Where is fundamental Analysis needed
As an investor it should be sufficiently clear that fundamental analysis is the starting point before deciding to invest in a company. Here are a few situations where fundamental analysis is especially needed.
Unexpected changes in the economy such as the impact of the Wuhan Virus or Covid-19 is an example of where fundamental analysis is needed. Many businesses were forced to close down as several lockdowns followed and as a result these companies were not getting cash needed to function. The fundamentals of these businesses had changed as a result.
When a business is not getting money or a reduced supply of money because it is unable to sell its products, that is a sign of potential danger. If no money is coming into the business, then there is hardly any prospect for the company to make profits.
Other companies during the lockdown would have seen a boost to their balances as a result of the changes in consumer habits during the lockdown. Consumers bought almost everything legal online and thinking about the follow through in that process, delivery companies would have seen an increase in demand.
Commercial real estate investors in warehouse or others that are used by delivery companies would have seen a good return over this period of time. Shrewd big players have scooped up warehouse or order processing spaces as this article reveals.
Companies like Zoom have become ubiquitous in our daily work life. Netflix, Disney and other similar companies have seen their number boosted by new subscribers to their products and services.
A significant amount video content has been consumed during this period of time so YouTube or better yet Alphabet the parent company of Google has seen an increase in revenue and profit over this time.
Situations like those listed above are an opportunity to delve deeper into these companies and see which one is the most promising now and into the future as best as possible.
Fundamental analysis can help you see which companies can survive a downturn much better.
Inflation is another recent ‘event’ that can present opportunities and closely looking at how companies may be impacted by inflation will show if the opportunity is worth it.
Some companies do better during periods of high inflation while others do not fare as well. Carrying out analysis should help clarify any doubt as to which companies to invest in.
In a situation where you already have a positions or invest in a company, it is worth reviewing that investment from time to time to make sure your financial expectations are still valid.
Companies are dynamic entities; reacting to opportunities, regulations and other factors in the market place. Unless you have a passive investing strategy where you can invest, hold and wait long term, it makes sense to review the investment made into these companies.
Fundamental analysis is beneficial when looking to re-invest in a company. In some cases the outcome of the investigation may suggest a reduction in the position but then that is the point of analysis – to invest or not to invest.
Which type of Fundamental Analysis
There are different approaches to fundamental analysis but the ultimate goal is the same; to find a company or companies to invest in.
The main styles are the Top down approach and the Bottom up approach.
Top down Approach
With this approach to fundamental analysis, an analyst will be looking at the overall economy, followed by the different sectors, the industry and finally the companies in those sectors.
Economy: This includes looking at the Gross Domestic Product of that economy in question. Other aspects such as Employment, Interest Rates and Inflation will be considered as you try to determine if the economy is in a good state or not.
The Central Bank in that country may choose to increase interest rates, leave them as they are or reduce them and those action can have an effect on the companies operating in that economy.
Industries: The next thing to consider are the industries in this environment that are thriving or look promising in those economic conditions. A low interest rate environment means money is easy to borrow and if inflation is within the target, there may be no incentive to rein in consumer spending.
Sectors: Next the sectors in those industries can be analysed further based on the economic conditions and trends with the aim of finding companies that will benefit from the economic climate.
Companies: This is the final stage where we look at the companies in this sectors, compare them with their peers and decide on which to invest in based on research.
Bottom Up Approach
This involves looking at the company’s fundamentals and extending the research to the industry, sector, economy and other macro events that may be occurring. With this method you are looking first at the microeconomic factors and looking further at the macroeconomic factors.
The financial statement, balance sheet, cash flow statement and other relevant documents will provide into how the company functions. Once this is done, the focus can now move to how that sector is performing and where the growth can be.
An important take away here is to understand how the approach taken determines and influences the decision to invest in one company over another.
Consider this example and the relevant timing. Q1 2020, a bottom up approach shows Netflix is promising; the top line numbers are good, earnings are looking good and the overall fundamentals of the company are positive.
The lockdown in March later that year boosts the numbers for Netflix because more people are locked down and have a bit more time to watch their favourite shows. In this example you can see how bottom up approach and the macro events come together to boost Netflix.
In the same manner a slump in the price of oil due to restrictions on travel would hurt some companies and cause others to profit. It should be obvious that transportation related shares such as airlines and cruise ships will suffer.
Furthermore the lack of tourism means hotels, car rentals and any companies that would otherwise benefit from the lack of restrictions, will have to face hard times. Starting by looking at these macro events and drilling down further can highlight potential opportunities especially when the economy began to open up.
Summary
It is wise to carry out analysis before purchasing a stock or even a company bond and fundamental analysis presents a way to go about it. In some situations it could be when taking a new position in a stock or in others, trying to decide if you want to buy more or reduce your exposure depending on the prevailing economic situation.
There are a two main approaches to fundamental analysis namely top down or bottom up. The main differences between these approaches is the sequence in which different factors are looked at as a part of the decision making process.
A top down approach start by looking at the economic and political situation in a country, the industry of interest, sector and then any promising companies in that sector.
A bottom up approach reverses the process by looking at the fundamentals of the company, the sector, the industry and then the prevailing economic conditions.
