Analysing any potential purchase is a part of the process but when it comes to investing, a different type and deeper level of analysis is needed.
Naturally, if you are looking to purchase a car, house, or sometimes clothing it is not uncommon to shop around. The question here is why would you shop around when you know what you are looking for? Perhaps you are trying to get a fair price for what you are looking to buy.
Analysis is what you do or at least expected to do before you buy something and there are different reasons why you will do so. A few of the reasons are that to ensure you are paying a fair price for what you are purchasing and if plan to sell it in future, your analysis will include cover the fact that this ‘thing’ you are purchasing will be worth something in future.
This is the basis of analysing a potential investment. Putting the price aside, trying to determine the value of the item in question and more importantly, making sure that you can sell it at a future date for a much higher price than you paid for it.
It is not about selling the asset for a higher price; you can also earn some cash in the form of dividends. A better way to understand this is thinking of a rental property. As the tenant pays the rent, you get some returns in cash and as the property gains in value (capital appreciation), you benefit from the asset being worth more than what you initially paid for it.
When it comes to purchasing a financial asset there are three main types of analysis you can do namely fundamental, technical and quantitative analysis.
With fundamental analysis you are looking at the fundamentals of the asset you are purchasing and assuming it is a stock, you are looking at things like what does the company do? How does it make money? Who runs the company? Who are its competitors? What products does the company make and how good are they?
Technical analysis however involves looking more at what the market is pricing this asset and where the trends suggest the price will go. It could go up, down or side ways and what you are looking for with technical analysis is an entry or exit point for a trade and you aim to accomplish this with the help of indicators.
Quantitative analysis works by gathering large amounts of historical data about the asset or market and trying to determine how the behaviour of the market participants will affect the price.
In this article we take a look at the different methods of analysis, their benefits and drawbacks of each of the methods. We also look at which methods are preferred for which asset classes and any other techniques to consider.
Fundamental Analysis
What is Fundamental Analysis
Fundamental analysis is a methodical approach that includes pouring over a company’s financial statements, getting to know the management and looking closer at any documents produced by the company in an attempt to understand what the company is worth.
Companies that trade on major exchanges in most countries in the world are required to produce statements and closely examining these statements and coming to a decision to invest is what fundamental analysis is about.
Fundamental analysis allows you to go beyond speculating and guesswork. It presents an opportunity to discover promising companies, spot red flags in others and find undervalued or potential growth stocks.
Fundamental Analysis Basics
Financial Statements
In order to carry out fundamental analysis, there are a number of statements the company produces that are used for analysis.
Income Statement: This report shows the financial performance of the company over a period of time. It may be for a quarter or for the financial year for that company.
Balance Sheet: This reports allows you to see a companies assets, liabilities and shareholders equity. It helps you understand how much debt the company has and how it can survive hard times that may come up.
Cashflow Statement: This report shows how much money comes in to the company, and how the money is used in the company to fund its operation.
Financial Ratios
Using the information available from the financial statements, it is possible to come up with financial ratios as a quick reference guide so to speak, to understand how the company is performing.
These ratios can be divided into the following categories.
Efficiency Ratios: These allow us to measure how effectively a company is using its human and capital resources.
Leverage Ratios: These ratios show a company’s level of debt or debt load.
Liquidity Ratios: These measure a company’s ability to pay it short term (due in a year or less) and long term debt.
Market Value Ratios: These ratios allow you to evaluate the share price of a company’s stock.
Profitability Ratios: This ratio measures a company’s ability to generate income.
Here are a few popular financial ratios.
Debt-to-Equity: This ratio shows how much debt the company has taken or can take.
It can be calculated as follows:
(Outstanding long term + short term debt) / (Book Value)
Earnings-per-Share: This ratio allows the net income earned per share of the company’s outstanding stock.
It is calculated by:
(net income) / (number of shares outstanding)
Dividend Yield: This ratio measures the how much dividend is given to shareholders. It is calculated by:
(dividend per share)/(share price)
Gross Margin Ratio: This allows you to measure the gross profit and net sales to see how profitable the company is.
It is calculated as follows:
(Gross Profit)/(Net Sales)
Fundamental Analysis Advantages
Intrinsic Value: Fundamental analysis is one of the best ways to closely determine a company’s intrinsic value and this is crucial because you want to pay for what it is worth not necessarily the value as suggested by the current price.
Business Understanding: It allows you to understand how a company works. You can see how the company stacks up against its competitors.
Long Term: Fundamental analysis is a great tool for long term investments as it helps uncover companies and sectors that will be growing in the future.
Fundamental Analysis Disadvantages
Time Consuming: It is a time consuming process especially looking through financial statements and coming up with a decision to invest.
No Guarantee of profit: Being able to see how a company has performed over time does not guarantee a profit in future. Fundamental analysis does offer some protection from obvious red flags however a situation such as the great recession in 2008 will affect many companies across the board.
Garbage in Garbage Out: If the company produces false numbers in its financial statements, investors can be deceived by the conclusions they come to. Luckin Coffe is a recent example of this.
Technical Analysis
What is Technical Analysis
Another method of analysis an investor can use to determine what to buy and sell and when to, is Technical Analysis.
