Tag Archives: investing

Understanding Technical Analysis and Fundamental Analysis in Investing

This article is primarily intended to give an introduction to how technical analysis is used to make investment and stock market trading decisions. It will then compare the position of technical analysts to fundamental analysts in terms of what information and data each group uses in their quest for high returns.

I have sourced most of the information below from a copy of the 2007 CFA Level 1 course notes that I have been reading.

Technical Analysis

Technical analysis involves the examination of past market data, such as stock prices and the volume of
trading, to lead to an estimate of future price trends and subsequently an investment decision.

The assumptions underpinning the technical analysis model are as follows:

  1. The market value of any good or service is determined solely by the interaction of supply and demand.
  2. Supply and demand are governed by numerous factors (examples include people’s moods, guesses and opinions). The market weighs all these factors continuously and automatically.
  3. The prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time. That is, when new information enters the market, it leads to an adjustment of stock prices.
  4. Prevailing trends change in reaction to shifts in the supply and demand relationship. These shifts can be detected at some point in the action of the market itself.

The philosophy behind technical analysis is in sharp contrast to the efficient market hypothesis and fundamental analysis.

Fundamental Analysis Versus Technical Analysis

Fundamental Analysis involves making investment decisions based on the difference between the fundamental value of a company and the current price of that company’s stock.

Fundamental analysis involves an examination of the economy, a particular industry, and financial company data in order to lead to an estimate of value for that company. If this value is then compared to the current stock price, investment decisions can be made assuming that the market will correct and move towards the estimated value at some point in the future.

Although both fundamental and technical analysts agree that the price of a security is determined by the interaction of supply and demand, technical analysts and fundamental analysis have different opinions on the influence of irrational factors. A technical analyst might expect that an irrational influence may persist for some time, whereas other market analysts would expect only a short-run effect with rational beliefs prevailing over the long-run.

A bigger difference exists between the two regarding the speed of adjustments of stock prices to changes in supply and demand. Technical analysts believe that new information comes to the market over a period of time because of different sources of information or because certain investors receive the information or perceive fundamental changes earlier than others. Based on this belief they expect stock prices to move in trends that persist for long periods, and a gradual price adjustment to reflect the gradual flow of the information.

However, fundamental analysts believe that new information comes to the market very quickly and they expect stock prices to change abruptly as a result of this.

How do Technical and Fundamental Analysts make investment decisions?

  • Technical analysts make investment decisions by examining past market data to estimate future price trends. They identify new trends and take appropriate actions to profit from the trends. Technical analysts use market data and non-quantifiable variables like psychological factors and claim that their method is not heavily dependent on company financial accounting statements.
  • Fundamental analysts make investment decisions by examining the economy, the industry and the company to estimate the intrinsic value of the company’s stock. They then compare the intrinsic value to the prevailing market price and take appropriate actions. Fundamental analysts typically use economic data (including accounting data and information released by the company to the market).

Why Technical Analysts believe Technical Analysis is superior

According to technical analysts, it is important to recognise that the fundamental analysts can experience superior returns only if they obtain new information before other investors and process it correctly and quickly. Technical analysts do not beleive that most investors do so consistently.

Secondly, Technical analysts believe that it is too difficult for fundamental analysts to pinpoint a specific time to take investment actions even if they have identified the under-valued or over-valued securities.

Technical analysts need only quickly recognise a movement to a new equilibrium value for whatever reason (they need not know about an event and determine the effect of the event on the value of the firm and its stock). In addition, because they don’t invest until the move to the new equilibrium is under way, they contend that they are more likely to experience ideal timing compared to the method of fundamental analysts.

Finally, technical analysts believe that financial statement analysis is not sufficently accurate to depend on to make investment decisions and therefore consider it advantageous not to depend on such statements.

I will later write an article about the potential fundamental analysts’ responses to these points but more can be read about fundamental analysis and Warren Buffett’s concept of Value Investing in one of my previous articles (includes a video).

