Note: I originally published this article on Sharesansar. I am resharing this here because it saves me a lot of time explaining to my followers the difference between the strategies when they are confused about which to start with.
In a lake, there are two kinds of fish: the surface feeders and the bottom feeders. Surface feeders get most of their diet from the surface of the lake. Meanwhile, the bottom-feeders spend their time in the depths of the lake to get their food.
Surface feeders and bottom feeders rarely confront each other. They do not have to compete for food because their system of feeding is entirely different.
Fundamental analysis and technical analysis are two strategies of investing in the stock market that can be related to this analogy. Although proponents of either theory like to pull each other’s hair and debate about which strategy is correct, these two theories can coexist without harming the other.
This article is a must-read for beginners who want to make sense of fundamental and technical analysis. In the earlier phase, everyone wants to know which strategy is superior to another. If this is you, keep reading.
There are different valuation methods, tools, and ratios in fundamental analysis. If you want to feel dumb, these are some big words: Discounted cash flow, economic moat, P/E ratio, and book value.
However, fundamental analysis is not about these tools, just like painting is not about the paintbrush. These are just tools. The essence of fundamental analysis is to study the fundamentals of a company and make a prediction about its future performance.
“Fundamentally, anybody can do Valuation. I think we choose to make it complex. Who’s we? The people who practice valuation. Why? Because that’s how you make a living. You’ve got to cover things up with layers of complexity, keep people away.”
These fundamentals are indicators that drive a business. For example, if you run an ice cream company that is always on loan but has little profit, then fundamental investors will be wary about your company. However, if you have taken a loan to establish multiple ice cream parlors, it might actually be a good thing. If the capital is invested wisely, reduced profit in the present may bring exponential returns in the future. This is what matters in fundamental analysis.
The price of a stock is determined by market consensus. To buy a stock and expect it to grow means that you are defying this market consensus. It means that you have seen in a company what other investors have not. You are basically betting that the company is worth more than what the investors believe it is. For this very reason, fundamental analysis involves intensive research to find this edge and take action (buy the stock) before others. If the investors realize this edge, later on, they will offer higher for the stock, and the price will rise. Hence, your early investment will be profitable.
“If you do a good valuation, it should sing a tune. It should tell me a story. That’s what I’m looking for. Behind the numbers, what is the story you’re telling about a company?”
Now, there is another school of thought which is entirely different from the fundamental analysis approach. Technical analysis is rooted in the fact that investor sentiment, and not company fundamentals, is what drives a stock price.
As far as technical analysis is concerned, investors can make money from the stock market without ever touching the balance sheet and sophisticated financial reports of a company. In the international markets, some technical analysts and stock traders invest and profit without ever knowing what the company actually does.
Isn’t this strange? Behind every stock is a company that does business. How can you bet on a company’s future without ever knowing what it does and how it does things?
Simple. The trick is to look at the market and find out what the other market players are doing. If other investors are trying to buy a stock, are overly optimistic about its future, then the stock will go up indeed. So if you can somehow know what the investors are doing, you can interpret what they are trying to do with the company. Then, if you are sneaky enough to join them, you will make as much profit as them, in lesser time than them (fundamental investors sometimes wait forever), with far less work than they did.
Well, things are not always this ideal, but you get the idea.
This is why technical investors/traders study charts, volume, and price action. Other investors can do anything they like. In the end, they have to take action. They can either buy a stock or sell one. And this action is always represented in charts. Thus, for technical analysts, the chart is a storybook that condenses investor hopes and fears, company fundamentals, and people’s perception of it in a neat visual diagram.
Which one is superior?
The question is incomplete. The correct question should be – Which one is superior for you?
The strategy that is the best for one will not be so for another. If you are starting out with Rs. 30,000, you won’t wait for 10 years for that amount to grow. You will be better investing that money and start a business of your own. In 10 years, homeless people have gone from rags to riches.
It is a general understanding that fundamental analysis is for people with deep pockets. Although not entirely the case, there is some trace of truth to it. As Indian businessman/ investor Rakesh Jhunjhunwala says, stock trading and technical analysis are for multiplying your capital. Fundamental analysis is to preserve the money that you make.
However, the drawback of technical analysis is that investors have to play on a limited window of opportunity. Even though market sentiment affects stock prices, they ultimately reflect the fundamentals. As Benjamin Graham put it, in the short run, the market is like a voting machine, influenced by speculations and market psychology. But in the long run, the market is like a weighing machine, one that tells a story about the company.
This is the reason why technical investors may sometimes miss out on multi-bagger companies – ones that provide a return of 200%, 300%, or more. This is because, in technical analysis, there are profit targets, sometimes as low as 20%. If you hit your target, you should sell no matter what. Some technical traders hold the stock until a sell signal is received. But basically, technical analysis thinks that holding a stock for years makes no sense.
Fundamental and Technical analysis are not dogs and cats
It is interesting to listen to the debate between a fundamental analyst and a technical analyst. Their attempt to prove the efficacy of one over another is futile at best. At the end of the debate, none of the parties is ready to change his mind. So it makes one question whether the debate was of any meaning at all.
Technical analysis and fundamental analysis do not affect each other in any way. Speculators who use technical tools may make a stock volatile for a while. But if a fundamental analyst is sure about his projection, the stock will reach that level anyway. It does not matter how it reaches there as much as the fact that it does.
On the other hand, a technical analyst can survive perfectly well in a market full of fundamental investors. In fact, he will perform better. This is because if everyone does due research and buys a company, the market will become more rational. This rationale will be reflected in the charts and the technical analyst will make fewer errors.
Bottom feeders and surface feeders. Remember?
Why not use both?
A new strategy is also getting popular, which is called the techno-fundamentalist approach. As cool as it sounds, the idea is even cooler.
Basically, you do your research using fundamental analysis to filter sound companies from poor companies. And then you study these shortlisted companies using technical analysis. This helps you to time your entry and exit better so that you can grab maximum profits.
Nevertheless, while saying this, we must tell you that each strategy is complete in itself. One does not need to learn both strategies to profit from stocks.