Fundamental Analysis vs Technical Analysis
There are two dominant investment strategies to the business of buying and selling stocks. Many famous investors among which Warren Buffett, George Soros, and Peter Lynch use fundamental analysis to identify and purchase potential winners in the stock market. However, technical analysis also holds a great name such as Charles Dow, the technical analyst who created the Dow Jones Industrial Index and founded The Wall Street Journal.
Fundamental analysis and technical analysis both are used to forecast the trend of the stock price. As stock prices are always in motion and the reward lies in the direction of the stock price going in your favour: what are these strategies, what are the differences, and which one is better suited for investing?
1. What is fundamental analysis?
Fundamental analysis is a method where the art of stock picking is determined by the intrinsic value of a stock through evaluating the company by its financials, the management, the industry in which the company operates, and the overall economy. The goal is to identify whether the stock is undervalued. The idea is that, if the stock is undervalued, this could signal a good buying opportunity as the stock price will adjust itself and go up in the future.
The balance sheet, profit- and loss account, and cash flow statement represent the financial household of a company. You can derive important information from these documents such as the earnings, expenses, assets, and liabilities. With this information, you can calculate the intrinsic value of a company to compare with its current stock price on the stock exchange. And above all, the management of the company needs to be capable of steering and giving effect to the vision and strategy of the company or pivot when the time calls.
Next to knowing how the company is performing financially, you want to know whether its business and cash flows are sustainable by looking at the industry in which the company is operating. You need to assess the products/services provided by the company, gaps in the market, market trends and the competitors. Also, what are the strengths and weaknesses and what are the opportunities and threats? Furthermore, it’s important to know where the company is currently located on the industry life cycle. I would be interested in a growth company, while I will rather pass the company that is declining.
Lastly, we have to zoom out to the broader economy and analyse the economic circumstances in which the company and its industry are operating. After all, good businesses are benefitted from favourable market circumstances in which they can thrive so we want to know the state of the economy and if the stock market is risky now. Valuation metrics and macroeconomic indicators and how they develop provide information about the current and expected future economy. But subjective indicators like the sentiment of companies, consumers, and investors are of equal importance, as they influence the macroeconomic context.
2. What is technical analysis?
Technical analysis builds on the assumption that all fundamentals of the company and the economy are already factored in the stock price. This means we shouldn’t be calculating the intrinsic value of companies and their stock. We should rather be analysing stock charts and statistical trends to identify patterns and trends that indicate how the stock price will develop. Consequently, technical analysts are keen to identify indicators like the support and resistance levels and trend lines.
Support and resistance levels
Certain price areas on stock charts tend to act as barriers that prevent the stock price from falling below the support level and a climbing stock price from going through the resistance level.
The support level is a price level where demand for the stock increases to a point that the stock price is prevented from falling further. The graph below shows a support level at the price of USD 6.82, where the stock price bounced four times before it made an upward leap.
On the other hand, the resistance level is a price level of the stock where the sentiment to sell the stock increases. The tendency for the market to sell the stock at these price levels leads to sort of a ceiling which can be difficult for the stock price to pass.
The idea is that, once the stock price reaches an area of support or resistance, it can either bounce away from this level or go past this price level and continue its direction until it hits the next support or resistance level.
The next graph shows a resistance level at USD 10.08, where the stock price bounced against three times before going through this ceiling. The price areas around the support and resistance levels can be identified by other indicators such as trend lines.
Similar to the support and resistance levels, trend lines prevent a stock price from falling below or passing certain price levels. However, compared to the previous indicators, trend lines are formed while the stock price is trending up or downwards over a longer period. Below is an example of trend lines that are upward trending.
Trend lines are used to forecast the direction of a stock and predict the next support and resistance levels while the stock price is moving.
3. Key Differences
In fundamental analysis, the basis for investing is to calculate the intrinsic value of a company first, evaluate its management, and assess the environment and economy in which it is operating. On the other hand, technical analysis doesn’t do any of this and focuses on charts to identify statistical trends via historical stock prices and volume. In the latter method, market psychology and behaviour plays a major role as it is based on the idea that buyers and sellers use past market information to base their decision on buying and selling. This is missing largely in fundamental analysis.
Another difference is that fundamental analysis is often used for long term investments as it can take years for the stock price to adjust to its intrinsic value if that happens at all. Technical analysis is often used by day traders for short term investments, as indicators and patterns can differ by month, week, or (intra)day.
Furthermore, technical analysts analyse stats and charts to base their buy and sell decisions on while fundamental analysts use financial reports, news events, industry statistics and economic reports.
4. Which one is better?
The investor’s paradigm of how the stock market functions determine the method of stock analysis. Fundamental and technical analyses have fundamentally opposing views for buying and selling stocks, but both have been used for a long time and are still being widely used. However, some investors have dismissed technical analysis entirely as historical stock prices are based on past price moves and past news, thus offering no real information about what will happen in the future.
While I am a firm advocate of fundamental analysis, I still believe technical analysis has some benefits. When I find an interesting company in an industry that I understand, I calculate the intrinsic value and I assess the playing field, also in relation to the broader economy.
Although this is not always the case, support levels have the potential to coincide with a buying opportunity as this is generally the area where investors buy the stock, which pushes up the stock price. If the stock price hits a support level that coincides with a price range that I set up for myself and the fundamentals haven’t changed, I’m inclined to buy. Nonetheless, when using technical analysis, you still need to be aware of disclosures of the company you’re following or invested in.
As a believer of the importance of business models, cash flows, and interaction of companies with the economic environment in which they are operating, I use fundamental analysis for my investment decisions. Still, if a company on my watchlist approaches a support line, it draws my attention.