Fundamental, Technical...Why Not Both?

04/03/2013 9:00 am EST

Focus: STRATEGIES

Paul Goodwin

Emerging Markets Specialist and Analyst, Cabot Heritage Corporation

Astute investors don’t need to choose a camp, says Paul Goodwin of Cabot Wealth Advisory. The best portfolios can benefit from a combination of both fundamental and technical analysis.

In the world of equity investing, there is a significant distinction between a fundamental investor and a technical investor.

The fundamental investor wants to figure out the intrinsic worth of a stock by looking at data like revenue, earnings, cash flow, projected growth, return on equity, profit margins, and more of that ilk. They want to know everything there is to know about a company’s operations, management, markets, competitors, and prospects.

But the biggest emphasis is on financial performance. Ultimately what a fundamental investor wants to determine is a value for the company, sometimes called the liquidation value.

Once the investor knows what a company’s assets would be worth—even if the company went belly-up—it’s a relatively easy matter to buy only when the stock is trading at the greatest discount to that intrinsic value. Then all the investor has to do is wait for the stock’s price to increase to that value and sell it.

There are differing opinions about which fundamentals produce the best results, including price-to-earnings ratios, price-to-book, price-to-sales, price-to-discounted-cash-flow, or myriad other approaches. But the basic approach is always the same: Calculate the intrinsic value, find the bargain, and wait for the appreciation.

Pure fundamental investors—often called value investors—are often willing to wait years for their stocks to come around. And once the stock becomes fully valued, they’ll sell, no matter how strongly the stock is advancing at the time.

At the other end of the spectrum is the technical investor. Technical analysts evaluate stocks by looking at  price and volume patterns to try to find strong stocks, identify trends and patterns, and determine buy and sell points.

The technical analyst’s primary tool is a chart that shows a stock’s price, trading volume, moving averages, and other information over a specified period of time. Seasoned analysts learn to recognize patterns in these charts that indicate rising or falling support for a stock.

The information gleaned from this kind of analysis usually leads to much shorter holding periods and more active trading. The purest practitioners of technical analysis may not even know what products are made or sold by the stocks that they follow. The only thing that matters is the chart and its patterns.

Some technical analysts look for stocks that have strong positive momentum and are outperforming the broader market (or are in base-building periods with minimal selling pressure) with supportive trading volume. Technical analysts generally do not establish sell or target prices when they buy, preferring to monitor performance closely while letting stocks rise as high as possible.

Stocks favored by technical analysts are typically growth stocks, and these stocks’ high P/E and other ratios are a major distinguishing feature. As with fundamental analysis, there are different schools of thought about what technical indicators to look at, and the statistical methods used to find promising patterns.

We think that following either of these investing styles exclusively can be risky for your total portfolio.

Pure fundamental analysts, while keeping risk low, can miss out on the huge profits to be made during bull markets. By giving so much weight to valuation, these investors can also leave money lying on the table by selling at predetermined levels when stocks have strong upward momentum.

And pure technical analysts, by ignoring fundamentals, can build portfolios of very expensive stocks with such high volatility and risk that following them can be a full-time job.

We always take fundamental factors into account, even in our most aggressive recommendations. We see no point in excluding any information that can increase the success rate of our featured stocks. So we keep exploring every kind of information available and every method of analysis.

Like all skilled workers, we want to have as many tools at our disposal as possible. We think you should, too.

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