THE SOUTH AFRICAN INDEX INVESTOR

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Investment Philosophies, Theories and Practices (continued…)

 

Fundamental and Technical Analyses

 

Fundamental analysis seeks to determine what a firm is worth by studying and analysing a company’s assets, sales, earnings, cash flow, and return on equity whereas technical analysis endeavours to predict a company’s future stock price by reviewing its past price and volume movements.

 

Benjamin Graham pioneered the fundamental approach in the 1930s. Graham’s methodology as explained in his two best-sellers “Security Analysis” and “The Intelligent Investor” stood the test of time and is today as relevant as it was 60 or 70 years ago. The most famous and successful investor of all times, Warren Buffet, was a student of Graham and meticulously applied these principles throughout his investment career.

 

Basically, with fundamental analysis one tries to identify undervalued companies, thus stock that is currently trading at a lower value (discount) than its perceived intrinsic or true value. Over time the market will re-assess such companies and ascribe a more reasonable price, hence investors buying companies at discount could reap significant rewards by identifying value propositions.

 

However, it is not that easy to determine a company’s intrinsic value. Invariably one must make assumptions and projections about future profitability and growth rates. Second, even if one could accurately forecast a company’s true value, the market might take its time to adjust to those intrinsic values. Thus, patience and not necessarily a short-term investment view are required to make this strategy work.

 

Technical analysts, on the other hand, spend little time analysing a company’s business and financial statements. Instead, they forecast future price movements by analysing trends emanating from past prices and volumes – very much like driving by looking in the rear-view mirror. Generally speaking, followers of this philosophy seek quick profits by moving rapidly in and out of the market, rather than holding positions for long-term growth, hence the term “traders.”

 

Traders and analysts use sophisticated statistical models and charts such as “MACD” (moving average convergence or divergence), “RSI” (relative strength index), and “Momentum” to assess their next trading move or to predict the direction of prices in the short term. 

 

Technical analysis leans heavily on crowd or mob psychology. When the market hits a high and does not move any higher, traders say it has hit a “resistance level”. If the market is approaching the resistance level, it is said to be “testing the resistance level”. When the price then moves above that level, it is expected that the market will increase sharply in the short run until it hits another resistance level. The converse of the “resistance level” is the “support level”, thus when prices start to fall it will stop at the support level. Once that level has been breached, a sharp downward movement in prices can be expected until another support level kicks in.

 

 Although technical analysis charts and predictions can be very impressive and perhaps for some market participants it even presents something of an exciting gamble, it is lacking in one fundamental truth: future price variations cannot be determined only by looking at past prices. Poor earnings, weak economic data, war, oil shortages, or even catastrophic climatic events (hurricanes!) can have a rapid and dramatic effect on prices. In the end, changes in the crowd psychology are impossible to quantify and difficult, if not impossible, to predict.

 

Over the years some traders have made enormous profits by “perfecting” their trading strategy. However, it is more than likely that the majority of market participants will be net losers. Furthermore, no academic study could ever conclusively prove that technical analysis works. Hence, most academics and professional investment managers view technical analysis with some scepticism, something that verges on the borders of astrology.

 

Most investors have a long-term investment horizon, certainly longer than that of traders! Therefore, technical analysis should not really form part of their investment strategy, nor is it vital to have a deep, thorough understanding of such analysis. Investing (or gambling!) by technical analysis could however be a fulfilling and “entertaining” experience, but watch out: you could lose your shirt in the process! Therefore, make sure you can afford to lose some money or that you have the nerves before entering this fast-paced, adrenalin-filled arena.

 

The application of fundamental analysis principles is far more relevant for the everyday investor, especially understanding that any investment is good only if it is a value proposition. Most investors will leave the responsibility to identify such opportunities to their asset managers. However, caution must be exercised not to expose your investment capital all at once to stock markets when they are trading at all-time highs and expensive P/E levels. Rather, take a more conservative approach; limit your equity risk exposure in your portfolio, inter alia low-equity balanced funds. Similarly, you can increase your equity exposure when markets are cheap (low P/E ratios, high dividend yields) relative to other asset classes.