How to determine which stocks to buy
In choosing which stocks to buy, investors normally think that fundamental analysis and technical analysis are in conflict with each other and cannot be combined. In most cases, short-term traders use technical analysis while long-term investors use fundamental analysis to determine which stocks to buy.
However, given my exposure to both, I’ve seen how combining can actually help enhance returns.
Before I begin, let me differentiate the two. Fundamental analysis is the method of measuring a stock’s intrinsic value or fair value by studying economic, industry and financial factors that affect the company’s earnings. Fundamental analysis believes that investors should only buy a stock if its market price is below the fair value derived from the study of the factors stated above.
On the other hand, technical analysis focuses on patterns of price movements, trading signals and various analytical charting tools to determine whether or not a stock will go up. Technical analysis believes that a stock should be trending higher and showing a bullish chart pattern before it should be bought.
Although short-term traders mainly focus on technical analysis, adding fundamental analysis can help enhance returns by improving the odds of success. After all, companies’ long-term earnings growth is the main driver of share performance, and companies with good earnings growth outlook go up in a more sustainable way.
By combining both schools of thought, short-term traders can reduce their short list of stocks to buy. Moreover, since the likelihood of success is higher, traders can be more aggressive in their trades. For example, they can already start buying fundamentally attractive stocks even if these stocks are still consolidating in anticipation of possible breakouts. Traders can also bet a larger portion of their portfolios.
On the other hand, long-term investors can benefit from using technical analysis to determine whether or not they should aggressively buy a stock. Long-term investors should buy more aggressively if a stock is trending up and be more cautious if a stock is trending down. In fact, long-term investors should wait until prices stabilize before they start buying stocks that are trending lower. If a stock’s technical picture is still unattractive, long-term investors should accumulate slowly instead of buying all at once, allowing them to improve their average cost.
Technical analysis can also help investors spot turnarounds early. An investor can start investigating a stock that is showing improvement, technical-wise, as there might be some important factors that are beneficial to the company like commodity price movements or new trends.
There are two scenarios when technical and fundamental analyses are in conflict with each other. The first scenario is when the market is strong and stocks are expensive relative to their fair value. Fundamental analysis would recommend investors to stay away given the heightened risk that prices will fall if earnings disappoint. On the other hand, technical analysis would recommend traders to buy.
The second scenario is when the market is weak and stocks become cheap relative to their fair value. Fundamental analysis would recommend investors to start buying given the significant capital appreciation potential. Technical analysis would recommend traders to stay away.
Nevertheless, even under these two scenarios, there is still value in combining fundamental and technical analyses.
When the market is strong, traders who follow technical analysis can still trade stocks. However, given that stocks are already expensive fundamentally, traders should be more risk averse, betting smaller amounts, locking in gains faster and being strict in observing cut loss rules.
On the other hand, when a stock is weak technically, investors who use fundamental analysis should also be more cautious. They need to do more research as the stock’s weak performance could be an advanced indicator that something is fundamentally wrong.
For example, during the global financial crisis in 2007 and 2008, there was nothing wrong with the Philippine economy. However, because of contagion, Philippine stocks still fell by an average of almost 60 percent.
Moreover, even if a stock is cheap, it doesn’t mean that it can’t become cheaper. This is especially true when there are no catalysts that will allow earnings to go up or for the company to unlock its value. By incorporating technical analysis, long-term investors can minimize the risk of getting stuck in value traps.
Although fundamental and technical analyses may seem in conflict with each other, they have their own unique strengths and weaknesses. By combining both, the weaknesses of the two disciplines are addressed, helping short-term traders and long-term investors earn higher returns.
