Saturday, June 19, 2010

On the Fundamental Side

It is probably clear to regular readers of these articles that I consider myself to be a technical rather than a fundamental trader. My basic philosophy for directional trading that has worked well for me over the past decade plus has little to do with fundamentals of a company. In simplest terms, I look for an opportunity defined by some technical indicator where there is a disciplined exit nearby in the event I am wrong on the direction. Since I have an initial exit strategy that is designed to cut losses without any emotional decision on my part I need then only adopt a strategy to let profits run in a similarly disciplined fashion. A key, for me, is to use technicals in such a fashion that I enter and exit using some technical signal that provides the discipline that my emotions don't provide. In using such a methodology, the fundamentals of a company mean little, if anything, to me. As I have shown in the last couple of articles, a fundamentally sound company does not necessarily translate into a good stock (in terms of price appreciation), sometimes even over periods of years. Of course, as time goes by, the fundamentals can be expected to change and I am always hard pressed to find a good answer as to precisely what change in fundamentals would signal me to act.

Since my trades tend to be of the swing type, lasting ordinarily from a few days to perhaps a few months, long term fundamentals are less important to me than they might be to a buy and hold investor. In any event, if I do look at fundamentals at all I tend to focus on those that I consider to have greater weight. I am the first to confess that these are my opinions only, and I offer them only for the readers' consideration. First, I consider debt to be extremely important. For anyone who may disagree, take a look at a chart of BP as the debt from the oil spill mounts ever higher. Clearly, a technical trader had several potential exits on the downturn. She could have exited on a break below the double bottom price support formed back in February, or on a break below the 50 day, 200 day, or 500 day moving average and any of those would have cut the loss. What, however, was the fundamental investor to do? Should she have exited on the news of a spill, or when the barrels per day lost reached some specific number (what number), or on some other basis or should she just hold? Fundamentally, the point is that BP's debt is climbing and climbing quickly. How does the fundamentalist cut losses in that situation? Though many companies like airlines may necessarily have high debt, it may be important to look at companies in the same sector to compare how their debt relates to other companies in the same sector. Debt can be a serious enemy and all things being equal from a fundamental perspective I'd probably give the edge to the company with the lower debt load as a potential investment.

Earnings are another critically important factor in my estimation. The old adage: "follow earnings, follow earnings," is worth considering. I want to see increasing earnings compared to the previous like period. In other words, year over year or this second quarter compared to last year's second quarter, etc. The periods compared can be important in the decision making process. For example, in a retail stock, I may not want to compare January earnings to December earnings since one would expect Christmas season earnings to be higher than those in January. In that situation, I would want to compare this December to last December and this January to last January. Using such comparisons, what I would want to see is increasing earnings if I intended to buy the stock.

If I am looking for dividends I like to see both a good history of payments as well as regular increases in the dividend. In terms of the book value, I like to look at the price to book ratio and prefer it be relatively low in most circumstances since a low price to book can suggest that the stock is trading near break-up value.

Other considerations for fundamentally oriented investors might include things like product and competition. I remember several years ago when DELL was rocketing and splitting time and again. They had the product and though there was competition they were clearly leading the pack. Now the stock has fallen off quite dramatically from the highs. Back then, in the late '90s and in 2000, AAPL was relatively cheap and it now trades in the vicinity of $240-$250 a share. MSFT shares, on the other hand, have somewhat the opposite chart, very high in the late '90s and 2000 and down since then. Much of those moves I would suggest relate to product and competition. The question, again, for the fundamentalists is when to act based on the fundamentals. What is the specific fundamental trigger for entry and what, specifically, is the fundamental trigger for exit. In other words, how, precisely, does one use fundamentals to cut losses and let profits run?

I am well aware that there are many other fundamental factors besides those mentioned in this article. The bottom line question for me, though, is no matter what fundamentals are used, how can one enter and exit precisely to cut losses and let profits run using fundamentals alone?

by Bill Kraft, Editor
Copyright 2010, Makin' Hay, Inc.
All Rights Reserved

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Anonymous said...

Dear Mr Kraft,

I read your column "On the Fundamental Side" and found it like all your previous articles, extremely wise and interesting. I too have been in the stock market for the last 30 years and found myself transformed in the last 10 to 12 years from an 80% Fundamental/20% Technical to an 80% Technical/20% Fundamental. This change in me was mainly triggered in the late nineties with the surge of the "" companies which made me realize first that trying to make a buck on the facts learned from pretty much "cooked" annual reports rather than "jumping in on the bandwagon" of a meaningless stock however running unchained and frivolently wild may not be the most opportunistic way neither to invest nor to trade. In other terms, it made me realize that taking the calculated risk, of course with many years of experience in that field, on the price movement of a stock is far better off than putting in my money on a "fundamentally sound" stock after a lot of brain-scratching and staying in, religiously faithful, hoping that one day a price movement north from where I started, will carry me into the heavenly kingdom of the "that's how you do it son" old-fashioned school, which turned out to be a school of lying Chairmen and CEOs that fed us news that were only good to satisfy their own greed.

I applaud your wisdom and vision and find you unsurpassed in your talent and at what you do. Bravo!

Nadim R Kawar (Ned)

Bill Kraft, said...

Ned, thank you for those very kind words. I am in agreement with your insight regarding fundamentals and what some of the companies were doing during the dot com bubble. In addition, technicals provide a specific trading discipline that I, at least, find key in establishing entries and exits.
Bill Kraft