5 Great Reasons Why Fundamental Analysis Works
In our discussion of the three main styles of investment management, we have already covered macro investing and technical analysis. Now we turn to the final main approach–fundamental analysis.
When we buy and sell stocks, we are not trading pieces of paper. We must always remember that a stock represents ownership in an underlying business. Although some may view purchasing shares of Apple (AAPL) as placing a bet on the change in its stock price each day, a fundamental trader is buying AAPL because he believes in the company’s management and business. By taking a stake, this investor will profit as AAPL’s business grows.
While the other investment approaches I’ve discussed rely upon big picture ideas and supply versus demand characteristics that present themselves in stock charts, the fundamentalist takes a longer view. By appreciating a company, how it is positioned in its industry, the business cycle, and future business prospects, fundamentalists are not pressured to constantly monitor their investment for small changes. Instead, comfort is placed in the process and the business is left to evolve.
I believe in the value of fundamental investing. While macro and technical models may win in the short-run, a fundamental approach stands the test of time. Fundamental investors are best served to understand the five main assumptions of this approach. They are:
1. Cash flow is king – Finance textbooks teach that the value of any asset is the sum of its discounted cash flows. Fundamental analysis practices this approach. Value is determined by understanding and predicting future cash flows based on how the business will perform and then discounting these cash flows by a risk factor that matches the riskiness of the company.
2. Numbers don’t lie – By standardizing reported numbers and comparing financial ratios we can come to solid answers about the health of a company. While some may argue over patterns in charts, financial ratios are clear-cut.
3. Business ownership yields an investment philosophy – More than other approaches, fundamental investors rely upon business ownership to justify their decisions. By taking a stake in a company, we can create an investment rationale that allows us to revisit ideas in the future.
4. Time demands are intensive – One major drawback of fundamental investing is the time needed to perform analyses. While websites and software can quickly give us ratios, only by studying financial statements and deconstructing footnotes can we understand a company, its business model, and its financial performance.
5. Patience pays off – When buying a business, time is on your side. If the company is operating well and deploys capital efficiently, there is no need to worry. Fundamental investors allow time to work in our favor and our wealth to compound.
When deploying capital, solid fundamental analysis allows us to determine the safety of our investment while contemplating potential gains. By understanding a business and its competitive factors, we have a rational basis upon which to assess performance at a later date.
See also 3 great profitability ratios, 3 great liquidity ratios for fundamental investing, and 5 ways to measure investment risk.
Sean Hannon, CFA, CFP is a professional fund manager. He runs EPIC Insights Weekly, the free Sunday newsletter, and also is the founder of EPIC Advisors, LLC. View Sean’s Full Bio.
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