What’s the best stock picking strategy? That’s an age-old question that every investor will wrestle with. Should you listen to the “experts,” do your own research, ask the neighbor what he thinks, or look at some charts to try to predict the future?
Technical investing is the art of looking at past market data and drawing conclusions about future performance based on historical performance. It relies heavily on looking at the price per share listed on stock exchanges. There is also a component of looking at charts that map out historical stock prices and inferring what the stock price will be based on a recognizable pattern on the chart. You might hear about the head-and-shoulders chart, which has a historical price that resembles the silhouette of someone’s head and shoulders.
The double top, which looks like a mountain range with two distinct peaks, and the double bottom which is the inverse of the double top.
Technical investing also takes into account moving averages and their inflection points to try to assess whether there is a rising or declining market and whether it’s a good time to go long or short a stock. The vast amount of charts, and interpretations in technical investing have been the subject of many books, and the details and techniques of this methodology can be highly technical and based on statistical analysis of market trends. There is one underlying problem with this approach, it is based on charts that don’t take into account the health of the specific company you’re looking at and places an over reliance on and past behavior of the stock price and not necessarily the company itself.
Many technical analysis models do not reflect current debt levels for the company, the health of its balance sheets or other financial statements, or even the revenue and profitability of the company. The charts themselves can often reflect irrational behavior in the markets due to an overreaction to world news, or other events not based on facts but rather market psychology. It is difficult to know which chart is about to occur based on the preceding stock price movements until after the fact and can therefore become a bit of a guessing game.
Fundamental analysis is the practice of analyzing stocks to determine their intrinsic value. Unlike technical investing, value investing relies heavily on looking at the health of the company itself. It is a long term strategy that is rooted in the belief that companies that generate consistent free cash flow will continue to grow and as a result will have rising stock prices. The key to becoming a successful value investor is to research the company by assessing its debt levels, return on equity, cash left over after subtracting capital expenditures from operating activities, and the general health of its balance sheet, cash flow statement and income statement.
Value investing also looks at a company’s competitive advantage over its competitors, its product roadmap and sales projections, and the company’s management structure and the leaders themselves. All of this information is then used to arrive at a value for the company itself and its stock. The intrinsic value of the stock may or may not be the same value as the price that the stock is currently trading at in the stock market. It is these variations between the observed share price and the calculated intrinsic value that lead to an investment decision. If the intrinsic value of the stock is lower than the current stock price then the company is thought to be overvalued and therefore not a good investment. If, however, the intrinsic value of the stock in higher than the current stock price then the stock is thought to be trading at a discount and would therefore be a good investment choice.
And the Winner is…
Value Investing is rooted in techniques used to assess the value of a business where as technical investing tends to overstate short term market swings based on market psychology, which could be irrational at times. While both market psychology and technical analysis & charting can retroactively provide perspective on past performance, the long term success of a business often relies on tangible things like sales, revenue, and the overall debt of a company. If you are of the belief that a company’s share price reflects its profitability and opportunities for growth, then the value investing approach is a good long term strategy to follow.