BMO NESBITT BURNS The Gabri Lalonde Advisory Group Fundamental vs. Fundamental vs. Kevin Gabri, B.A. Economics, CIM Vice President, Branch Manager, Wealth Advisor, Associate Portfolio Manager Tel: 613-938-0151 kevin.gabri@nbpcd.com Troy Lalonde, B.A. Comm. Wealth Advisor, Associate Portfolio Manager Tel: 613-938-0151 troy.lalonde@nbpcd.com Cindy Charlebois, B.A. Econ Investment Representative Tel: 613-938-0151 cindy.charlebois@nbpcd.com BMO Nesbitt Burns 100-55 Water Street West Cornwall, ON K6J 1A1 www.kevingabri.com Introduction How many times have you heard on BNN or read news articles that talked about fundamental or technical research? The likelihood is pretty high that at some point you have come across these terms. For many however, they don t fully understand the differences and advantages that each type of research provides. As a team we have decided that it is imperative that our clients fully comprehend the methods we use in constructing portfolios and that we continually educate our clients. History of Fundamental and Fundamental analysis is as old as the markets themselves. The modern day fathers of fundamental analysis can be traced back to the publication of Security Analysis which was authored by Benjamin Graham and David Dodd in 1934. Dodd & Graham offered investors an insight as to what factors one should be examining when making an investment decision. These included; earnings, revenues, growth rates, cash flow assessments etc. Most investors are aware and use this type of analysis whether they realize it or not. Technical analysis on the other hand goes back roughly 100 years and has evolved considerably over the last century. Charles Dow the first editor of the Wall Street Journal played a pivotal role in the development of technical analysis. He began what is known as Point and Figure Charting which is a simple logical way of recording the supply and demand relationship in any stock. Dow s definition of what a trend is and his focus on studying price action for gaining insight into stocks set the foundation for technical analysis as we know it today. Fundamental Analysis So what exactly is fundamental analysis? Well the purpose of fundamental analysis is to estimate a security s intrinsic value by examining a combination of qualitative and quantitative factors. Once an estimate of a security s intrinsic value is determined it is then compared to the security s current price. The security can be one of three things when compared to intrinsic value; 1) Overvalued (current price>intrinsic value estimate), 2) Undervalued (current price < intrinsic value estimate), or, 3) Properly valued (current price=intrinsic value estimate). If the security is deemed to be overvalued we sell or go short and if we believe it is undervalued we go long or buy. The idea is that over time the security s price will converge and reach our estimated intrinsic value producing a return in the process. The Gabri Lalonde Wealth Advisory Group
The Gabri Lalonde Advisory Group In conducting this type of analysis two significant assumptions are made. The first is that the current price of the security being analyzed is incorrect. Essentially, this means that the market is believed to be wrong. The second assumption is that over the long-term the security will approach its intrinsic value. These two assumptions open the door to significant criticism. Those that believe that the markets are efficient and in what is known in finance as the Efficient Market Hypothesis argue that the current price of a security reflects all information both current and future. The other criticism comes in the assumption that the security will approach its intrinsic value. Is it really realistic to assume that the security s price in the market will converge to your estimate of intrinsic value? Some would argue no while fundamental analysis proponents would say yes. Conducting Fundamental Analysis When a fundamental analyst sits down to begin his/her analysis they must gather a wide variety of data in order to compare and analyze both quantitative and qualitative factors. Before the analysis begins the analyst lays out a wide range of questions which they will attempt to answer on their way to generating that ever important intrinsic value estimate. These questions include but are not limited to: What is the company s current business? Is revenue growing? Are they profitable? What are their products/services? How are they faring vs. competitors? What is the industry structure? What is their financial situation? Do they have a strong management team? Both quantitative and qualitative factors are used to answer these questions. Quantitative Factors Quantitative factors are measured in numerical terms. They would include things such as earnings, cash flow needs, growth rates etc... and the data used to compile them is pulled from a variety of financial sources. The three main sources of data used in compiling quantitative values are the company s balance sheet, income statement and cash flow statement. The company s balance sheet shows their assets, liabilities and equity at a particular point in time. The income statement shows a summary of a company s revenue and expenses for a given period and the cash flow statement shows a company s cash inflows and outflows. From these three statements Gabri Lalonde Wealth Advisory Group Quantitative Factors Financial Statements Balance Sheet Income Statement Cash Flow Statement analysts are able to answer some of the questions listed above. A fundamental analyst will then take all of the quantitative data and calculate various financial metrics in order to get a sense of the company s prospects going forward and to compare them relative to their peers and the industry they operate in. They also use Ratio Analysis to gauge whether the company appears to be undervalued, or overvalued versus their peers. Qualitative Factors We Bring Value to Life Fundamental Analysis Ratio Analysis Qualitative Factors Preparation of Pro-Forma Statements Valuation Models Intrinsic Value Business Model Quality of Management Patents Competitive Advamtage Qualitative factors are much more challenging to analyze compared to quantitative factors in that they are very difficult to measure. They include but are not limited to intangibles such as: the strength of the company s business model, the quality of their management team, patents, their competitive position and corporate governance structure. Analysts attempt to come up with some way of attaching a value to these things that can be used in the determination of the company s intrinsic value.
