The number of rules, strategies and theories you can consult to become a successful investor is almost endless but fundamental analysis remains an important cornerstone of investor success. Here’s an introduction to how it works.
For share investors
If you’re attempting to use fundamental analysis to pick shares that have the best potential to produce capital growth and income, you will need to delve into the underlying company’s financial records, including its balance sheet and cash flow statements.
These are the records that will give you, according to fundamental analysts, the greatest insight into whether or not a company’s shares are worth buying or holding onto.
Then there’s the qualitative part of fundamental analysis. This involves making a subjective assessment of the quality of the company’s management and of whether it has a competitive advantage in its particular marketplace.
TIP: the other main type of analysis is called TECHNICAL and it involves studying a stock’s historical price movements to determine where it is most likely to go to next and measure good times to buy and sell a particular stock.
Fundamental analysis should enable you to make judgements about whether:
- A company’s revenue is growing
- It is actually making a profit
- It has a competitive advantage in its particular market
- It has low and manageable levels of debt and
- It is well-managed and transparent
There are many tools or resources you will need to successfully assess the fundamentals of any listed company. Its latest annual report is the best place to start.
The most important rule of fundamental analysis concerns “intrinsic value” and the idea that market movements don’t necessarily always reflect the true value of any particular stock/listed company.
For example, in times when general market sentiment is poor all stock prices can be pushed down irrespective of whether or not a quality stock’s business is strong with great prospects for growth and profitability.
At such a time this stock would be considered to be under-valued by the market and may represent a very prudent buying opportunity. You’re getting a quality stock for a cheap price.
Of course, it’s only worth believing in a stock’s intrinsic value and buying when it’s under-valued if you also believe that sooner or later its actual share price will reflect its true value and you will be able to sell at a profit.
The core quantitative part of fundamental analysis is performed by examining a company’s financial statements. The core qualitative part involves understanding what the company actually does, whether it has an edge over its competitors and whether it is well-managed.
Fundamental analysis is most commonly used in relation to shares but it can be used to assess the fundamental value of any investment or commodity, including bonds, managed funds, foreign exchange, you name it.
For example, if you are starting out in foreign exchange and want to assess the fundamentals of what makes one currency move against another (such as the Aussie dollar against the US or the Euro) you would need to delve into economic fundamentals such as:
- Interest rates: high interest rates attract investors to a “risk” currency such as the Australian dollar
- Demand for our resources
- General economic well-being and management
Many websites have information about how to conduct fundamental analysis and many books have been written on the subject including our favourite, VALUE-ABLE by Australian author and value investor, Roger Montgomery.