The Challenges of Being a True Fundamental Analyst

Date: September 15, 2010

by Roger Tan, SIAS Research

In elementary finance, we were taught to reject any investment opportunities that require more initial investment than its value. When investing in equities, we were taught to estimate the value of the firm and invest when the equity price is below the estimated value. This is what fundamental analysis attempts to do.

However, when it comes to actual investing, this axiom is often ignored. To satisfy investors, many fundamental analysts have turned to speculating price movements rather than estimating value.

Why is it so difficult to invest based on fundamental analysis? Why is there an infatuation with price? Why is it so difficult to buy and hold? We will explore these issues in this article.

Defining Speculation and Investing

In fundamental analysis, the main objective is to identify the value of a stock through estimating future cash flows and the required rate of return. This calls for an analyst to understand a company’s strategy given the environment it is in and its competitive advantage.

A fundamental purist will look for a company that can grow in good times and survive in challenging ones. The value of a firm is derived from the company’s ability to earn a return on its invested capital over and above its cost of funds and at the same time survive for a long time.

The economic cycle of the company is therefore not the most important consideration. The more important consideration is the environment it is operating in and the strategy it has implemented.

The fundamentalist would therefore develop propositions of a company after an investigative process (both primary and secondary), convert these propositions into hypotheses and test these hypotheses against the company’s qualitative data.

It is only after this process is satisfied that a fundamentalist would estimate the company’s future performance, calculate its risk adjusted required rate of return and establish a valuation. Ratios are usually used as constraints to ensure that estimates are realistic (we will discuss more on the analysis and projection process in future articles).

Where does the share price enter the whole analysis? Only after the valuation has been estimated would the fundamentalist compare it to the current market price to determine if a stock is worth investing in.

When would a fundamentalist exit his investment? Only when the following happens:

1. When a company’s strategy changes in such a way that would undermine its competitive advantage causing valuation to move below its current price.

2. When the environment that the company is operating in changes but the company did not change its strategy accordingly to prevent the erosion of its competitive advantage causing valuation to move below its current price.

3. When the company’s price moves significantly above its value.

In simple terms, the fundamentalist will invest when the current market price is below valuation and divest when the current market price is above it. He invests because he is able to extract value from the company’s operation and not because he is able to foresee changes in price. He admits he cannot foretell price movements.

With this definition in place, we can therefore clearly separate the speculator from the investor. A speculator’s main objective is to identify potential price changes of a security in the market. Looking at the fundamentals is incidental to his speculation as he is not interested in extracting value from the company’s operation. He is interested to determine if he knows something about the company no one else knows, take a position, wait for others to find out and profiteer from it when there is a mad rush for the stock. Speculation is not limited to the short term but the longer the speculator has to wait, the more he will expect to gain. The mantra of a speculator is “liquidity is your friend and never be the biggest fool”.

As mentioned, the investor, on the other hand, looks for ways to earn returns from the long term operations of a company. The only way to do that is to invest in companies that could earn returns that are over and above its cost of invested capital (adjusted for risk). If the company’s share price is below its value, the investor gains the advantage of an additional “margin of safety”. Since the investor is interested chiefly in the company’s operation, liquidity is not the most important factor in his consideration. To an investor, capital gains are incidental to his investment decisions.

Speculators will try to make guesses (educated or not) on which company to speculate by looking at economic cycles and market conditions – also known as the top down approach. Some will also look at charts to check for divine insights into the movement of stock prices. Some will hide their speculative intentions by incorporating fundamental analysis into their guesses (combining technical with fundamental and top down with bottom up). But ultimately speculators will always tell you about target prices and argue that it is supported by its fundamental value.

Investors, on the other hand, will pay attention mainly to changes in the environment and strategy. What is important is whether a company is building its strength or taking advantage of opportunities. The former is sustainable while the latter can be derailed by changes in the economic cycle. An investor is also interested if new threats are arising and if weaknesses are increasing. If not managed properly, threats can turn into weaknesses, and weaknesses can overpower a company’s strength and stifle its ability to take advantage of opportunities. To an investor, a company’s ability to understand its environment and conceive and implement the right strategy is of paramount importance.