Fundamental vs. Pro-Forma Statements Preparation and Valuation Models Once the analyst has compiled the quantitative data and analyzed qualitative factors they then produce what is called Pro-Forma financial statements. These are forward looking financial statements that analysts use to project out companies cash flows, earnings etc. After pro-forma statements have been created, analysts then turn their attention to plugging the data into valuation models. These are usually proprietary and vary substantially in the way that they arrive at a final intrinsic value. Summation Performing fundamental analysis should provide analysts/ investors with a strong understanding of the security s business model, the industry it operates in and its competitive advantage. By using both quantitative and qualitative factors, analysts are then able to generate pro-forma financial statements and take the results and plug them into a valuation models in order to produce an estimate of the security s intrinsic value. Once the analyst has performed the pain staking task of gathering and analyzing all the data and has produced the intrinsic value estimate they simply compare it to the security s current price and buy if the price is below the intrinsic value and sell if the security s current price is above the estimate. Technical analysis differs from fundamental analysis in that the emphasis is not on determining an intrinsic value but rather it focuses on identifying patterns and trends which may suggest future price movements. It uses statistics generated by past movements in both price and volume data. Technical analysts hold the belief that historical performance of both stocks and the markets are indicators of future performance and focus their attention on identifying patterns. Some analysts rely on chart patterns and others on technical indicators in order to predict future security performance. At its root technicians rely solely on supply/demand of a particular security in forecasting future performance. The field of technical analysis relies on three assumptions holding true. The first assumption is that the markets discount everything. That is all information is already incorporated in the price of a security. The second is that prices move in trends. The final assumption which is probably the most important of the three is that history repeats itself. Technicians believe that investor psychology provides consistent reaction given certain stimuli over time. Like fundamentalists technicians do suffer from criticism. The largest comes from fundamentalists who argue that technical analysis ignores company fundamentals completely. Technicians know nothing and care to know nothing about the security they are analyzing. Instead they focus their attention on strictly supply and demand conditions. Conducting Technicians begin their analysis by compiling price and volume data. From there they use a wide array of statistical tools which can be broken down into two categories; 1) Charting 2) Technical Indicators. Gabri Lalonde Wealth Advisory Group Price Data (Charts) Charting 1. Line Charts 2. Bar Charts 3. Candlestick Charts 4. Point and Figure Charts Identify Support/Resistance Levels Determined Trend Identify Chart Patterns We Bring Value to Life Statistical Tools Volume Data (Charts) Technical Indicators 1. Moving Averages 2. MACD 3. Oscillators 4. Short-Term Momentum 5. Long-Term Momentum 6. Relative Strength Predicting Future Security Performance
The Gabri Lalonde Advisory Group Charting Technicians examine charts in order to identify patterns and trends which they use to gain an idea of where they think the security s price will go. 4 Types of different charts are usually analyzed in this process. 3) Candlestick Charts-use colours to explain different events over a specific period. One colour represents up days while another indicates down days. These four charts are 1) Line Charts, 2) Bar Charts, 3) Candlestick Charts and 4) Point and Figure Charts. 1) Line Charts-represent only closing prices over a set period of time. The line is formed by connecting the closing security prices. Source: Yahoo Finance 4) Point & Figure Charts-are a graphical representation of supply/demand conditions for a given security. They use price on the vertical axis and time on the horizontal. X s represent demand while O s represent supply. Source: Yahoo Finance 2) Bar Charts-takes a line chart and adds additional data. It includes the high, low and close for the security. Source: Dorsey, Wright & Associates Source: Yahoo Finance Technicians analyze these types of charts in an attempt to identify patterns and to determine the overall trend for the security. There are two types of trends, positive and negative. As investors we want to be buying stocks which exhibit positive trends while avoiding those with negative trends. Technicians look at the trend on both a short and long-term basis.