Click here for a look at Company Valuation methodologies like multiples and discounted cashflow analysis.

Hedge Fund Trading Styles and Strategies Uncovered

There are four broad styles of hedge funds and multiple strategies beneath each style which are discussed at length in the book Hedge Funds Demystified by Scott Frush. This article summarises the four broad hedge fund styles and provides an insight into the management of hedge funds.

In many cases, Hedge Fund managers combine strategies from the styles below but regardless of the strategy, each has the aim of generating attractive absolute returns. This is the fundamental difference between most investing funds (eg mutual funds) and hedge funds; hedge funds aim to deliver absolute returns in both a bull and a bear market.

The following are the primary strategies employed by hedge funds (such as the infamous Long Term Capital Management Fund), grouped by style:

Tactical (also known as directional)

  1. Macrocentric – Strategy where the hedge fund manager invests in securities that capitalise on domestic and global market opportunities. Trading strategies are generally systematic or discretionary; systematic traders tend to use price and market-specific information (often based on technical trading rules) to make trading decisions, while discretionary managers use a judgmental approach regarding differences between current financial market valuations and what is perceived as the ‘correct’ or fundamental valuation.
  2. Managed futures - Strategy where the hedge fund manager invests in commodities derivatives with a momentum focus, hoping to ride the trend to attractive profits.
  3. Long/short equity - Strategy where the hedge fund manager combines long holdings of securities that are expected to increase in price with short sales of securities that are expected to decrease in price. Long/short portfolios are directional – that is, the investment strategy is based on the manager’s expectation of future movements in the overall market – and may be net long or net short. Short positions are expected to add to the return of the portfolio, but may also act as a partial hedge against market risk. However, long/short portfolios tend to be quite heavily concentrated and thus the effectiveness of the short positions as a hedge against market risk may be limited.
  4. Sector-specific – Strategy where the hedge fund manager invests in markets in specific sectors by going long, short, or both.
  5. Emerging markets – Strategy where the hedge fund manager invests in less developed, but emerging markets.
  6. Market timing – Strategy where the hedge fund manager either times mutual fund buys and sells or invests in asset classes that are forecast to perform well in the short term.
  7. Selling short – Strategy where the hedge fund manager sells short borrowed securities with the aim of buying them back in the future at lower prices thus making a profit.

Relative value (also called arbitrage)

  1. Convertible arbitrage - Strategy where the hedge fund manager takes advantage of perceived price inequality with convertible bonds and the associated equity securities.
  2. Fixed-income arbitrage - Strategy where the hedge fund manager purchases a fixed-income security and immediately sells short another fixed-income security to minimize market risk and profit from changing price spreads. This was one of the key strategies employed by Long Term Capital Management before its demise. This is known as a non-directional spread trade. Managers take equal long and short positions in two related securities when their prices diverge from their typical relationship. Positive returns are generated when the prices of the two securities re-converge. Because arbitrage opportunities can be limited and the returns from these trades tend to be quite small, arbitrage strategies often employ higher leverage than other funds in an attempt to maximise the profit from exploiting these perceived mis-pricings.
  3. Equity-market-neutral - Strategy where the hedge fund manager buys an equity security and sells short a related equity index to offset market risk. An example of this would be buying Coke stock and selling Pepsi short. Market neutral managers attempt to eliminate market risk by constructing portfolios of long and short positions which, when added together, will be largely unaffected by movements in the overall market. Positive returns are generated when the securities which are held long outperform the securities which are held short. Market neutral portfolios tend to be more heavily leveraged than the long/short directional portfolios discussed above.

Event-driven

Event-driven strategies seek to take advantage of opportunities created by significant corporate transactions such as mergers and takeovers. A typical event-driven strategy involves purchasing securities of the target firm and shorting securities of the acquiring firm in an announced or expected takeover. Profits from event-driven strategies depend on the manager’s success in predicting the outcome and timing of the corporate event. Event-driven managers do not rely on market direction for results; however, major market declines, which might cause corporate transactions to be repriced or unfinished, may have a negative impact on the strategy.

