InvestorQ : I hear a lot about fundamental and technical analysis in stocks. Can you throw some light on the basic differences between fundamental analysis and technical analysis?
indhumathi Sayani made post

I hear a lot about fundamental and technical analysis in stocks. Can you throw some light on the basic differences between fundamental analysis and technical analysis?

Answer
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shrinidhi Rajan answered.
1 year ago


Like the word suggests, fundamental analysis is about poring over mounds of numbers like sales, profits, and margins and then making projections for future years and then using such projections to value the company. Fundamental analysis looks too drab and boring. Who is going to be interested in an analyst with thick-rimmed glassed poring over mountains of data to finally decide whether a stock is underpriced or overpriced?

Comparatively, the technical analyst looks a lot cooler. It is so much more fashionable to sit in front of 4 giant computer screens mounted one on top of the other and then identifying esoteric trends that give you levels to enter and exit a stock. Sorry, these are classic stereotypes! In fact, these stereotypes do little justice to the fundamental analyst and also to the technical analyst. Let us the difference between fundamental and technical analysis and see how their roles differ? Let us look at technical analysis vs fundamental analysis which is better; if there is a debate at all. Ultimately it is about how fundamental and technical analysis of Indian stocks actually works. Let us look at some basic differences between fundamental and technical approach to investing.

Fundamental analysis is all about cash flow forecasting. Fancy words like discounted cash flow (DCF), dividend discount model, P/E ratio all belong to the realm of fundamental analysis. It seeks to forecast cash flows of a company based on how the economy, industry and the company will perform. That EIC analysis is the first step. Then you arrive at a present value, which is the benchmark for the market price of the stock. This gives an idea of what a stock is actually worth. You buy underpriced stocks and sell overpriced stocks. Technical Analysis on the other hand, believes that market is the king and hence focuses on internal market data. The focus is on identifying patterns and trends that will repeat and therefore the trader can capitalize on.

Analysts and chartists define value very differently. Fundamental analysts look at equity as an option on the underlying assets and liabilities of the company. The company is estimated to have value only because of the cash flows that it generates. The fundamental analyst would sell shares when the market value of shares is above the intrinsic value and make profit. The technical analyst debunks the concept of stock value and believes that prices are just random movements that cannot be predicted. However, since the markets reflect the collective knowledge and ignorance of the investors, it is always more advisable to focus on studying these signs.

Contrarian views work better for fundamental analysts. Fundamental analysts do not worry about price trends and volume trends. They believe that if a stock has value, the price will eventually gravitate towards the value. The time frame is not clear to the fundamental analyst but the belief is that over the longer run this convergence should happen. They are also agnostic about the holding period, which technical analysts are not. When fundamental analysts see value in a stock then they are also willing to go contrary to the market trend and buy or sell the stock. For a technical analyst, trend is the friend and it is trends and patterns that matter in the final analysis. Chartists believe that past trends will eventually be repeated again and the current movements can be used for studying the future trend. For the chartist, once the underlying trend is identified, the rest is just a cakewalk.

Fundamentals work best when the view is long term. Fundamental analysis seeks to predict the value of the stock on the assumption that market price will eventually converge to the intrinsic value. Here the stock means the company which has a robust and running business on hand. Fundamental analysis believes that prices cannot be controlled or predicted. That is why it becomes important to latch on to an idea early, even if means going contrarian and waiting longer. If you buy a quality stock that is undervalued at an early stage then you can make profits. It is much harder to make profits in Maruti and Britannia today than it was 5 years back. The technical analyst is not overly worried about cash flows and valuations. After all, for them the price reflects everything.

Technicals work better when the view is of a very short term. Try doing intraday trading or short term trading using fundamental analysis. You are bound to fail because that is not what they are meant for. In such cases, the patters identified by technical analysis are likely to work much better. At the shorter end it is the trends and signals that matter and these are best captured in technical charts. Charts are a subject that is open to interpretation and hence it is better that you be your own chartist.

The decision making process is quite different. Fundamental analysis is laborious, and often thankless, job. It entails the careful study of financial statements, demand forecasts, quality of management, earnings and growth. Finally, the intrinsic value of the company is estimated by a mix of quantitative, qualitative and competitive factors. Technical Analysis believes that decisions are taken by listening to what the market has to say. The basic lesson is to be humble and listen to the market. The market always has a story to tell and it is this story that you have to listen to. Of course technical analysis uses plethora of long standing theories like supports, resistances, oscillators, overbought/oversold zones, stochastic, break outs, Elliot Wave etc.

They are predicated on their unique set of assumptions. Fundamental Analysis is based on the assumption that stock prices will converge towards value at some point in the future. Big money is to be made if such value can be deciphered well ahead of the market. Technical analysis believes that it is impossible to identify multi-baggers since markets are smart and reflect everything. Hence the best one can do in this kind of a random market is to identify trends and play them. Trends repeat because the traders who trade the market are the same and driven by the same set of emotions.

Finally, let us look at how exactly to marry these two approaches, which is also popularly called an eclectic approach to equity investing. Fundamental analysis can identify undervalued or overvalued shares. The gap is called the margin of safety and higher the margin of safety, the better it is. Based on this gap, you can take a decision to buy or sell the stock. But it is not always either / or. The best of fundamental analysts use charts to time their entry and exit. The best of technical analysts look at stock fundamentals and macro cues.

The moral of the story is that quite often these two are more complimentary rather than being competitive. Even the best of fundamental investors do use the power of technicals to fine tune their entry and exit levels. It just adds to their timing of the trades, which matters a lot in the final analysis.