those in the top league share a few things in common, they didn’t rely on trend lines, charts and candlestick charts to amass their fortunes; they relied on fundamental analysis and focused on finding long term value in their investment decisions.
Well and good, but over the past decade the scandals of Enron and more recently the Bank of America, Citi Group, GM and the list goes on of companies cooking the books calls into question the auditor’s report, “that the financial statement gives a true and fair view of the state of affairs of the company.” In a globally connected, highly competitive world, where success is handsomely rewarded and failure punished, the pressure for companies to perform is greater than ever, sometimes, not always, financial statements and reports may be economical with the truth. For this reason, an investor who ignores or dismisses technical analysis as tea leaf reading would do so at their own peril. The fundamental analyst may interpret value in a stock after interpreting its accounts, but they may also be oblivious to high volume trades in the stock due to say, insiders selling. Such a move would blip on the technical analyst’s radar and they would be able to take measures to preserve wealth.
You may not drive your car looking only in the rear mirror, but it certainly helps you avoid an accident by checking regularly what is going on behind you. Perhaps it is for this reason that all large broking houses now employ technical analyst.
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