Let's assume you've been reading this blog for a while and you've been applying our tips by investing the cashback you receive from your purchases in the Vivid app. Now you want to take it to the next level and invest a significant portion of your savings. But how do you make sure you’re doing it right? Should you be looking at stock charts? Should you be reading earnings reports? How important is doing one over the other?
In cases like this, it can be a good idea to see how the pros do it. So let’s take a look at the different methods investment professionals use when picking their stocks.
Broadly speaking, all the things professional investors do can be grouped together under the term stock analysis. Stock analysis is the set of techniques that help to assess a security, sector or market. Analysts and investors study the past and present of a company or asset in order to gain a competitive advantage when investing.
Basically, they try to estimate the great unknown of equity investments: their profitability. At this point, the path forks into two distinct methods: technical analysis and fundamental analysis. They interpret data on the behaviour of markets and securities in very different ways. But, in the end, both seek to anticipate the future.
Fundamental analysis is kind of the nerdy brother of stock analysis. This method requires reviewing a lot of data to decide whether a stock could be profitable or not.
Fundamental analysts think the fair value of a stock does not always correspond to the value it has in the market.
You have probably heard that when a share is undervalued it is advisable to buy it, or that when it is overvalued it is time to sell it. That is exactly what fundamental analysis tries to find out.
The fair value of a stock is based on information provided by the company on the assets it owns, the profits it generates, the extent to which it is indebted, its liquidity, efficiency, year-on-year growth, etc.
These data can be found in the company's annual reports, presentations and press releases. In particular, most fundamental information can be found in the three main financial reports: the statement of operations, the balance sheet and the statement of cash flows. In case you don't remember, we talked about them in our post on the earnings report.
From all this data, we calculate the ratios that help to compare companies, such as the PE ratio, the dividend yield or the price-to-book ratio. If you want to know more about this topic, you can also read an article on financial ratios.
A company's performance is often compared to previous years or other companies in the same sector. Environmental data, such as interest rates and how the local and global economy are performing, are also considered.
The main idea here is to answer the question: will buying the stock make me money? This can happen either if the stock price increases, or through dividend payments. But in essence, fundamental analysis is just about knowing every detail of a company’s business to make an estimate about how healthy it is, and how it will perform in the future. You can usually find these documents on the company website, but they are also available on websites such as Morningstar or Yahoo finance, which have a section with financial data and calculate the ratios.
If fundamental analysts is the nerdy brother, technical analysis is the cool sister that’s into astrology. This type of analysis takes into account the past and present share prices to predict future stock movements.
Technical analysis has premises you have to believe in. There are conclusions that analysts have reached after centuries of studying market behaviour, and are:
Technical analysis uses charts showing the share price and the volume of shares traded over time. In other words, it tracks the price in relation to supply and demand in the market.
Volume is decisive in confirming a trend. Trends are lines connecting points of highs and lows. It is considered an uptrend when it rises above the reference high, and a downtrend when it falls below the reference low. Bullish and bearish trends help us decide when to buy and sell.
In addition to trends, there are other indicators, such as resistance (price highs that are not usually exceeded), support (price lows below which the price does not usually fall), or sideways trends (the price moves in a range without large swings). There are also hundreds of chart patterns that indicate historically repeating trends. It is a kind of record of human reactions to movements in share prices.
It is only really useful when supply and demand influence the stock price. If it is for other reasons, like changes in management or a merger with another company, it might not be effective.
Of course, we can’t answer this question. Especially because we don’t know the answer.
Different systems may come to the same conclusion for very different reasons. In the end, many investors and analysts use a combination of the two, to get an in-depth view of companies and the emotional state of investors.
Fundamental analysis understands that although a company may have ups and downs due to internal or external factors, in the long term, if the business is sound, it will be profitable. But in the short term, stocks are not always driven by rational reasons. There are countless examples of stocks that move in price without being related to a change in the company, but for speculative drivers.
Technical analysis may be more useful as a trading tool and a complement to fundamental analysis in long-term investments.
One difference to bear in mind is that fundamental analysis is much more time-consuming. Think about reading company reports, checking ratios, etc. Technical analysis requires you to spot trends and recognise patterns, but tracking is faster.
Any opinions, news, research, analyses, or other information contained on this website are provided as general market commentary, and do not constitute investment advice, recommendations nor should be perceived as (independent) investment research. The author or authors are employed by Vivid and may be privately invested in one or several securities mentioned in an article. Vivid Invest GmbH offers as a tied agent of CM-Equity AG the brokerage of transactions on the purchase and sale of financial instruments with the exception of those in the area of foreign exchange brokered by Vivid Money GmbH.