With technical analysis, an investor is looking to determine the price movement in an asset by looking at historical prices and statistics in the market.
While fundamental analysis looks at the company or other factors behind the asset class, technical analysis primarily looks at how the charts and trends or patterns suggest the price of the underlying asset will move.
The Different Types of Charts
Charts and indicators are to technical analysis what financial statements are to fundamental analysis. To carry out technical analysis, the analysis is done on a chart and here are few of those charts.
Area
An area chart is similar to a line chart but has an area highlighted as it helps visualise the price movement.
Candlestick
A candlestick chart shows a green or a red line and this simply indicates where the current price is above the opening price or below the opening price respectively.
Line
A line chart shows the different data points on a line and it usually depicts the current price from the closing price. If the current price is currently above the closing price, the line will be green and if the current price is below the last closing price, the line will be red.
Indicators
What are the main types of indicators
Technical indicators are used to determine when to enter or exit a trade. When performing technical analysis, these indicators are especially useful because they show where there is volume, in what direction the trend is moving and any other relevant information you will need to know.
The two main types of technical indicators are Overlays and Oscillators. Here are some well known Technical Indicators.
Most used Technical Indicators
Average Directional Index: Also known as the ADX, it works on a scale between 0 and 100 and it shows how strong a trend is — whether the trend is up or down. It is based on a moving average of the price over a period of time.
Bollinger Bands: This indicator provides a price range the asset trades in and the range will indicate any volatility on the asset. If the bands are closer to the price line, it indicates a lower volatility and if the bands are wider, it denotes higher volatility.
Exponential Moving Average: This indicator is similar to a moving average and it shows momentum in an asset class. It is more sensitive to price changes.
Moving Average: Sometimes known as a simple moving average and it shows the direction of a price trend, without taking into account any short term spikes in the price. A simple moving average can be used over a 20, 50 or 100 day period (or any for that matter) to give a closer look into how strong a trend is with regards to an asset.
Moving Average Convergence Divergence: MACD shows the changes in momentum and it does so by comparing two moving averages. This can help you identify opportunities to buy or sell and including support or resistance levels.
Relative Strength Index: The RSI is a number between 0 and 100 that helps identify momentum. A value of 30 or below is generally considered oversold and a value 70 or above is generally considered overbought.
Stochastic Oscillator: This indicator compares the closing price of an asset to a range of its prices over time and helps identify momentum and how strong a trend is. Similar to the RSI, this oscillator is usually a number between 0 and 100 where a reading of 20 or below indicates an oversold and a reading of 80 or above show the asset is overbought.
Technical Analysis Advantages
Range of applications: One of the main advantages of technical analysis is that it can be applied to any asset on any timeframe. Technical analysis can be performed on Commodities, Forex, Equities, ETFs, Options and other asset classes.
In sync with the market: This means, depending on your timeframe you know what exactly the market thinks and is doing when it comes to an asset you are looking at. With fundamental analysis, in the near future, you may be proven right if you come to the right conclusion from your analysis. With technical analysis the result is sooner rather than later.
Knowing when to buy or sell: Technical analysis can point out entry or exit points when it comes to trading an asset and this is crucial because the trend as they say, is your friend.
Quick decision making: With technical analysis, you open a chart, add indicators, see where the trend is and make a decision using information that is readily available for free. You can look at a 5 minute, 15, 30 or 60 minute chart and make a decision to trade off the back of that.
Technical Analysis Disadvantages
Mixed Signals: Two different indicators may suggest different courses of action where one signal may suggest a sell and the other may suggest the asset is bought.
Spikes in Data: When there is a temporary spike in the price of an asset due to volatility, it may skew the data and the interpretation of that information which can lead to the wrong action carried out.
Over Analysis: It is possible to over analyse an asset due to the sheer number of different indicators out there and knowing which one to apply and pay attention too comes with practice. This can lead to mistakes and can increase the amount of time it takes to make a decision.
Quantitative Analysis
What is Quantitative Analysis
Quantitative analysis makes use of research, data, modelling and statistics to gain insight into the market to help with making investing decisions. It allows you to determine how events in the real world may affect the price of the asset based on data collected.
This method looks at historical price data and will use make use of some technical indicators to build a trading strategy based on how the asset class has traded in the past. It can also uncover relationships between asset classes depending on the economic environment.
Quantitative analysis includes gathering relevant data, back testing it and often times creating trading strategy (coding it) and applying it to the market.
Advantages of Quantitative Analysis
Easy to verify: Since the data is available, it is easy for anyone to backtest the data and verify the result of the trading strategy.
Decision making: The decision making process here is much easier since the findings from the data, back test and any strategy off the back of that will show which strategy is best and this in contrast to technical analysis where two or more indicators can give mixed signals.
Speed of Execution: A large amount of data can be analysed at a time compared to a single analyst looking at different data. Applying the right trading strategy means opportunities can be found and taken advantage of much more quickly.
Disadvantages of Quantitative Analysis
Not forward looking: Since the models are built off historical data, some future possible events are not taken into account that can spell disaster.
