"A picture is worth ten thousand words" - Old Chinese proverb
1. Technical v.s. Fundamental Analysis
Most opt for one of two methods: technical or fundamental analysis. Technical is essentially the making and interpreting of stock charts. Fundamental analysts believe the market is usually logical. Caring little about the particular pattern of past price movement, fundamentalists seek to determine a stock's proper value.
2. What can chart tell you? The rationale for the charting method
The fist principle of technical analysis: all information about earnings, dividends, and the future performance of a company is reflected in the company's past market price.
The second principle: prices tend to move in trends. "Prices move in trends, and trends tend to continue until something happens to change the supply-demands balance." - Magee, Technical Analysis of Stock Trends
Three "most plausible" explanations of why charting is supposed to work: First, it has been argued that the crowd instinct of mass psychology makes trends perpetuate themselves. Second, there may be unequal access to fundamental information about a company. Third, investors often underreact initially to new information.
Why might charting fail to work? Market may well be a most efficient mechanism.
3. The technique of fundamental analysis
In estimating the firm-foundation value of a stock, the fundamentalist's most important job is to estimate the firm's future stream of earnings and dividends.
Because the general prospects of a company are strongly influenced by the economic position of its industry, the obvious starting point for the security analyst is a study of industry prospects.
Four basic determinants to help estimate the proper value for any stock:
(1) The expected growth rate
Hazardous as projections may be, share prices must reflect differences in growth prospects if any sense is to be made of market valuation. Also, the probable length of the growth phase is very important. ("the rule of 72": number of years to double your money ~= 72 divided by the interest rate you earn)
Rule 1: A rational investor should be willing to pay a higher price for a share the larger the growth rate of dividends and earnings or the longer an extraordinary growth rate is expected to last.
It is the P/E multiple, not the price, that really tells you how a stock is valued in the market. High P/E ratios are associated with high expected growth rates.
(2) The expected dividend payout
Many companies tends to buy back their shares rather than increasing their dividends, If expected growth rates are the same, you are better off with the one whose dividend payout is higher.
Rule 2: A rational investor should be willing to pay a higher price for a share, other things being equal, the larger the proportion of a company's earnings that is paid out in cash dividends.
(3) The degree of risk
Rule 3: A rational and risk-averse investor should be willing to pay a higher price for a share, other things being equal, the less risky the company's stock.
A "relative volatility" measure may not fully capture the relevant risk of a company (see Chapter 9).
(4) The level of market interest rates
To attract investors from high-yielding bonds, stock must offer bargain-basement prices. In the early 1980s, when yields on prime-quality corporate bonds soared to close to 15%, the expected returns of stocks had trouble matching these bond rates. Again in 1987, interest rates rose substantially, preceding the stock market crash of October 19. However, the relationship between interest rates and stock prices is somewhat more complicated than this discussion may suggest.
Rule 4: A rational and risk-averse investor should be willing to pay a higher price for a share, other things being equal, the lower the interest rates.
4. Three important caveats of fundamental analysis
The mathematical precision of fundamental-value formula is based on treacherous ground: forecasting the future.
Caveat 1: Expectation about the future cannot be proven in the present.
Caveat 2: Precise figures cannot be calculated from undetermined data.
Caveat 3: What's growth for the goose is not always growth for the gander.
It would be very dangerous to use any one year's valuation relationship as an indication of market norms.
5. Why might fundamental analysis fail?
(1) incorrect information and analysis
(2) estimate of "value" might be faulty
(3) the stock price may not converge to its value estimate
Example: the market may revalue its estimate of what growth stocks are worth. Not only can the average multiple change rapidly for stocks in general, but so can the premium assigned to growth.
6. Using fundamental and technical analysis together
Rule 1: Buy only companies that are expected to have above-average earnings growth for five or more years.
Rule 2: Never pay for a stock than its firm foundation of value.
There are important advantages to buying growth stocks at reasonable earnings multiple - "double bonus". Peter Lynch's strategy: PEG (P/E-to-growth) ratio!
Rule 3: Look for stocks whose stories of anticipated growth are of the kind on which investors can build castle in the air.
Ask yourself whether the story about your stock is one that is likely to catch the fancy of the crowd.
There is even a term for "growth at reasonable price" - GARP!
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