Therefore a contrarian who buys into the market during an economic downturn because he believes that equity prices will always move in cycles and stock market is always on an uptrend is a speculator while one who buys simply because the price‐value gap has widened after re‐evaluating the company is an investor.

Why is understanding this distinction between speculators and investors important? Because it will help us understand ourselves better and hopefully invest wiser.

Our Brain is Wired for Speculation

Some would argue that speculation is really a zero sum game that does not add value to the economy as a whole and over a long period the net return from speculation is close to, if not below, the market return. Investing rationally based on the above fundamental process would therefore be more ideal as opposed to speculating. But why is it so hard for us to become investors at our own will?

While our hearts may want us to be true investors, our minds, on the other hand, encourage us to do otherwise. James Montier explained in his book “Behavioral Investing” that human emotions cause us to take decisions that are often irrational. In an example, he illustrated how our fear of incurring losses encourages us to take a sure gain over a gamble that has a higher expected value. It also causes us to take gambles that have a higher expected loss instead of taking a sure loss whose value is lower than the gamble.

Montier also pointed out that humans are hardwired to “herd” and also focus on short term gains (I personally call it “myopic expectations”). As such, it is difficult for investors to follow a “rational” contrarian strategy with such hardwiring. Buying and holding is even more painful when you have to wait for such a long time while the “Jones” next door has been making money from short term trades (and bragging about it).

Why Can’t the Industry Change This?

Given that the finance industry is filled with economics and finance experts trained to avoid the behavioural pitfalls, we would expect them to attempt to help investors recognize and avoid these pitfalls. However, finding industrial players that put consistent effort to encourage proper investing is hard.

Many would have noticed fundamental analysts declaring 12 month target prices for a company they have recently covered or even add technical analysis at the end of their fundamental report to enhance the believability of their findings. These are inconsistent with the philosophy of fundamental analysis.

But we cannot fault these analysts for their effort. Research work and reports are costly to conduct and produce. Analysts must be sufficiently compensated to make the effort worthwhile. But many investors, who are also “customers” of analysts, are unable to escape the claws of emotional decisions, herding, and myopic expectations and would therefore prefer analysts who provide speculative views (and hopefully from there speculative returns as well) over one that tells them an undervalued company that they can buy and hold.

Investors would look for analysts that could pinpoint stocks whose price will soon change. To them those who could identify a valuable company but whose share price may not attract a high level of liquidity for a long and unknown period are a waste of time. Fundamental analysts would therefore have to incorporate some level of price speculation into their research or shift fully into it if their job is to encourage trades.

Are You Suggesting Speculation is Wrong?!

At this juncture, some readers would be wondering if I am advocating that speculation is wrong. I am not.

Speculation, in my view, facilitates a few important processes. Firstly, speculation facilitates the discovery of undervalued stocks such that prices could start to inflate from increased liquidity. Without speculators, investors would really have to hold on to a stock “forever”.

Secondly, speculators increase the chances of investors finding undervalued stocks. By jumping in and out and cycling funds around different stocks to position for potential price changes, some stocks become sufficiently attractive to invest. Without speculators, undervalued stocks would be hard to find.

Finally, speculation makes the market more exciting. Without speculation volatility would also probably be lower (contributed mainly by the macro‐environment) and trading opportunities a lot less.

Rewiring is Hard but Not Impossible

Will we be stuck as a speculator forever since our brain is hardwired in such a way? The good news is that scientists have found that the brain can be rewired. Montier iterated that the brain isn’t fixed in a certain format and is capable of rearranging its connections. This is known as plasticity.

So while it may be a challenge to be a true fundamental analyst, it is not impossible. As long as one is willing to learn and is willing to put in the effort to do it, picking up proper investing knowledge is not impossible.

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