Fundamental vs. Charting Resistance and Support Levels Positive Trend A positive trend is simply a security that exhibits higher highs and higher lows. Support and Resistance levels are viewed as important psychological levels ( mental barriers ). When a stock or security breaks through its support or resistance it is more likely to make a significant move on the upside if it breaks resistance and on the downside if it falls through its support level. A breakthrough of resistance means that demand for that security has surpassed supply. The opposite is true for a security whose price breaks through the support level which is an indication that supply has now outstripped demand. Pattern recognition is also a part of technical analysis when reviewing charts and each pattern has implications for predicting future price movements. Some of the more common patterns are: Negative Trend A negative trend is simply a security that exhibits lower highs and lower lows. Technicians also analyze charts in an attempt to determine whether a security is exhibiting support or resistance. Double Top Double Bottom Triangle Head and Shoulders In summary, technicians analyze charts to identify three key pieces of information: 1) The Trend, 2) Support/Resistance Levels, 3) Patterns in hope that they can use this information in predicting future performance. Technical Indicators Technicians also use volume data. They examine price movements and the volume accompanying them. Moves in either direction accompanied by significant volume are more robust then those accompanied by lower volume. Volume is also used to confirm trends and chart patterns.
The Gabri Lalonde Advisory Group Technical analysis also uses complex mathematical tools in making investment decisions. In conjunction with charts, analysts also calculate technical indicators which are used to identify the trend. The technical indicators are all calculated off of the charts and include; Moving Averages, MACD, Oscillators, Short and Long-Term Momentum as well as Relative Strength. Summation Unlike fundamentalists, technicians do not care whether or not a stock is properly valued. Instead they only care about the underlying supply/demand relationship of the security being analyzed. If supply is in control, the price of the security should drop and if demand is in control the price should rise. They start by collecting price and volume data. They construct various charts and use a variety of technical indicators in an attempt to identify the trend and patterns in order to predict future performance. Which Is Better, Fundamental or Technical Analysis? The verdict is still out as to which type of analysis is better, however, we believe that both have merit. For this reason we incorporate both types of analyses in running our clients portfolios. It is our belief that fundamental and technical analysis do not have to be mutually exclusive. Instead, we believe that by combing the two we are much further ahead than just using each on an individual basis. So our investment process uses fundamental analysis to narrow down the investment universe and then applies technical indicators to give our team entry and exit points. By buying securities that are both strong on a fundamental and technical basis we are increasing our probability of success. Which would you rather have? A company with weak fundamentals and weak technicals or a company that is both strong on a fundamental and technical basis? For more information on the Gabri Lalonde Counter-Intuitive Investment Process or on technical or fundamental analysis feel free to contact our team. Fundamental vs. Goal Assumptions Criticisms Tools Used Fundamental Analysis To calculate estimate of intrinsic value and compare to security s current price 1) Current Price of Security is Incorrect 2) Over Long-Term the Security Will Approach its Intrinsic Value 1) EMH says Markets are Efficient and All Information is Already In the Security s Price 2) No Guarantee Price Will Approach Intrinsic Value 1) Quantitative Factors 2) Qualitative Factors Identify the trend and use patterns in order to predict future performance 1) All Information is Already Incorporated in the Price of the Security 2) Prices Move in Trends 3) History Repeats Itself 1) Ignores Company Fundamentals-Technicians Do Not Know Anything About the Underlying Security 2) Major Assumption to Believe That History Repeats Itself 1) Charts 2) Technical Indicators The Gabri Lalonde Wealth Advisory Group The opinions, estimates and projections contained herein are those of the author as of the date hereof and are subject to change without notice and may not reflect those of BMO Nesbitt Burns Inc. 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