  1. Distressed securities - Strategy where the hedge fund manager invests in the equity or debt of struggling companies at steep discounts to estimated values.
  2. Reasonable value – Strategy where the hedge fund manager invests in securities that are selling at discounts to their estimated values as a result of being out of favor or being relatively unknown in the investment community.
  3. Merger arbitrage - Strategy where the hedge fund manager invests in merger-related situations where there are unique opportunities for profit.
  4. Opportunistic events - Strategy where the hedge fund manager invests in securities given short-term event-driven situations considered to offer temporary profitable opportunities. An example of this may be if a piece of legislation is about to change and particular companies are likely to benefit.

Hybrid

  1. Multistrategy - Strategy where the hedge fund manager employs two or more of the above strategies at one time. Managers may elect to employ a multi-strategy approach in order to better diversify their portfolio or to avoid constraints on their investment opportunities.
  2. Funds of funds - Strategy where the hedge fund manager invests in two or more stand-alone hedge funds rather than directly investing in securities.
  3. Values-based - Strategy where the hedge fund manager invests according to certain personal values and principles.

When and why to sell a stock short; rules and strategies (Pt 1)

Xray short sellling vision

Many investors have heard of the concept of short selling and perhaps many of those people are familiar with the rules of short selling and the strategies behind doing it.

It is intrinsically a very risky move as you are betting against the upward trend of the stock market in the hopes that a stock will go down in price but when used strategically with other long positions or on a case by case basis, it can be very profitable.

When I think of describing the concept of short selling, I almost think of it as the opposite of investing because you believe a company’s stock price will rise. That is, you believe the stock price of a company is overvalued and that it will drop when the market corrects.

Thus, the seller is selling high and then buying low. The profit will be the difference between the price you eventually buy the shares for and the (higher) price you sold them for (minus brokerage fees).

The problem however, is that when value investing in a stock, you can hold the stock forever waiting for it to increase and your losses are limited to the capital you contributed whilst when you are short selling, your losses are not limited and waiting longer time frames become very risky and costly.

Edit 22 September 08 – Short selling no longer possible on the ASX.

Short selling stock procedure

Short sales are orders to sell securities that the seller does not own. It order to do this, a seller must follow the short-sale procedure below:

Continue reading When and why to sell a stock short; rules and strategies (Pt 1)

9 key definitions to understand the valuation and earnings of companies

learning goggles - key valuation definitions

Valuation of Companies and 9 key definitions

After skimming through The Fast Forward MBA in Finance, Second Edition by John Tracy, a few key concepts (such as EPS, ROE, market capitalisation and P/E) kept coming up again and again when dealing with the value of companies. When read in combination with Joel Greenblatt’s book, The Little Book That Beats the Market which simplifies things to some degree, an understanding of these concepts is required to begin understanding whether a company is undervalued or overvalued on the stock exchange and hence whether you should invest in the company.

It is important to firstly recognise that the value of a company’s shares on the stock exchange is only a representation of what the public will pay at any particular time for a stake in the company and is not a direct representation of the company’s true value per se. This fact is actually why smart investors should always be able to make money investing the stock market. For example, if an investor is able to identify a under or overvalued company, they can make the appropriate decision to either buy the stock if it is undervalued or sell the stock (we’ll come to how you can sell stock you don’t have later) if it is overvalued. Over time, whether it is overnight or over 5 years, the market will correct itself and the investor will profit from his analysis of the companies true value compared with the market’s perception of its value.

In later posts, I will describe how Greenblatt’s book proposes a magic formula strategy for identifying undervalued companies based on a company having a high earnings yield and a high return on capital. Firstly, however, this post will aim to explain these concepts so that we can get familiar with them first. Some of the definitions below are drawn from Tracy’s glossary in The Fast Forward MBA in Finance, Second Edition.

Continue reading 9 key definitions to understand the valuation and earnings of companies