- When it comes to investing, there are two major schools of though: fundamental analysis and technical analysis.
- Warren Buffet practices fundamental analysis, while George Soros followed short term trends. Both were immensely successful.
- The bottomline is that there is no one correct strategy that works. One needs to consider time horizon, risk appetite before choosing a strategy.
Warren Buffett and George Soros feature among the greatest investors of all time. Ever wondered what differentiates the two? Although both of them made a fortune in the financial markets, they happen to be polar opposites when it comes to the investment strategy each of them employed. While, George Soros made his wealth betting on short term trends in forex markets whereas Warren Buffett’s wealth has been a result of his beliefs in the fundamentals of a company. George Soros clearly used technical analysis resulting in huge gains for him on black Wednesday (Sept 16th 1992) while Warren Buffett has landed a fortune keeping his trust in fundamental analysis for around 60 years now. They represent the two divided schools of thought in the financial analysis industry.
The two schools of thought under the broad heading of stock analysis are: The Technical and Fundamental schools of thought. Let’s look at what each of these schools try to focus on, the logic behind their approaches, the inputs used by each of these approaches, differences between them and how each of them is important to an investor.
Technical Approach to Investing
Technical analysts believe that the market price of a security is the best input which can be used to estimate the future price movement. They make an assumption that the current stock price takes into consideration the fundamentals of the underlying company and the fundamentals of the company do not have to be analysed separately. The three basic assumptions of technical analysis are:
- The Stock Market takes everything into account while fixing the price.
- The Stock Prices move in trends and are governed by the principles of demand and supply.
- History repeats itself.
The three assumptions explain the foundation of technical analysis: Analyzing historical price movement is sufficient to forecast future price. The most important tools of technical analysis are: Trend Analysis and Price patterns. The technicians attempt to identify a trend in its early stages and capitalize on the short term price movement to make profits.
The figure below shows how a typical technical chart looks with the price movements and indicators like Bollinger Bands, MACD and the Simple Moving Average. Technical analysts try to find patterns in the price movement of a stock to predict the future price movement.
Source: Google technical chart by Amigobulls
Fundamental Approach to Investing
Fundamental analysts believe that the best indicators of a stock’s fair or intrinsic value lie in its fundamentals. Fundamental analysts believe that the intrinsic value must be calculated after analysis of past trends in fundamental factors like revenues, dividend, profitability, growth prospects and so on. The fundamental factors have to be adjusted for the ability of the company to sustain the same in the future. The last step in fundamental analysis is to buy stocks whose intrinsic value is significantly higher than the current market price and sell stocks whose intrinsic value is lower than the current analysis.
The charts below show what a fundamental analyst typically looks for. The stock charts below show an example of Apple revenue, and Apple EPS over a three year period. Note that in fundamental analysis, one needs to check the fundamentals over long periods, as the purpose of investing is for the long term.
Source: Apple revenue
Source: Apple EPS
The differences between the two schools of thought lie in the inputs required to make a decision, the time horizon and the objectives of the investor.
The technical analyst requires price charts as a basic input. These charts are used to identify the trends and look for patterns as a signal of buying or selling a stock. However the fundamental analyst requires the financial statements of the company as an input to calculate the fair price of the stock.
The objectives of the decisions also differ across technical and fundamental analysis. Technical analysis results in a trade. Trade is the purchase of a stock because the trader believes he can sell the same at a higher price. Therefore the profits or losses in technical analysis arise purely out of differing opinions of people rather than value creation. However fundamental analysis results in an investment. Investment is the purchase of a stock because the investor believes the value of the stock will appreciate. The appreciation is a direct result of value creation by the underlying company. Hence investors make their profits due to value created.
While technical analysis is short term in nature fundamental analysis is more concerned about the long term value creation. Technical analysis can be based on weeks, days, hours or even minutes while fundamental analysis can have a time horizon of several years as it can take a stock from a few months to several years to correct itself and reach its intrinsic value.
The debate as to which is better can be as never ending as every other debate in this world. However in my opinion the best strategy for an investor is to follow a combination strategy of technical as well as fundamental analysis, by looking at the investing decision in two parts. The first is picking the right stocks to invest in and the second is choosing the right time to invest in them. While fundamental analysis helps to answer the question of ‘Right Stocks’, technical analysis is a better tool to answer the question of the right time to invest in a chosen stock. Using technical analysis to identify the right time to make an investment can help to tremendously increase the returns of a fundamental analyst. Hence I would like to conclude that the best approach for any investor would be to use a combination strategy rather than a purely technical or purely fundamental analysis.