Predicting the future: In some cases the trading model is improved to cater for possible future events however it is difficult to predict the future to an accurate degree. And this can lead epic disasters. Long Term Capital Management is an example of this.
Fundamental Analysis or Technical Analysis
Now we have had a brief introduction to the different ways in which an asset can be analysed, we can look closer as what analysis should we apply when investing in bonds, stocks, commodities, forex or any other asset class.
Bonds
A bond is a debt instrument where the issuer of the bond pays interest to the bond buyer for the duration of the bond and pays pack the principal when the bond expires.
A bond can be issued by a government or a company and in a situation where the bond is issues by a company, one can carry out fundamental analysis, technical and quantitative analysis.
You can look at the financial statements of the company to determine if they have the ability long term to pay their bills. Combining this with technical analysis will help highlight if this is a good or bad time to buy.
A government bond can be seen as a safe haven or a flight to safety and in that case, the market may be reacting to an event.
Since a government does not produce financial statements such as you will get with fundamental analysis, it is difficult to perform fundamental analysis on government bonds.
One form of analysis you can do before purchasing a government bond is by looking closer at the economy such as employment rate, interest rates and other indicators that should show the government will be able to pay back its debt.
Bearing that in mind, there are ratings agencies such as Moodys that rate bonds and can help give an indication as to which bonds are safe i.e triple A and others that are not.
Commodities
Whether it is oil, gold, lean hog, orange juice and other commodities out there, it is a bit challenging to carry out fundamental analysis going off the back of financial statements because there is no single commodity company out there that produces an income statement, balance sheet to cash flow statement that can analysed on behalf of all the players in commodity space.
On the other hand, research can be done to look into harvest, droughts market events such as the impact of lock downs on the price of crude oil and using technical analysis, see how the market reacts to these events and trade accordingly.
In some cases where a disease that wipes out some animals which means demand is even further increased. Recently china announced the outbreak of a disease that affected its pig production so this gap in supply affected prices.
Stocks
When it comes to evaluating stocks, all the methods of analysis can be applied. Fundamental and technical analysis both have their part to play when analysing a company and as a savvy investor, it is crucial to know how to carry out both and understand what course of action the signal suggests.
The outcome of fundamental analysis may show a company has strong fundamentals however may have suffered a bad quarter or not quite met earnings estimates for one quarter and the market may react negatively to that news – albeit for some time.
In such situations, timings key and it may be better to wait for the noise to settle before purchasing the stock.
Quantitative analysis can also be done for aspects of the company to further improve the quality and detail of the information and decision made off the back of it.
Forex
When it comes to analysing forex currencies, technical and quantitative analytical methods are mainly used. There are some ‘fundamental’ factors that determine how a currency may trade against another such as commodity prices, interest rates, employment rate, etc however by and large, technical analysis is used to interpret the effects of those numbers on the market.
There are no financial statements to be analysed such as cash flow or income statements when it comes to currency pairs so fundamental analysis in that sense has little to no impact here.
This table below illustrates what methods of analysis work best for the different asset classes.
| Fundamental Analysis | Technical Analysis | Quantitative Analysis | |
| Bonds | YES | YES | YES |
| Commodities | NO | YES | YES |
| Stocks/Equities | YES | YES | YES |
| Forex/Currencies | NO | YES | YES |
Summary
When it comes to investing for the purpose of getting value from an asset we are about to purchase, it is imperative to perform analysis and there are three main types.
Fundamental analysis looks at the fundamentals of the business allows you to better understand the company behind the ticker.
Fundamental analysis is done by looking at the financial statements a company produces and coming to a decision to invest – this is what separates you an investor from an auditor or accountant.
Technical analysis is done by looking at indicators and patterns that show entry and exit points for a trade. It can be performed on any asset class and the aim is to buy or sell an asset at the right time.
There are a number of indicators that show the price trend, volume and momentum of an asset. All these enable an analyst to make decisions on how to invest.
A quantitative approach to analysing an asset captures a lot of data and relevant stats to determine how the asset will trade. The data is backtested and usually a trading strategy is created off the back of the analysis.
When to use Fundamental or Technical Analysis
Considering the different types of analysis mentioned above, there are situations where one is more appropriate than the other however it depends on how much time and knowledge you have.
Ideally it is better to apply both styles of analysis before purchasing an asset class as they provide different outlooks that will help the investment making process. The aim is to gather as much relevant information as possible.
For example, sometime in March 2020 the market was down and by that I mean there main indices in the US, UK and across the world due to the lockdown as a result of Covid-19. Good companies based on your analysis were still good companies because the fundamentals as of that date had not changed. Many of those companies such as Netflix, Disney and Amazon have bounced back and done better.
Technical indicators of these stocks on the day in March would have suggested a sell due to the heading in which the market was going but fundamental analysis will suggest the fundamentals of the company are still the same so selling at that point in them may not seem like a good idea.
This simple example shows why applying fundamental and technical analysis is necessary. When it comes to quantitative analysis using this example above, if the data model is forward looking to capture a situation like this, a better decision can be made by the trading strategy.
A situation where there is a 10% or more movement in the market in any direction if incorporated in to the data set, can be used beneficially from a trading point of view.
