There are two basic ways to analyze investment opportunities:
- Fundamental analysis, and
- Technical analysis.
Fundamental analysis examines topics like the management of a company, the markets they serve, the products they create, manufacture and sell. Fundamental analysis also covers company earnings, corporate balance sheets and other financial data. A large portion of fundamental research rests on the projections for future sales, estimates future revenue growth and predicted market share.
Using fundamental analysis can tell you if the stock price of a particular company is relatively cheap (or expensive) compared to their peers, or compared to the entire market in general. Much of the investment community in 2010 (still) relies on fundamental analysis to make investment decisions.
What could be wrong with fundamental research?
First, look at what was written a few lines earlier: fundamental research rests on projections. Call them estimates, forecasts, predictions, or projections. Fundamental research and analysis is based on information provided by management. But the information can be wrong (intentionally or not). The forecasts are nothing more than educated guesses at what the future will bring:
- When will their new product be available?
- How much market share will this company grab in the next year?
- What will be the future sales revenues?
- What will the earnings for this company be next quarter?
- Will the earnings for next year be higher? And by what rate will the company grow?
This is what all investors want to know: what will happen in the future.
What ELSE could go wrong with fundamental research?
All companies change over time. Companies will expand, some will contract. Some corporations will hire many people, which may slow down their rate of growth (as new employees get trained). This will also increase expenses, which may mean their earnings do meet forecasts.
Other businesses may close a division, lay off workers. Severance pay can hurt their earnings short term. Sometimes companies need to raise capital and will raise money by selling stock, or borrow money (and then pay interest). Businesses may sink money into research and developing new products. Or they move relocate their offices, or refurbish locations. Or sell entire parts of their company.
All of these “one-time” expenses can change earnings over time. They can also change what the company looks like (are they now larger or smaller?) going forward.
Accounting and tax laws are often changing. This creates events where companies might recognize “one-time” gains or losses. And there have been plenty of times where companies have gone back and “re-stated” earnings for a previous quarter (or even previous years).
The point is, none of this can be extremely predictable.
And that lack of predictability makes forecasting a tough job.
Now, after all of these events that can change the forecast for the future of a company, now add in the fact that management is often judged on “how they are doing” by the company stock price. At times, management of a business may be too optimistic (or too aggressive) in their belief of what the future will bring. Or they can misjudge their markets.
And this isn’t limited to company management. The analysts that follow these companies can also be too aggressive or too optimistic.
Which makes this “prediction” business difficult. It is hard to predict the future. In the next article, we will examine technical analysis, and (going forward), we will compare the two types of analysis. I will share why both fundamental and technical analysis matter, to get a better understanding of how markets work.